NATIONAL ASSOCIATION FOR INDEXED PRODUCTS

January 5, 1998

Mr. Jonathan Katz, Secretary

Securities and Exchange Commission

450 Fifth Street, NW

Washington, DC 20549-6009

Re: Equity Index Insurance Products

File No. S7-22-97

Dear Mr. Katz:

In response to the Commission's request for comments concerning the status of equity index insurance products ("EIPs") under the federal securities laws, 1 we are submitting this letter on behalf of the National Association for Indexed Products (the "Association"). On behalf of our membership, we would like to thank you for the opportunity to comment on this important public issue.

The Association is a non-profit corporation organized in 1997 for the purpose of promoting EIPs and educating all sectors of the industry with regard to EIPs. The Association membership includes insurance companies, insurance brokers and agents, marketing professionals, actuarial consultants and other individuals and entities with an interest in EIPs. The Association's activities extend to EIPs that are unregistered, as well as those that are appropriately registered under the federal securities laws.

Because we previously submitted a letter dated March 6, 1997, to Susan Nash, Esq., of the Commission's staff (the "March letter") concerning our legal analysis of EIPs, we will not repeat that analysis in this letter. We are, however, submitting a copy of our March letter as an addendum to this letter, in order to make it part of the record in response to the Commission's request for comments. We note that many of the questions raised in the Concept Release are addressed in our March letter.

In Part I of this letter, we take the opportunity to address the legal status of EIPs from a more global perspective. In our view, EIPs present two primary regulatory questions:

(1) How can regulators best ensure that insurance companies have sufficient assets to meet their payment obligations to consumers under EIPs; and

(2) How can regulators best ensure that consumers have adequate information to make informed decisions as to whether to purchase an EIP?

It is our view, respectfully submitted, that the investment risk/marketing test customarily used in analyzing the status of insurance products under the federal securities laws, at least as applied to EIPs, may obscure the answers to these questions. We believe that by focusing on these questions, it will become apparent that in many instances, state insurance regulation alone provides sufficient regulatory protection for purchasers of EIPs, and that in others, there is also room for a federal regulatory role.

In Part II of this letter we expand on some of the comments in our March letter and address some of the specific questions raised in the Concept Release.

PART I.

A. Introduction

Section 3(a)(8) of the Securities Act of 1933, as amended ("Section 3(a)(8)"), reflects a Congressional determination that certain types of instruments that would otherwise meet the statutory definition of a security, i.e., "any insurance or endowment policy or annuity contract or optional annuity contract" issued by an insurance company, are to be left to the sole regulation of state insurance regulators. The purpose of this statutory exemption has been described by the Supreme Court as follows: 2

The point must have been that there then was a form of "investment" known as insurance (including `annuity contracts') which did not present very squarely the sort of problems that the Securities Act and the Investment Company Act were devised to deal with, and which were, in many details, subject to a form of state regulation of a sort which made the federal regulation even less relevant.

As is noted in the Concept Release, "(t)he Commission has previously stated its view that Congress intended any insurance contract falling within Section 3(a)(8) to be excluded from all provisions of the Securities Act . . . ." 3 Neither the language of Section 3(a)(8) nor the legislative history place any limitation on the types of securities that are exempted from federal securities law regulation.

In interpreting this statutory provision, the courts and the SEC have fashioned a two-part test under which the status of a contract as a "security" or "insurance" for purposes of Section 3(a)(8) depends on (a) the degree of investment risk under the product and (b) the degree of marketing emphasis placed on the investment aspects of the product. This test derives from SEC v. Variable Annuity Life Insurance Co. of America (" VALIC"), 4 and SEC v. United Benefit Life Insurance Co. ("United Benefit"), 5 and is the basis for Rule 151, 6 which, together with the related SEC Releases proposing and adopting Rule 151 7 , is customarily used as the basis for analyzing whether an EIP is required to be registered with the Commission as a security.

It is our view that this analysis obscures the core regulatory issues posed by EIPs. All cash value insurance products place some investment risk upon the contract owner. This was true in 1933, when Section 3(a)(8) was enacted, and it is true today. Consistent with this reality, as discussed in the March letter and below, 8 Rule 151 provides a safe harbor from securities registration with the SEC for insurance contracts under which the contract owner bears a not insignificant amount of investment risk. Accordingly, while an inquiry into how much "investment risk" is too much may be useful in analyzing some insurance products, it does not provide guidance as to the status of many products because of the difficulty of drawing lines between degrees of "investment risk" in the absence of Congressional guidance.

Likewise, in view of the foregoing, it naturally follows that marketing materials for any cash value insurance product must describe the investment aspects of the product. We strongly believe that purchasers of EIPs must be given a full and accurate description of the product, particularly the equity index interest crediting mechanism, so that they will have an adequate basis for their purchase decision. The question has been raised that, under the marketing test, providing such a description may necessarily place the primary emphasis on the investment aspects of the product, and therefore require classifying a particular product as a "security". A test that may deter some insurers from providing as complete a description of the investment aspects of their product as they might otherwise provide is, in our view, counter-productive.

Accordingly, in our view the focus of the SEC's inquiry should be on what regulatory framework would best protect consumers who purchase EIPs. This approach would be consistent with Congress' apparent determination in adopting Section 3(a)(8) that state insurance regulation alone was sufficient protection for purchasers of life insurance and annuity products. In making this analysis, the SEC should consider what regulatory issues EIPs present, how they will be regulated in the absence of SEC regulation, and whether the issues presented by these products go to the core competencies of the SEC. The answers to these questions will determine whether or not a dual regulatory regime is necessary and permitted under Section 3(a)(8).

EIPs in many respects present the same types of issues as other cash value insurance products that are not registered with the Commission as securities. EIPs usually are structured so as to be similar in most respects to other unregistered products sold by the offering insurance company.

Accordingly, the two primary regulatory issues unique to EIPs, which flow directly from the distinguishing characteristic of EIPs, i.e., the equity index interest crediting feature, are:

(1) How can regulators best ensure that insurance companies have sufficient assets to meet their payment obligations to consumers under EIPs; and

(2) How can regulators best ensure that consumers have adequate information to make informed decisions as to whether to purchase an EIP.

We will address each of these issues in turn.

B. Ensuring that insurance companies have sufficient assets to meet their payment obligations to consumers under equity index insurance contracts

Under the typical equity index insurance contract, the insurer promises to credit interest to the cash value of the contract in accordance with a formula set forth in the contract and to pay the benefits described in the contract in amounts calculated on the basis of the cash value. The amount of interest credits typically is not linked in any way to the value or performance of the insurer's assets. Accordingly, one of the most significant regulatory questions raised by EIPs is how to ensure that the insurer will have sufficient assets to meet its benefit obligations under the contract.

As lawyers, we do not intend to substitute our judgment for that of actuaries and state regulators on this issue. Our point, rather, is that this issue engages one of the core competencies of state insurance regulators and lies totally outside the usual realm of securities regulation.

One of the primary roles of state insurance regulators is to ensure that insurance companies have sufficient assets to meet their benefit obligations under their outstanding contracts. State regulators meet this role in a variety of ways. Among other things, the states establish permissible categories of investments and promulgate detailed reserving and risk-based capital requirements for different types of insurance products. Moreover, state regulators periodically conduct inspections to test the adequacy of reserves and risk-based capital.

State insurance regulators are addressing these issues in a comprehensive way in the context of EIPs. The Life and Health Actuarial Task Force of the National Association of Insurance Commissioners ("NAIC") has asked the American Academy of Actuaries ("AAA") to develop recommendations governing all actuarial aspects of EIPs. The AAA in turn has formed a Task Force (the "AAA Task Force") to comply with this request. The areas in which the AAA Task Force is preparing recommendations include reserving issues, valuation actuary issues, risk-based capital issues, investment issues, and marketing and disclosure issues. As of November 1997, the AAA Task Force had issued three Interim Reports. The report of the AAA Task Force, when completed, will be used by the NAIC in formulating new model regulations and changes to existing regulations applicable to EIPs.

This type of substantive regulation differs significantly from the SEC's regulation of securities and certain insurance products. As a general matter, the SEC does not engage in substantive regulation of securities issuers. The SEC's role is primarily to ensure that issuers of securities provide adequate disclosure concerning themselves and the securities that they issue. While these disclosure requirements cover matters such as the issuer's financial condition, results, management, and securities, the SEC does not prescribe and enforce financial requirements such as are the essential elements of state insurance regulation.

This type of substantive regulation also differs significantly from the SEC's regulation of investment companies. While the Investment Company Act of 1940, as amended, contains numerous substantive provisions, SEC regulation of investment companies does not as a general matter dictate how investment companies meet their investment objectives, but rather that those objectives be fully disclosed and that prospective investors be provided with sufficient information to be able to evaluate on their own the company's and its investment adviser's qualifications to seek and succeed in reaching those objectives.

The suggestion has been made, however, that at least some EIPs should be treated similarly to variable insurance products for both state and federal regulatory purposes. If this suggestion were generally adopted by the states, it might well warrant different regulatory treatment under the federal securities laws, as the reserving and other financial requirements applicable to variable insurance products under state law generally differ significantly from those currently applied to EIPs and under consideration by many state regulators and the AAA Task Force.

Equity index insurance contracts, however, differ significantly from variable insurance products. Most significantly, EIPs, unlike variable insurance products, do not provide for the pass through of the performance of any of the issuing insurance company's underlying assets. The interest credited under an EIP depends on a formula established in the contract, in which the changes in an outside index are one of the elements. That interest is not linked to the actual performance of the insurance company's assets. Moreover, the insurer’s general account assets are available to meet the insurers contractual obligation to pay interest on its EIPs. Thus, the insurer's obligation to pay equity-linked interest is more akin to the insurer's obligation under a traditional fixed life insurance or annuity contract, which also is not linked to the performance of the insurer's underlying assets. In addition, we understand that because index-based interest does not reflect the actual performance of the insurer's assets, under at least some state insurance laws an equity-index insurance contract would not qualify as "variable insurance" even if the assets were held in a separate account. 9

Finally, we note that this distinction between equity index and variable insurance products was implicitly accepted by the SEC staff in issuing the Valley Forge Life Insurance Company No-Action letter. 10 There, the staff provided no-action relief permitting the issuer of an equity index annuity contract to hold the assets underlying the contracts in an non-unitized separate account, without registering the separate account as an investment company. 11 While the staff imposed several conditions in its response, the primary basis for its conclusion was that the interest was determined based on a formula fixed in advance and was "not dependent on the investment experience of a separate account." 12

C. Ensuring that consumers have adequate information to make informed decisions as to whether to purchase an EIP

It is beyond dispute that prospective purchasers of EIPs should be provided with full and adequate disclosure concerning all of the features of the product, including the equity index interest crediting features of the product, irrespective of whether the product is regulated as a security or solely as insurance. We do not propose here to describe the specific disclosure that should be provided to the purchasers of EIPs. Rather, our point is that insurers that offer EIPs are attentive to disclosure issues, and state insurance regulators are in the process of developing disclosure standards specific to EIPs.

In our experience insurance companies that offer EIPs take extensive steps to ensure the adequacy of the disclosure in their marketing materials and in the presentations by their sales force. Marketing materials for EIPs frequently are subjected to lengthy review by internal and outside counsel to ensure that the presentation is balanced and complete. Particular attention typically is paid to ensuring that the interest crediting formula is clearly described and that investors are made aware of the minimum interest that may be credited to their contract, as well as the possibility of additional index linked interest. Many insurers also use a product summary highlighting key features of the contract and take steps to ensure that each purchaser receives a copy of the summary. Many insurers also have instituted training for their agency forces and some require that agents pass a test before they are permitted to sell EIPs.

The insurance industry and the state insurance regulators have been cooperating in numerous ways to develop guidelines and standardized disclosure materials to ensure that consumers are well informed about the product they are buying. Since 1996, NAIC working groups have been working with industry groups on disclosure guidelines. Among other things, these industry groups have provided reports and comments on a proposed Buyers Guide, which would provide generic disclosure concerning equity index annuity products, guidelines for narrative disclosure concerning the elements of a specific EIP, and proposals for illustrating EIPs.

In addition, one of the Interim Reports of the AAA Task Force referred to above included disclosure recommendations for contract benefits and values. That report also included a recommendation that disclosure materials for EIPs should contain balancing language, as well as examples, to ensure that prospective purchasers are made aware of the negatives as well as the positives of EIPs.

In this regard, it should be noted that the involvement of today's state insurance regulators in marketing issues is very different from the court's perception in VALIC, which was decided 40 years ago. There, the concurring opinion stated that "(t)he system (of state insurance regulation) does not depend on disclosure to the public, and, once given this form of regulation and the nature of the `product', it might be difficult in the case of traditional life insurance or annuity contract to see what the purpose of it would be." 13

State insurance regulators have increasingly focused on market conduct issues, including the adequacy of disclosure in insurance company marketing materials and the methods used by insurance agents to sell insurance products. Many state insurance departments require the filing of sales literature with the filing for approval of the contract. Sales practice problems in the sale of universal life insurance products have resulted in numerous state regulatory enforcement cases and private litigation. In response, state insurance regulators are devoting increased attention and additional resources to disclosure and sales practice issues in the sales of all types of insurance products. Moreover, as the NAIC's interest in EIPs shows, state insurance regulators are aggressively evaluating new products in order to devise adequate regulatory responses before problems arise.

Moreover, federal regulation of EIPs will not answer the disclosure questions raised by those products, but merely move them to a different forum. While disclosure is one of the central missions of the SEC, for obvious reasons the SEC currently has no well elaborated guidelines for EIP disclosure. State regulators, on the other hand, have been considering them for over one year. Moreover, because of state substantive regulation of EIPs and the nature of the products themselves, much of the financial and operational disclosure required by the SEC (and in which the SEC has unquestioned expertise) is of limited utility. For instance, disclosure concerning the composition of the insurer's general account assets will not help a prospective contract purchaser to evaluate the prospects for the crediting of indexed interest.

D. Conclusion

While VALIC made clear that the existence of adequate state regulation does not by itself eliminate the need for federal securities regulation of an insurance contract, 14 we believe that the NAIC's initiative in the area of EIPs should be an important factor in the SEC's consideration of the status of EIPs under the federal securities laws. As stated above, Congress' rationale in adopting Section 3(a)(8) is that certain types of insurance contracts do not squarely present the types of issues that the federal securities laws were intended to address. As Justice Brennan's concurring opinion in VALIC makes clear, one basis for that rationale is that those types of contracts were subject to comprehensive state regulation. 15

As described above, the primary regulatory issues raised by the typical EIP are the types of issues that traditionally have fallen within the purview of state insurance regulators or that have clearly become a part of state insurance regulation. Moreover, state insurance regulators are actively seeking to carry out their obligations in that regard. In our view, these factors weigh significantly in favor of the conclusion that the typical EIP should be treated as "insurance" for purposes of Section 3(a)(8) and against a blanket determination that EIPs should be subject to federal regulation as securities.

PART II.

A. Investment Risk

Our comments concerning the application of the "investment risk" test to EIPs is set forth at length in our March letter, which is submitted herewith. In this part of our letter, we wish to supplement that discussion in certain respects.

As a general matter, it should be noted that EIPs typically place significant limitations on the amount of investment risk assumed by contract purchasers. Equity index annuity products generally guarantee that the cash value will never be less than 90% of the premium paid accumulated at 3% annually, in accordance with state non-forfeiture laws for single premium deferred annuities, and also guarantee any additional interest credited to the cash value. Equity index life insurance is subject to differing non-forfeiture law requirements consistent with its differing structure. Accordingly, the investment risk issue in the context of most EIPs is not the risk of loss of principal, as is the case with most types of securities, but rather the risk that the excess interest credits may be more or less.

These guarantees are substantially stronger than the guarantees found to be inadequate in United Benefit. 16 There, the insurer guaranteed that the cash value in the first year would be at least 50% of the premium paid and would increase gradually thereafter until it reached 100% of premium after 10 years. 17 In contrast, most EIPs guarantee a higher percentage of the premium, i.e., 90%, at the outset, reach 100% of premium within four years, and guarantee that interest will continue to accumulate at least 3% thereafter. Accordingly, owners of EIPs that provide these types of guarantees assume much less investment risk than was assumed by owners of the contract held to be a security in United Benefit.

In addition, the formulas used in many contracts contain features that further limit the amount of investment risk assumed by the contract purchaser. For example, most formulas do not permit reductions in the cash value to reflect declines in the measuring index. In addition, crediting formulas provide additional guarantees to the contract owner by guaranteeing previously credited index-based interest. This feature relieves the contract owner of the risk of subsequent declines in the index after the crediting event.

Also, the amount of investment risk assumed by the owner of an EIP typically is lessened if the owner holds the product to maturity. The amount of interest credited to a contract holder in different one year periods may differ significantly depending on the amount and direction of change in the measuring index during that period. When longer holding periods are considered, however, the differences in the amount of interest credited in different periods tends to decrease, because each holding period is likely to contain some good years, some ordinary years and some bad years.

In addition, we believe that the investment risk assumed by purchasers of many EIPs is similar in degree to the risk assumed under other unregistered insurance products and permitted under Rule 151. Clearly, the degree of risk assumed will depend on the characteristics of the specific product. However, purchasers of types of insurance products in existence in 1933, when Section 3(a)(8) was enacted, and still offered today assume investment risks similar to those assumed by purchasers of EIPs. For example, participating whole life insurance policies, which are clearly insurance, declare dividends at the end of each year and do not guarantee any annual dividend.

Indeed, in a sense, the purchaser of a whole life insurance policy assumes more investment risk than the purchaser of a typical EIP. The dividend on a participating whole life policy is entirely dependent on the discretion of the insurance company, and the insurer may tailor the amount of the dividend to its earnings on its general account assets. The interest credited to an EIP, on the other hand, is determined based on a formula linked to changes in an external index, and the insurer guarantees to pay the amount determined under that formula irrespective of the earnings on the underlying assets. The act of "objectifying" the basis for crediting interest should not be regarded as contributing to an EIP's status as an investment product.

Also, as discussed in our March letter, Rule 151 anticipates that owners of unregistered insurance products may properly assume some risk of fluctuations in the amount of interest credits from year to year. Rule 151 only requires that excess interest rates be guaranteed for one year in advance. As a result, as the SEC noted in the Release adopting Rule 151, the purchaser of an annuity contract exempt from registration under Rule 151 properly could assume the investment risk that after the initial guarantee period "(1) no discretionary excess interest will be declared or (2) the rate actually declared will fluctuate (up or down) from the rate guaranteed in the immediately preceding period." 18 While Rule 151 sets a floor for interest rates and requires that excess interest rates be reset no more frequently than annually, the SEC imposed no ceiling on the extent to which those rates may change between guarantee periods, leaving the contract owner exposed to that investment risk.

While this risk may be small with respect to a particular guarantee period, the range of interest rates paid under a traditional fixed-rate annuity might vary greatly over the life of the contract, while still complying with the requirements of Rule 151. For example, where a fixed annuity contract guarantees an excess interest rate for successive one-year periods, subject to a 3% minimum rate guarantee, the interest rate guaranteed and paid in the seventh year of the contract might differ greatly from the rate in earlier years.

We believe that the investment risk should be considered in the context of the life of the contract, as opposed to individual contract years, because one characteristic of traditional insurance products is that they are intended as "long-term insurance devices for retirement or income security". 19 In this perspective, the risk of fluctuations in the amount of interest credited under a typical EIP design would not necessarily differ significantly from the risks assumed by the purchaser of an insurance product that met the requirements of Rule 151.

Use of a retrospective formula does not per se mean that excessive investment risk is assumed by the purchaser of an EIP. As noted above, the type of investment risk at issue here is whether the excess interest credited to an EIP may be greater or lesser. As discussed above, even where excess interest rates are declared in advance for one year periods, as required by Rule 151, those amounts can differ greatly from year to year. Furthermore, some types of traditional insurance products, such as participating whole life insurance products, which clearly are not securities, credit dividends that are determined retrospectively. Accordingly, we believe that the retrospective nature of the formulas used in typical EIPs is not determinative of their status under Section 3(a)(8).

Finally, we note that the type of investment risk under a typical EIP differs qualitatively from the investment risks assumed by the purchasers of the contracts at issue in VALIC and United Benefit. In both cases, the decision in part turned on the Court's view that despite the insurance aspects of the variable annuity contracts in question, in reality they were substantially similar to open-end investment companies. 20

The purchasers of an EIP, however, are not acquiring an interest in the investment management success of the insurer. As discussed above, the interest credited to the typical EIP does not represent a passthrough of the insurer's earnings on its underlying assets. Instead, the insurer is obligated to credit index-based interest in the amounts determined under its crediting formula, irrespective of the insurer's success or failure in managing its underlying assets. While the terms of the formula, including items such as participation rates, typically are affected by the insurer's expectations of its ability to earn the amounts necessary to pay index-based interest, in this respect the insurer's conduct does not differ from the conduct of an insurer that sets a declared interest rate in advance based on the expected return on its underlying general account assets.

B. Marketing

Our comments concerning the marketing test are set forth in the March Letter, which we are submitting herewith. As that letter indicates, we believe that it is appropriate and permissible under the marketing test to include in the marketing for an EIP an extensive description of the product's investment aspects, in particular the interest crediting mechanism.

We would, however, like to take this opportunity to urge the staff to provide guidance on compliance with the marketing test. We understand that in the past the staff has declined to provide such guidance. The absence of formal guidance from the staff, however, leaves insurers in a difficult position in determining what is or is not permissible under the marketing test. As noted above, we are concerned that in some instances this uncertainty may inhibit insurers from providing consumers with disclosure concerning the investment aspects of EIPs that the insurers would otherwise provide. At a minimum, it would be helpful for the staff formally to state that full non-promotional descriptions of the index-based interest crediting method will not be regarded as marketing the investment features. Accordingly, we believe that the public interest would be better served if the staff would reconsider its position.

We would like to take this opportunity to call the Commission's attention to an anomalous result of the application of the federal securities laws to certain EIPs. Assuming that an EIP is appropriately registered under the federal securities laws, the issuer is severely handicapped in providing useful and essential information to prospective investors. Under current law, the only type of product advertising permitted to registered EIPs is "tombstone" advertisements under Rule 134 under the Securities Act of 1933 (the "1933 Act"), and supplemental sales literature, which must be accompanied or preceded by the statutory prospectus. Accordingly, registered EIPs (indeed all registered insurance products other than variable life insurance and annuities) are placed at a competitive disadvantage to unregistered EIPs, which are not subject to this restriction, and variable annuities, which are permitted to use this type of advertising pursuant to Rule 482 of the 1933 Act. We urge the staff to consider using its authority under Section 10(b) of the 1933 Act to enact a regulation permitting registered EIPs to use advertisements containing information the substance of which is set forth in the products' registration statements. We do not believe that there is any policy reason for the distinction and accordingly recommend that the staff propose regulation to correct this disparity.

* * *

On behalf of our membership, thank you for this opportunity to present our views. The Association and its members stand ready to assist you in your further consideration of these issues. If we can provide you any additional information or you would like to discuss any of the foregoing points, please contact me at the telephone number written above or (202) 625-3780 or contact Christopher S. Petito at (202) 625-3784.

 

Very truly yours,

National Association for Indexed Products

Joan E. Boros, Chairman

(202) 625-3780

March 6, 1997

Susan Nash, Esq.

Assistant Director

Office of Insurance Products

Division of Investment Management

Securities and Exchange Commission

450 Fifth Street, N.W.

Washington, D.C. 20549

Re: Legal Analysis of Equity-Index Insurance Products Under Section 3(a)(8) of the Securities Act of 1933

Dear Ms. Nash:

In response to your request at our meetings during the week of February 3, 1997, we are submitting this letter summarizing our analysis of the application to equity-index insurance products of Section 3(a)(8) ("Section 3(a)(8)") of the Securities Act of 1933, as amended (the "1933 Act"), which as a general matter exempts "insurance" and "annuity contracts" from the registration and other requirements of the 1933 Act. Since, as discussed below, Section 3(a)(8) requires a "total facts and circumstances" analysis, we thought it would be helpful for your present purposes to discuss the general framework of our legal analysis and its application to certain product features commonly found in equity-index insurance products. We note that this letter expresses our views as attorneys who practice in this area, and does not represent the views and analysis of other legal practitioners or industry participants. At our meeting on March 12, we will be happy to discuss the contents of this letter and to amplify or supplement this analysis.

C. Introduction

Equity-index insurance products are a new form of an old means for consumers to attain traditional insurance goals of life insurance protection and long-term retirement planning. While equity-index insurance products are built on the framework of traditional life insurance and annuity products, the benefits payable under equity-index insurance contracts reflect the realities of consumer demand in today's market for retirement products. Because of the product's guarantees of principal and interest, however, equity-index insurance products, like more traditional insurance and annuity products, continue to appeal primarily to insurers' traditional market of risk-averse consumers who are attracted to the stability and security offered by insurance company guarantees coupled with extensive state regulation of the insurance company's financial strength.

Most of the equity-index insurance products issued to date have not been registered with the Securities and Exchange Commission ("SEC") as securities under the 1933 Act. At least three products, however, have been registered with the SEC.

While features vary, equity-index insurance products typically resemble each other in that (a) the interest credited to the policy value of these products is determined under a formula linked to the percentage changes in an index and (b) the product provides guarantees of the contract holder's principal and at least a minimum rate of interest. The extent to which changes in the relevant index affect interest credits depends on the particular indexing formula used in the contract.

The fundamental legal issue raised is whether a particular equity-index insurance product is an "insurance" product within the meaning of Section 3(a)(8). If so, the product is exempted from the registration provisions of the 1933 Act. 21 If not, the product is a "security" 22 whose offering must be registered under the 1933 Act and made through a statutory prospectus. 23

The statutory definition of "insurance" includes "(a)ny insurance or endowment policy or annuity contract", without carving out any category of insurance contract for regulation by the SEC. Over the years, however, the SEC and the courts have repeatedly addressed the issue of whether specific insurance products, notwithstanding their issuance by insurance companies, contain essential terms that so differ from traditional insurance products and are marketed in such a way that such insurance products should be registered and regulated as securities. Through rulemaking and policy statements by the SEC and the staff, and in judicial proceedings, a body of law has emerged defining the parameters of the statutory definition of insurance. Although single premium deferred annuity contracts have drawn particular regulatory attention, 24 the SEC also faced this issue in deciding, in the 1950s, that variable annuities and, in the 1970s, that variable life insurance should be registered as securities 25 and again in the 1980s when the SEC apparently decided that universal life insurance need not so register. 26

The SEC's most explicit recent guidance on the application of Section 3(a)(8) is provided by Rule 151 27 and the Rule 151 Releases, i.e., Releases 6645 and 6558. 28 While Rule 151

provides a safe harbor under Section 3(a)(8) for certain types of deferred annuity contracts, the SEC has stated that Rule 151 and its underlying rationale may be relied upon for guidance in analyzing any insurance product under Section 3(a)(8). 29

Rule 151 provides a three-part test for determining whether a deferred annuity contract fits within its safe harbor. The three parts, briefly stated, are: (1) whether the contract is issued by an insurer; (2) whether the insurer assumes the investment risk under the contract; and (3) whether the marketing for the product places primary emphasis on the investment aspects of the product. These three conditions generally reflect the requirements of prior case law and the SEC's prior analysis of this issue. Rule 151 and the Rule 151 Releases also provide explication as to the application of these conditions to certain features of deferred annuity contracts.

Because Rule 151 does not expressly address the use of index features such as the formulas used to determine excess interest under equity-index insurance products, our analysis of equity-index insurance products does not rest directly on Rule 151. Instead, our analysis ultimately rests on Section 3(a)(8). As the SEC suggested in the Rule 151 Releases, 30 however, our analysis relies heavily on the conditions set out in Rule 151 and the Rule's underlying rationale, as well as other relevant factors identified in appropriate judicial interpretations of Section 3(a)(8).

We have analyzed numerous equity-index insurance products utilizing this analytic framework and in many instances concluded that, in our view, particular equity-index insurance products do not need to be registered as securities under Section 3(a)(8). As you are also aware, we also have served as counsel to insurance companies in connection with the registration of certain equity-index annuity contracts under the 1933 Act.

To assist you in your evaluation of equity-index insurance products, we have prepared the following discussion explaining how equity-index insurance products can fit within the statutory definition of insurance under Section 3(a)(8). Given the diversity among existing equity-index insurance products, we have not discussed a specific product or products, but rather outlined our analytic framework and described how certain common indexing formulas or product features would fit within that analysis. Accordingly, Part B of this letter describes some of the features commonly found in equity-index insurance products, Part C describes in more detail our legal analysis of the standards under Section 3(a)(8), and Part D discusses the application of this analysis to equity-index insurance products.

D. Overview of Product Features

Most equity-index insurance products issued to date have been single premium deferred annuity contracts. A few companies, however, are also offering flexible premium deferred annuity contracts with index-based interest features. At least one company is selling an equity-index universal life insurance product.

Equity-index insurance products typically do not directly pass through the performance of the underlying index. Instead, the percentage change in the index over specified periods of time is plugged into a formula for determining the index-based interest to be credited to the contract. The formulas generally provide a "floor", or a minimum percentage of interest that will be credited annually to the contract. Many contracts also include a "cap", or a maximum percentage of index-based interest that will be credited annually (or for a specified period). Products other than "spread contracts" also typically specify a "participation rate", which is a percentage of the percentage change in the index that will be used in calculating index-based interest. "Spread contracts" determine interest credits by subtracting a specified percentage, for example 250 basis points, from the percentage change in the relevant index during a specified period of time, and use the remainder in determining the index-based interest to be credited to the contract.

Current equity-index insurance products utilize a wide variety of mechanisms to take index changes into consideration in calculating interest credits. A similarly wide variety exists among surrender, annuitization, and death benefit mechanisms of those policies.

To our knowledge, existing equity-index insurance products utilize equity indexing formulas to calculate contract values only during the accumulation phase of annuity contracts and in calculating the amount of benefits under life insurance contracts. We are not aware of any existing equity-index insurance products that utilize equity indexing formulas to calculate the amount of benefits to be paid during the payout phase.

The primary mechanisms currently in use for calculating index-based interest are described below:

1. Point-to-point. Indexed-based interest reflects the percentage change in the relevant index over a specific period of time, generally a term of years. Certain contracts include a "lock-in" feature, which enables the insured to select a date as of which the guaranteed value of the contract will be increased to reflect a portion of any increase in the relevant index to that point.

2. Cliquet or annual ratchet. Index-based interest is credited annually based on any percentage increase in the index over the course of the prior year. Subsequent declines in the index do not reduce previously credited index-based interest.

3. Highwater mark. Index-based interest is determined by looking at the highest value reached by the index during a specified period of time or at specified times during a specified period of time. For example, certain products determine the index-based interest rate by comparing the starting value of the index with the highest value of the index on any contract anniversary during a term.

4. Vesting schedules. Some products incorporate a vesting schedule, under which index-based interest is calculated at various times during the term, but a portion of the interest is not credited to the contract value (and therefore available for withdrawal or annuitization) until a later point in the term. This feature is intended to encourage persistency. The vesting schedule typically is fixed in advance and does not vary with changes in the index.

5. Averaging formulas. Some products incorporated "averaging" formulas, under which the change in the index is determined by comparing the value of the index at one time, for example the beginning of the term or contract year, with the average value of the index during a specified period of time, such as a contract year. Some contracts combine averaging with a point-to-point formula. Under these contracts, the ending value of the index is determined by averaging the value of the index on each day during a period at the end of the measuring term. The purpose of this feature is to avoid substantial changes in the expected index-based interest credit as a result of sudden changes in the index shortly before calculation of the interest credit.

Most of the products issued to date have used the S&P 500 Stock Composite Price Index (the "S&P 500 Index"). The S&P 500 Index is intended to provide a measure of US stock market performance. The 500 companies in the index are intended to be representative of their respective industry groups. The index is market-value weighted.

Equity-index insurance products could be issued using other domestic equity indices or other types of indices such as bond indices or overseas stock market indices. 31 As a practical matter, a limiting factor on the use of such indices in equity-index insurance products would be the cost to the insurer of hedging its index-based interest obligations linked to changes in such an index.

Most current equity-index insurance products provide a guarantee of the insured's principal and previously credited interest. The insurer also typically provides guarantees as to the rates used in the interest crediting formula, such as, for example, that the participation rate will be a fixed percentage for a term or contract year. For consistency with the requirements of Rule 151 under the 1933 Act, as discussed below, current unregistered equity-index insurance products guarantee that the credited rate of interest at a minimum will meet the requirements of relevant state non-forfeiture laws. The guarantees do not preclude the insurer from deducting expenses and charges from the value of the policy.

To date, equity-index insurance products have been issued through the insurer's general account. Separate accounts have not heretofore been used, among other reasons, because of a possible need to register the separate account under the Investment Company Act of 1940 (the "1940 Act") and therefore to comply with the other requirements of that statute. This may change as a result of the no-action relief recently granted by the staff in Valley Forge Life Insurance Company. 32

E. Legal Analysis

1. Section 3(a)(8)

As a general matter, insurance is "exempted" from registration by Section 3(a)(8). Absent this exclusion, cash value insurance products, including equity-index insurance products, could be deemed to be "investment contracts", which are one of the categories of instruments included in the statutory definition of security in Section 2(1) of the 1933 Act. 33

2. Early judicial cases

The basic framework for analyzing whether an insurance product falls within the statutory definition of insurance under Section 3(a)(8) was established in two Supreme Court cases, SEC v. Variable Annuity Life Insurance Co. of America ("VALIC"), 34 and SEC v. United Benefit Life Insurance Co. ("United Benefit"), 35 both of which involved the status of variable annuity contracts under the federal securities laws.

In VALIC, the Supreme Court held the variable annuity contract at issue to be a "security", where it guaranteed no minimum accumulation value in terms of principal or return on principal. The contract merely provided for a cash surrender value equal to the dollar amount of the accumulation units as of the last day of the month in which the application for surrender was received, less a surrender charge ranging from $25 to zero over five years, based, in the case of a periodic payment contract, on the number of contract years premiums had been paid or, in the case of a single-payment contract, on the number of years from the date of issue. 36

As the Court stated in explaining its decision: "The difficulty is that, absent some guarantee of fixed income, the variable annuity places all the investment risks on the annuitant, none on the company. . . . we conclude that the concept of `insurance' involves some investment risk-taking on the part of the company. The risk of mortality, assumed here, gives these variable annuities an aspect of insurance. Yet it is apparent, not real; superficial, not substantial. In hard reality the issuer of a variable annuity that has no element of a fixed return assumes no true risk in the insurance sense. . . . For in common understanding `insurance' involves a guarantee that at least some fraction of the benefits will be payable in fixed amounts." 37

In United Benefit, the Supreme Court held the variable annuity contract at issue to be a "security", where it provided only a partial guarantee of the contractholder's principal until ten years after issue and provided no guarantee as to interest on principal. The contract guaranteed a minimum cash value measured by a percentage of net payments that gradually increased from 50% of payments in the first contract year to 100% of payments after ten years.

While the Supreme Court noted that the annuity contract at issue involved the assumption of investment risk by the insurer, the Court concluded that "while the guarantee of cash value based on net premiums reduces substantially the investment risk of the contract holder, the assumption of an investment risk cannot by itself create an insurance provision under the federal definition. The basic difference between a contract which to some degree is insured and a contract of insurance must be recognized." 38

The Court then looked to the sales material for the annuity contract in concluding that it was a security. As the Court described the sales material, "United's primary advertisement for the `Flexible Fund' was headed `New Opportunity for Financial Growth.' United's sales aid kit included displays emphasizing the possibility of investment return and the experience of United's management in professional investing." 39 Quoting SEC v. Joiner Leasing Corp., 40 the Court stated that "The test . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect. In the enforcement of an act such as this it is not inappropriate that promoters' offerings be judged as being what they were represented to be." 41

These two cases established as general principles that: (1) without a "floor" of value guaranteed by the insurer, an annuity contract is not "insurance"; (2) not every "floor" entails the assumption of sufficient investment risk by the insurer to ensure that an annuity contract will be deemed "insurance" and not a "security"; and (3) the manner in which an annuity contract is marketed is relevant, and may even be controlling, as to whether or not the contract is a security.

3. Rule 151

In 1986, the SEC enacted Rule 151 as a "(s)afe harbor definition of certain `annuity contracts or optional annuity contracts' within the meaning of Section 3(a)(8)." 42 Insurance contracts that meet the requirements of Rule 151 are not required to be registered with the SEC as securities or comply with the other requirements of the federal securities laws.

Rule 151 establishes three conditions, each of which must be met to establish eligibility for the safe harbor:

1. The annuity or optional annuity contract is issued by a corporation (the "insurer") subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia;

2. The insurer assumes the investment risk under the contract as prescribed in Rule 151(b); and

3. The contract is not marketed primarily as an investment.

Rule 151(b) provides that the insurer assumes the investment risk if the following three conditions are met:

1. The value of the contract does not vary according to the investment experience of a separate account;

2. The insurer for the life of the contract: (i) guarantees the principal amount of purchase payments and interest credited thereto, less any deduction (without regard to its timing) for sales, administrative or other expenses or charges; and (ii) credits a specified rate of interest (as defined in Rule 151(c)) to net purchase payments and interest credited thereto; and

3. The insurer guarantees that the rate of any interest to be credited in excess of that described in Rule 151(b)(2)(ii) will not be modified more frequently than once per year.

This provision does not require that excess interest be credited, only that any excess interest credited meet this requirement. In Release 6645, the SEC also noted that this provision would not preclude increases in the credited rate, provided that the new rate was not subject to downward adjustment for at least one year. 43

Because Rule 151 is a safe harbor, insurance contracts that do not meet its requirements are not per se securities and may nevertheless qualify to be treated as insurance under Section 3(a)(8). 44

If an insurer does not choose to rely on Rule 151, the requirements established in the Rule nevertheless are relevant to the analysis of an annuity contract under Section 3(a)(8). The SEC has expressly stated that "(a)ny insurer that is unable, or chooses not, to rely on rule 151 may still look to the (R)ule and accompanying releases for interpretative guidance. The rationale underlying the conditions set forth in the (R)ule is relevant to any Section 3(a)(8) determination." 45

Although Rule 151 establishes a safe harbor for annuities, it is also relevant to the determination of whether a life insurance policy is insurance under Section 3(a)(8). As the SEC stated in Release 6645, "(t)he securities law status of a life insurance contract may be analyzed by reference to the principles discussed in (R)ule 151 and accompanying releases and by reference to relevant judicial interpretation of (S)ection 3(a)(8)." 46 Accordingly, the status of equity-index life insurance contracts under Section 3(a)(8) also may be analyzed in light of Rule 151 and its underlying principles.

4. Rule 151 and Indexing Features

Rule 151, as originally proposed, would have excluded from the safe harbor any contract pursuant to which excess interest is determined in accordance with an external formula or index. 47 There, the Commission noted that for tax purposes Congress permitted the full deduction of excess interest determined under ". . . a formula or index guaranteed in advance for not less than 12 months, provided the terms of the formula are beyond the insurer's control and are independent of its investment experience." 48 The Commission declined to incorporate that test in its Rule 151 proposal, because, in the Commission's view, "an insurer which `externalizes' its discretionary excess interest rate shifts to the contractowner all of the investment risk regarding fluctuations in that rate." 49

In adopting Rule 151, however, the SEC evidently retreated from this view of investment risk by permitting "limited use of index features in determining the excess interest rate, so long as the excess rate is not modified more frequently then (sic) once per year." 50 As Release 6645 states:

The insurer, therefore, would be permitted to specify an index to which it will refer, no more often than annually, to determine the excess rate that it will guarantee under the contract for the next 12-month or longer period. Once determined, the rate of excess interest credited to a particular purchase payment or to the value accumulated under the contract must remain in effect for at least the one-year time period established by the rule. Thus, while the rate of interest calculated under a particular index or formula may fluctuate upward or downward on a daily basis, the excess interest rate actually credited may not fluctuate more than once per year. 51

The SEC was concerned that contracts that adjusted their rates more frequently than once each year operated "less like a traditional annuity and more like a security and that they shift to the contractowner all of the investment risk regarding fluctuations in that rate." 52

While Release 6645 does not state why the SEC changed its position with respect to index formulas, there are several reason that may have led to that change. First, using an index formula does not relieve the insurer of all investment risk. Using an index formula to determine interest credits is not the same as passing through the performance of an underlying portfolio, as occurs under a variable annuity. As discussed below (see Section D.1.d.), where interest credits are determined through the use of an index formula, the insurer commits itself to paying interest in the amounts determined under the formula, regardless of the performance of the insurer's general account assets. Accordingly, the insurer still bears the risk of investing its assets so as to be able to pay benefits in the amounts determined under the formula, just as the insurer does under a contract that credits interest at a fixed rate periodically declared in advance. 53 Indeed, the use of an indexing formula may impose additional investment risk on the insurer, to the extent that the insurer is deprived of discretion in setting the rate of interest it is obligated to pay.

Second, a contract using an index formula does not necessarily impose more investment risk on the contract owner than does a fixed rate contract that meets the requirements of Rule 151. Under a contract where fixed interest rates are set and guaranteed annually in advance in accordance with Rule 151, the contract owner may still bear significant investment risk that the annual interest rates declared and credited by the insurer may change substantially from year to year or over a term of years. Thus, while the rate credited in a specific year may be fixed, the total interest that will be credited to the contract over a period of years is not, and may be significantly higher or lower depending on, among other things, changes in market interest rates that affect the amount of interest that the insurer will be able to afford to credit to the contract. In this respect, the investment risk borne by the purchaser of an insurance contract that meets the requirements of Rule 151 is similar in kind to the risk borne by the purchaser of an equity-index insurance product, where the total interest that will be credited to the contract over a period of years will be higher or lower depending on, among other things, changes in an index. Of course, the amount of investment risk borne by the contract owner depends on the nature of the formula, the frequency with which the index is consulted, and the duration and nature of the guarantees under the contract. In this regard, it is also important to keep in mind that these insurance products are intended to be used as long-term retirement devices, such that variations in the rates credited from year-to-year are not as significant as they might be in evaluating an investment product designed to provide for short-term liquidity.

Release 6645 provides only limited enlightenment as to what is meant by "limited use". The only examples given are a composite bond index or Treasury bill rate. 54 The SEC did not address whether an annuity utilizing an equity index would fit within the Rule 151 safe harbor.

It is unclear from Release 6645 whether the SEC intended for Rule 151 only to permit the use of indices in setting interest rates to be credited prospectively or whether it would be appropriate, as is done under current equity-index insurance products, to set the formula utilizing the index in advance and to perform the necessary calculations retrospectively.

5. Rule 151 and the Marketing Test

Under Rule 151 (and the relevant judicial precedent), a contract may or may not be a security depending upon how it is marketed. The marketing test included in Rule 151 and discussed in the Rule 151 Releases is derived principally from United Benefit. Release 6645 specifically states:

"The standard adopted by the rule follows the Court's language in United Benefit and means simply that the thrust of the insurer's total marketing plan for the product must be targeted to appeal to purchasers `. . . on the usual insurance basis of stability and security . . . .' For example, a marketing approach that fairly and accurately describes both the insurance and investment features of a particular contract, and that emphasizes the product's usefulness as a long-term insurance device for retirement or income security purposes, would undoubtedly `pass' the rule's marketing test. By way of contrast, if a contract is promoted with primary emphasis on current discretionary excess interest, and the possibility of future interest, or other investment-oriented features of the contract, that contract would likely fail the marketing test." 55

Release 6558 describes the converse of the quoted approach:

". . . the Commission believes that insurers and others marketing a contract with primary emphasis on discretionary excess interest and other investment-oriented features, while relegating mention of the traditional retirement planning features of an annuity contract to the `fine print,' must be viewed as offering a security and not insurance. . . . In the Commission's view, among the factors relevant to this determination are whether the contract is promoted (1) with substantial emphasis on current discretionary excess interest, and the possibility of future interest, or other investment-oriented features of the contract, and (2) as one type of tax-sheltered investment that is interchangeable with other such investments." 56

The marketing test does not provide any "bright line" rules as to what is appropriate or inappropriate emphasis on the investment aspects of an insurance product. In Release 6645, the SEC expressly declined to provide a checklist of acceptable and unacceptable marketing techniques. 57

The SEC made clear, however, that the marketing test does not prohibit the insurance company from describing the investment aspects of the product: "the Commission is not saying, nor has it ever said, that an insurer in marketing its product cannot describe the investment nature of the (deferred annuity) contract, including its interest rate sensitivity and tax-favored status." 58 The SEC explained that it recognized that discussion of the investment aspects of a contract naturally flows from "the traditional long term nature of annuities." 59

The analysis under the marketing test evaluates the totality of the marketing effort for the product. 60 In applying this test, individual marketing pieces and phrases within marketing pieces for an insurance product should not be considered out of context, but rather should be evaluated in the context of the marketing as a whole. 61 Likewise, the Rule 151 Releases make clear that the improper remarks of a single sales person will not cause an insurance product to fail the marketing test. 62

The relevant factors include: (i) the nature of the market to be solicited; (ii) channels of distribution (e.g., captive life insurance sales force versus unaffiliated securities broker-dealers); (iii) incentives for salespersons (e.g., forms of commissions or overrides); (iv) all promotional efforts, including recruiting and training materials for salespersons, sales literature, advertisements, and authorized oral representations; and (v) procedures by which the insurer will supervise, control, and discipline salespersons. 63

6. Other case law interpreting Section 3(a)(8) and/or Rule 151

Other private civil cases under Section 3(a)(8) and/or Rule 151 provide additional interpretive guidance.

For example, in Olpin v. Ideal National Insurance Co., 64 a bonus fund endorsement to a life insurance policy was held not to be a security, where the endorsement basically committed the insurer to set aside annually in a special fund not less than $1.00 and not more than $2.00 per thousand dollars of life insurance issued, as the insurer's board of directors determined, to be accumulated at 2.5% annual compound interest.

In Grainger v. State Security Life Insurance Co., 65 the court reversed the lower court's finding that the participating endowment policy at issue there was not a security and remanded the case for further fact-finding. While the policy at issue had a fixed $10,000 death benefit, the court stated that the mere presence of a death benefit of any given dollar amount could not conclusively establish that the product was not an investment contract and that consideration must be given not only to the amount of the death benefit, but also to the relationship between the size of the death benefit and the size of premium payments. The court also concluded that the lower court had erred by failing to take into consideration the marketing methods used to sell the policies.

In Peoria Union Stock Yards Co. Retirement Plan v. Penn Mutual Life Insurance Co., 66 on an appeal from an order denying the insurer's motion to dismiss the complaint for failure to state a claim, the court ruled that the group deposit administration annuity contract there could be found to be a security, where the contract guaranteed no minimum accumulation value in terms of principal or return on principal.

The contract, which imposed a surrender charge, guaranteed minimum interest on contributions made during the first three contract years at a rate declining from 7.5% to 3.5% over the period that these funds were on deposit. With respect to contributions made thereafter, there was no guaranteed minimum rate, but rather interest rates were to be set in the discretion of the insurer. The contract further provided that the contract "shall participate in divisible surplus while it is in force," in amounts to be determined by the insurer. 67 Accordingly, the rates guaranteed in subsequent years depended largely on the investment performance of the insurer. The court held that the "floor" in this case was insufficient to establish that the contract was insurance under Section 3(a)(8), because there was no guaranteed minimum interest rate for contributions made after the third year. 68

In Otto v. Variable Annuity Life Insurance Co. ("Otto"), 69 the court ruled that the group "fixed annuity" contract at issue there was a security, where the contract permitted the insurance company complete discretion to modify the rate of current excess interest at any time. The contract provided a guarantee of principal, a guarantee of interest of 4% for the first ten years of the contract and 3.5% thereafter, and excess interest in the discretion of the company.

The court did not regard the specified minimum rate of interest as a sufficient guarantee, since the insurer could discontinue paying excess interest at any time. The court therefore concluded that the contract did not place sufficient investment risk on the insurer, stating: "on the facts of this case the minimum interest rates guaranteed under VALIC's fixed annuity plan, although they are somewhat in excess of those required by Rule 151, alone do not place the investment risk on VALIC sufficiently to exempt the plan from the federal securities laws." 70

The court's conclusion that Section 3(a)(8) requires that the payment of excess interest be guaranteed is not supported in any other reported case. In addition, the SEC has taken a different view. In an amicus brief (at 6) filed in support of the insurer's petition for certiorari (which was denied, 486 U.S. 1026 (1977)), the SEC stated as follows:

"The court's opinion on rehearing indicates that the court believed VALIC's fixed annuity failed to qualify as an `annuity contract' solely because the fixed annuity did not satisfy one element of the test set forth in the Commission's Rule 151 -- i.e., that the excess interest rate be guaranteed for one year. If that was the court's reasoning, it was mistaken."

In Associates in Adolescent Psychiatry v. Home Life Insurance Co. ("Home Life"), 71 the court ruled that the group annuity contract at issue there was not a security. The contract provided a guarantee of principal and minimum interest of 4% per year. In addition, the contract provided that excess interest rates were "to be `declared annually' by Home Life's board of directors." The court construed this language to mean that the rates on monies received could not be altered more than once per year. The court distinguished Otto on the grounds that there, the excess interest rate could be changed at any time, whereas under the contract in Home Life, the excess interest rate could not be altered more often than once per year. 72

The court also concluded that the contract was not "marketed primarily as an investment." In reaching this conclusion, the court determined that it was appropriate to consider the sales literature for the contract as a whole, rather than focusing on isolated passages. 73 In the court's view, although the sales literature "refers to the investment aspects and tax-favored features of the plan," and the insurer's sales representatives "hawked" the insurer's investment abilities, these were simply consequences of the contract's nature as a retirement funding vehicle, and not inconsistent with the conclusion that the contract at issue was insurance, not a security. 74

The court also rejected plaintiff's contention that the status of the contract at issue should be judged by the public's perception of it as an investment vehicle. As the court stated, "the public perception of the (contract) does not control the question whether it was marketed primarily as an investment. Rule 151 does not ask how the public perceives the insurance product; it merely asks how the insurer promoted it." 75

Finally, in Berent v. Kemper Corp., 76 the court held that certain single premium whole life insurance policies were not securities. The policies credited interest at a rate guaranteed not to be less than 4.5% annually. The interest was declared annually in advance and was represented to reflect "(the insurer's) own earning experience." 77 The court based its holding on its conclusion that the policies at issue met all three requirements of Rule 151. 78

In deciding that the policies met Rule 151's marketing test, the court relied on the emphasis that the marketing materials placed on the insurance aspects of the policies:

the . . . sales brochures clearly emphasize the insurance protection of the policies -- that they are paid up with a single premium, and provide death benefit protection and estate planning advantages. That the policies were marketed primarily as insurance is further evidenced by the facts that the sales brochures provided that the cost of the policies was less for non-smokers and in some circumstances, a physical examination was required for purchasers at specified ages. These medical requirements are certainly not things associated with a pure investment. 79

7. Assumption of Meaningful Mortality Risk

In releases prior to the adoption of Rule 151, the SEC considered the assumption of a "meaningful mortality risk" by an insurer under the annuity contract as a factor in Section 3(a)(8) analysis. 80 In Release 6051, the SEC stated that a central feature of insurance is the assumption of mortality risks and investment risks, and that the absence of meaningful mortality risk per se would establish that a contract is an investment. 81

While this factor was not included in Rule 151, we believe that it continues to be relevant to the status of insurance contracts under Section 3(a)(8). The SEC did not include this factor in Rule 151 because, "(w)hen Congress created the insurance exclusion under the (1933) Act, there were certain `traditional' annuity contracts in effect that involved no assumption of mortality or longevity risks by the insurer," e.g., annuities for a period certain. 82 While stating that the assumption of mortality risk is not a necessary feature of insurance for purposes of Section 3(a)(8), however, the SEC further stated in Release 6645 that assumption of mortality risk "may be an appropriate factor to consider in a general facts and circumstances analysis under (S)ection 3(a)(8)." 83

Moreover, in our view, the SEC's decision not to include assumption of mortality risk as a factor in Rule 151 does not affect its significance as a factor in analyzing the status of life insurance contracts under Section 3(a)(8). First, Rule 151 is a safe harbor, not an exclusive definition of insurance contracts under Section 3(a)(8). Second, Rule 151 applies to annuities, not life insurance contracts. The SEC's grounds for excluding assumption of mortality risk from its test for annuity contracts clearly is inapplicable to life insurance contracts, which inherently entail significant mortality risk. Finally, as noted above, in adopting Rule 151 the SEC acknowledged the continuing relevance of assumption of mortality risk.

F. Analysis of Equity-Index Insurance Products

Our view is that many equity-index insurance products can and do meet the statutory definition of insurance under Section 3(a)(8), by reason of the minimum guarantees provided under the contract, the assumption of investment risks by the insurance company under the relevant indexing formula, the nature of the marketing for the product, and the assumption of meaningful mortality risks by the insurer. Without addressing the status of any particular equity-index insurance product under Section 3(a)(8), the following discusses how current equity-index insurance products meet each of these requirements.

1. Assumption of Investment Risk

Release 6558 recognizes that, under a deferred annuity contract, the insurer and contract owner may share the investment risk to differing degrees. 84 Release 6558 states that VALIC 85 and United Benefit 86 each makes it "clear that the degree of investment risk assumed by the insurer is the critical factor." 87

The Rule 151 Releases and Rule 151 identify three principal factors to be considered in establishing whether the insurer is assuming sufficient investment risk: (1) whether the value of the insurance contract varies depending on the investment experience of a separate account; (2) whether the insurance contract provides a guarantee of principal and an adequate minimum rate of interest; and (3) whether the guaranteed rate of excess interest changes too frequently. Accordingly, our analysis of equity-index insurance products considers whether the product meets each of these requirements and in addition takes into consideration other factors relevant to whether the insurer assumes investment risk under the product.

a. Contract Value Does Not Vary With The Performance Of A Separate Account

This requirement was included in Rule 151 to exclude contracts that merely passed through to the contract owner the performance of the assets underlying the contract, similar to a variable annuity or variable life insurance contract. The SEC believed that in that circumstance, all of the investment risk was born by the contract owner, who therefore would need the disclosures and protections provided by the federal securities laws. 88

Current equity-index insurance products meet this requirement, since the value of an equity-index insurance contract changes to reflect interest credits calculated under a formula in the contract, not as a share of the assets held in a separate account. Accordingly, the value of the contract does not mirror the insurance company's performance in managing the assets underlying the contract, since the insurance company will owe the amounts calculated under the formula irrespective of the insurance company's success or failure in managing its general account assets. Moreover, assets underlying insurance company obligations under equity-index insurance products typically are held in the insurance company's general account, not in a separate account.

Moreover, as noted above, the contract values under current equity-index insurance products typically do not de facto vary in accordance with the performance of the underlying assets. Insurance companies typically invest in mixed portfolios of bonds, index options, and other instruments to meet their obligations to pay benefits under equity-index insurance products. While insurance companies seek to match the value of their assets to their expected obligations, (and, indeed, under state insurance laws are subject to reserve requirements intended to ensure that they do so), in the case of equity-index insurance products this hedging process is inexact and, as discussed below, insurance companies undertake significant investment risk. Accordingly, as a factual matter it would be extremely unlikely that the contract values under an equity-index insurance contract as determined under the relevant indexing formula at any time would be the same as the value of the underlying assets.

Likewise, as noted above, current equity-index insurance products typically do not "pass through" the performance of the relevant index. Rather, contract values are determined by combining changes in the index with other factors, such as participation rates or averaging formulas, to determine index-based interest credits.

Finally, even if a separate account were used to hold the assets underlying an equity-index insurance product, the product still would meet this requirement of Rule 151, provided that the interest credits under the contract were calculated in accordance with a contractual formula. In that circumstance, merely using a non-unitized separate account to hold the underlying assets, as described in the Valley Forge Life Insurance Company no-action letter, 89 would not cause the contract value to change in accordance with the performance of the separate account. Indeed, in Release 6645, the SEC expressly stated that the use of this type of separate account would satisfy this requirement under Rule 151. 90

b. Guarantees of Principal and Minimum Interest are Consistent with Rule 151

As discussed above, the Supreme Court stated, in cases involving the status of variable annuity contracts, that the concept of "insurance" involves some "element of a fixed return," "a guarantee that at least some fraction of the benefits will be payable in fixed amounts," a "floor." 91 The case law, however, does not specify a minimum floor that must be met to satisfy Section 3(a)(8), nor has the SEC. In Rule 151(b)(2), the SEC established such a floor for safe harbor purposes, by requiring that, for the life of the contract, the insurer guarantee principal and interest credited thereto (less any permissible expenses and charges) and credit interest to net purchase payments and interest credited thereto at a rate at least equal to either the relevant state nonforfeiture law or the rate required by the National Association of Insurance Commissioner's Standard Nonforfeiture Law.

In practice, as applied to single premium deferred individual annuity contracts, Rule 151(b)(2) requires that the contract must guarantee repayment of premium less expenses of no more than 10% of the single premium, plus interest at an effective annual rate of 3%, as specified in the Standard Non-Forfeiture Law. The application of Rule 151(b)(2)'s requirements to other types of contracts, such as flexible premium and group annuity contracts and universal life insurance, however, is unclear, because the Standard Non-Forfeiture Law does not provide a simple mathematical formula (or in some instances any formula) to determine non-forfeiture amounts for other categories of insurance contracts. Accordingly, we have to date interpreted this requirement to mean that an insurance contract must guarantee repayment of premium, less legitimate and reasonable expenses, plus interest at a specified rate guaranteed for the life of the contract.

Current equity-index insurance product designs are based on the assumption that minimum guarantees that at least meet the requirements of the Rule 151(b)(2) also are sufficient for Section 3(a)(8) purposes. Current equity-index annuity contracts typically meet this requirement by guaranteeing that at any time the contract owner may surrender the contract and receive at least the premium, less 10% of the premium for legitimate expenses, plus interest at a rate guaranteed for the life of the contract, in order to meet non-forfeiture requirements under state insurance laws. Current equity-index life insurance contracts meet this requirement by guaranteeing that at least a minimum rate of interest will be credited to the cash value of the contract, net of mortality charges and other reasonable expenses.

In our view, a market value adjustment feature ("MVA feature") in an equity-index insurance product would have the same effect on the Section 3(a)(8) analysis as it would in other insurance products. Under an MVA feature, the insurer adjusts the surrender value of an annuity contract upon early surrender to reflect changes in the value of the insurer's assets underlying its contractual obligations. Accordingly, an MVA feature shifts some investment risk from the insurer to the contract holder.

The SEC has stated that contracts with an MVA feature may not rely on Rule 151. 92 The reason for this treatment of MVA features is that in certain circumstances, certain MVA features may invade the previously credited minimum guaranteed interest or principal. This treatment of MVA features under Rule 151 "should not create the negative inference that no such contract is eligible for the exclusion under section 3(a)(8)," but instead reflects the SEC's determination that contracts with such features are not suitable for safe harbor treatment. 93

Whether a contract with an MVA feature would be deemed to be a security would depend on the degree to which the MVA feature shifts investment risk. For example, the SEC noted that an MVA feature that invaded the principal "would be more problematic under a (S)ection 3(a)(8) analysis than one that merely requires forfeiture of a small portion of previously credited excess interest." 94 We note that at least one of the current registered equity-index insurance products has an MVA feature that may invade principal.

c. Nature and Duration of Excess Interest Rates

As noted previously on page 10 of this letter, Rule 151 does not require the crediting of any "excess interest", i.e., interest above the minimum guaranteed amounts discussed above, only that any excess interest credited meet Rule 151's requirements.

In analyzing the payment of excess interest, the Rule 151 Releases look primarily at the duration of any guarantees provided by the insurer. Release 6558 states that "the longer the period for which such interest is guaranteed, the greater the degree of investment risk assumed by the insurer." 95 Accordingly, Rule 151, as adopted, imposes a requirement that the excess interest "will not be modified more frequently than once per year." 96

Current equity-index insurance products arguably do not meet this requirement of Rule 151, because the exact rate of index-based excess interest is not fixed at the beginning of the contract year. Nevertheless, the indexing formulae used in current equity-index insurance products typically include guarantees, applicable for extended periods of time, which impose significant investment risk on the insurance company beyond the guarantee of principal and minimum interest. Accordingly, we believe that these provisions are consistent with the intent of this requirement of Rule 151, that an insurance product should provide guarantees of excess interest for periods of at least one year.

Under many types of annuity contracts, the rate of excess interest to be credited is known in advance, often for a full contract year. Determining excess interest using an external formal or index may entail deferring the calculation until the end of the contract year. In certain cases, the excess interest rate will be known in advance. For example, credited interest, including excess interest, may be based on the stated yield of a broad-based bond index at the beginning of the contract year to which the credited interest applies. In other cases, such as in the formulae used in equity-index insurance products, only the methodology for computing excess interest might be known in advance, as when credited interest is based on the bond index yield at the end of the contract year or total return for the contract year for which credited interest is calculated.

Although not explicit in its analysis, Release 6645 appears to contemplate the specification of an index (no more often than annually), without prior knowledge of the actual rate to be applied. The specific language suggesting this interpretation is the statement that "(t)he insurer . . . would be permitted to specify an index to which it will refer . . . to determine the excess rate that it will guarantee under the contract for the next 12-month or longer period." (Emphasis supplied.) Consistent with that interpretation, Release 6645 further states: "Once determined, the rate of excess interest credited to a particular purchase payment or to the value accumulated under the contract must remain in effect for at least the one-year time period established by the rule." 97 (Emphasis supplied.) It therefore could be asserted that the Rule itself contemplates the formulae used in current equity-index insurance products, whereby the formula or methodology for crediting interest is known and guaranteed in advance for a specified period of time and the computation to actually calculate the excess interest is performed at the end of the relevant time period.

To be sure, the exact rate of index-based interest to be credited to an equity-index insurance product is not known in advance, unlike an annuity product which periodically declares fixed interest rates for upcoming periods. Whether the exact rate of credited interest is known in advance is not decisive to whether the insurer retains sufficient investment risk to classify a contract as "insurance" rather than as an "investment contract." Using an external index as a reference assures, even if the rate is not known in advance, that excess interest will not depend on the degree of investment success achieved by the insurer in managing its assets. Were the one dependent on the other, the contract would more likely be an "investment contract" and therefore a "security." 98

This analysis also indicates that, even though Release 6645 gives as examples indices based on fixed-income securities, it should not matter, for purposes of this analysis, whether the index used to determine excess interest is based on debt securities or equity securities. Since the indexation severs the insurer's contractual obligations from its investment results, then as long as the insurer retains sufficient investment risk, it would not seem to matter whether the applicable index relates to debt securities or to any other widely publicized and frequently computed financial measure. The limiting feature on an insurer's ability to chose an index is its ability to invest its general account assets so as to reasonably expect to meet its obligations under contracts with equity index features.

As a result of reserve requirements under state insurance laws, insurers offering equity-index insurance products are subject to comprehensive regulation in this regard. 99 In addition, the SEC recognized that the risk that an insurer would be unable to meet its obligations is "the type of risk that Congress deemed to be adequately addressed by state insurance regulation." 100

The formulas used under current equity-index insurance products for calculating index-based interest credits also address the Commission's concern that the contractual excess interest rate not be adjusted too frequently. Release 6645 states that the underlying rationale for this concern is that contracts that adjust the rate of return more frequently "operate less like a traditional annuity and more like a security and that they shift to the contract owner all of the investment risk regarding fluctuations in that rate." 101 The indexing formulae currently in use typically provide for calculating any index-based interest credits no more frequently than once per year. Moreover, the parameters used in those calculations -- e.g., any participation rate, floor, cap, or other factor -- typically are set at the issuance of the contract and guaranteed not to change more frequently than annually, if not for longer periods.

As discussed above, the indexing formulae used in equity-index insurance products vary greatly. The nature of the formula, as well as the duration of the guarantees provided under the formula, all affect the amount of investment risk assumed by the insurance company under a particular contract. Since the allocation of risk under a contract depends on the investment features of the contract as a whole, we do not believe that the inclusion of particular indexing features would require that a contract be registered under the 1933 Act. Discussed below, however, is our analysis of how certain types of indexing formulas and guarantees affect the assumption of investment risk under the an equity-index insurance contract.

Most products include guarantees applicable to the rates used in the formula used to calculate indexed interest, such as the participation rates. In some instances, these rates are guaranteed for a specified period of years. In others, guaranteed rates are set annually, in some instances subject to minimum and/or maximum values guaranteed for the life of the contract. The level of these guarantees and their duration all will affect the evaluation of the allocation of risk under a particular equity-index product. If the guarantees were such as to permit the invasion of principal or minimum guaranteed interest as a result of changes in the index, an issue would be raised as to whether the product was a security.

Certain products provide additional guarantees to the contract owner by providing that at the end of each term of years, the minimum guaranteed value under the contract is increased by an amount such that the total interest credited to the minimum guaranteed value is equal to the index-based interest credited to the contract value. The effect of this provision is to increase the possibility that, in the later terms of a contract, the minimum interest guarantees under the contract will result in an increase in the policy value, if the relevant index does not increase sufficiently during a term.

Other products provide additional guarantees to the contract owner by crediting index-based interest annually, if warranted under the indexing formula used in the contract. Examples of this feature are annual ratchet contracts and highwater mark designs. These policy features relieve the contract holder of the risk of subsequent declines in the index, after the crediting event or the high water mark. In each case, interest credits reflecting certain increases in the index are in effect locked in and guaranteed by the insurer. Where interest is credited less frequently than annually, either expressly or implicitly through the operation of a highwater formula, the contract holder is exposed for longer periods of time to the risk of variations in the performance of the index and therefore the risk that previous increases in the index will not be reflected in interest credited to the contract. Nevertheless, contracts that credit index-based interest less frequently than annually can meet the requirements of Section 3(a)(8), depending on the overall allocation of investment risk under the contract.

The duration of any guaranteed caps, floors, participation rates, and margins (for margin products) also affect the allocation of risk to the insurer. These rates reflect in part the insurer's estimates of what it will cost the insurer in the future to provide the benefits under the equity-index insurance product, including the insurer's estimates of surrenders, withdrawals, annuitizations, and death benefits. The longer that these guarantees are in effect, the greater the risk assumed by the insurer that these estimates may be wrong.

Where a contract includes a minimum index-based interest rate, the level of that minimum also affects the allocation of investment risk. Currently, these rates have been set at 0%, such that a decline in the relevant index would not affect indexed-based interest. Higher floors would shift additional investment risk to the insurer. In a higher interest rate environment, it is possible that some contracts may include this feature.

d. Effect of Other Factors on Investment Risk

Use of an equity index and the particular formula provided under a contract imposes significant investment risk on the insurance company beyond those of the underlying guarantee of principal and interest. For example, where a contract credits interest on an annual basis, the insurer bears any risk of a subsequent decline in the relevant index. Likewise, equity-index insurance products typically do not include provisions adjusting downwards the amount of the contract owner's principal or previously credited excess interest, to reflect declines in the relevant index or the insurance company's general account investments underlying the contracts. Thus, even leaving aside the guarantees of principal and interest typically provided by equity-index insurance products, the risks borne by a contract owner are not the same kind or degree of investment risk that are associated with insurance products registered under the federal securities laws or investment products such as stock mutual funds.

An additional indication that the insurance company bears significant investment risk is that equity-index insurance products are backed by assets held in the insurance company's general account. These assets will in part consist of corporate bonds, which may have some risk of default. In addition, while an insurance company typically invests in index options, futures contracts, or other financial instruments to meet its obligations to pay index-based interest credits as required under the indexing formula in its contracts, the company bears all of the expenses of investing in such contracts or instruments, all of the risk that its counterparty in those transactions will not be able to meet its obligations, and all of the risk that the return on such contracts and instruments will be insufficient to meet the insurance company's obligations to pay index-based interest credited to equity-index insurance contracts. Further, it is our understanding that as a practical matter, it is too expensive for insurance companies to purchase sufficient financial instruments to meet all of their potential obligations to pay index-based interest credits and offer competitive contract terms. 102 Accordingly, this risk of a shortfall is real and significant for insurers selling equity-index insurance products. Contract owners, on the other hand, typically bear no investment risk that the value of a contract (including previously credited index-based interest) will decline if the relevant index declines, or that the amount of index-based interest credits due under the relevant formula will be adjusted to reflect an insurance company's success or failure in investing its general account assets to meet its obligations under its equity-index insurance contracts.

Moreover, under current equity-index insurance products, insurance companies bear significant investment risks as a result of the contracts' surrender, annuitization, and death benefit provisions. Equity-index insurance products typically permit withdrawals or surrenders (with or without annuitization) without any market value adjustment. Likewise, many equity-index annuities provide for a death benefit, if the annuitant dies before annuitization. Under all of these types of provisions, the insurance company bears the risk of loss if a benefit must be paid prior to the maturity date of any underlying bonds in a declining bond market, since the insurance company may be required to sell bonds at a loss in order to pay the benefit. This risk is increased, where the contract provides (as many do) that the annuitization or death benefit include an index-based interest credit calculated as of the date of the annuitization or death. To be sure, equity-index insurance products have not been sold for a long enough time to be able to quantify the risk presented by these benefit provisions. Reason suggests, however, that contract owners would be particularly likely to surrender their contracts when interest rates are rising and the stock market is declining, circumstances which also could be likely to reduce the value of both the bonds and the index options underlying an insurer's obligations under its outstanding equity-index insurance contracts.

Finally, because of the guarantees offered under equity-index insurance products, the state insurance risk-based capital requirements for those products are those for a fixed deferred annuity, not a variable deferred annuity.

An additional factor in our legal analysis is the risk that the index-based interest credits actually received by the contract owner will differ from the expected return. In a fixed-rate annuity, where a specific interest rate is guaranteed for a specific period of years, that risk is small. 103 Other types of insurance products, such as whole life policies, however, include some variability in the interest credited to the policy without incurring the necessity of securities registration. At the other extreme, in a pure equity investment, such as a mutual fund, the range of possible returns can be substantial.

In Release 6558, the SEC acknowledged that this risk of fluctuation of rates credited under an insurance contract existed and implicitly indicated that the contract owner might properly bear some of this risk under a contract that met the requirements of proposed Rule 151. There, in discussing the allocation of investment risks under a deferred annuity contract, the SEC stated that the contract owner bore the investment risk that after the initial guarantee period "(1) no discretionary excess interest will be declared or (2) the rate actually declared will fluctuate (up or down) from the rate guaranteed in the immediately preceding period." 104 While Rule 151 requires a floor to excess interest rates and requires that those rates be reset no more frequently than annually, the SEC imposed no ceiling on the extent to which those rates may change between guarantee periods, leaving the contract owner exposed to that investment risk.

In light of the foregoing, our analysis of the allocation of investment risk under an equity-index insurance product also addresses whether and the degree to which the product limits the range of interest rates that may be credited in a particular period. Certain products address this issue by imposing a limit or "cap" on the amount of index-based interest that can be credited in a given period of time. Other products, while not having a formal cap, achieve a similar effect by calculating index-based interest based on the average value of index for a period of time at the end of the measurement period or, in some products, for an entire contract year. Averaging over a sufficiently long period can have the effect of dampening the volatility of changes in the relevant index, and accordingly can tend to limit the range of potential index-based interest credits that may be credited during a specific period of time, thereby significantly reducing this form of investment risk.

As noted above, Release 6558 indicates that an insurance product within the scope of Section 3(a)(8) may properly impose this type of investment risk on contract owners. Accordingly, the presence or absence of the types of limiting features described above is not determinative of the status of a particular equity-index insurance product under Section 3(a)(8). In our view, however, the presence of such a feature strengthens the conclusion that a particular product satisfies the requirements of Section 3(a)(8).

2. The Marketing Test

Because the marketing test does not provide a bright line rule to determine whether or not marketing is appropriate, it is impossible to generalize as to whether the marketing for equity-index insurance products meets the marketing tests. As noted above, the SEC has declined to provide any checklist of acceptable and unacceptable marketing techniques. The task of analyzing marketing for equity-index insurance products is made more difficult as a result of the diversity of distribution channels and marketing approaches used by different insurance companies. Accordingly, what follows is a discussion of some general issues that may arise in applying the marketing test to equity-index insurance products.

The precedents indicate that appropriate marketing will emphasis the insurance aspects of the product, its appropriateness as a long-term vehicle for accumulating retirement funds, and its guarantees. As discussed above, the precedents also clearly permit the discussion of the investment aspects of an insurance product, provided that the marketing does not place "primary" emphasis on those investment aspects.

Accordingly, in our view, the marketing materials for equity-index insurance products may include an extensive description of the operation of the interest crediting mechanism and the indexing formula without running afoul of the marketing test. The description need not be predicated on the past performance of the index. One need not show how well a product would have done last year to demonstrate how an annual ratchet or highwater mark formula works. We note, however, that at the organizational meeting of the Equity Index Products Association, a state insurance regulator indicated that, while certain issues would need to be resolved, he would favor using historical index data over a substantial period of time (for example, 25 years) to provide in summary form an illustration of the range of possible index-based interest amounts that may be credited under a particular contract calculated using the current participation rate and other factors.

In order to ensure that prospective purchasers understand the product, marketing materials for equity-index insurance products may need to devote greater space to the investment aspects of the product than is required for other types of more traditional insurance products, with whose features a prospective purchaser may be more familiar. This by itself should not be taken as an indication that "primary" emphasis is being placed on the investment aspects of the contract, but rather that the insurer is prudently and properly seeking to ensure that the prospective purchaser understands the product before purchasing it.

Likewise, references to and descriptions of the index used in the relevant product's indexing formula also should not be taken as an indication that primary emphasis is being placed on the investment aspects of the relevant equity-index insurance product. Here again, the insurer is permitted to provide sufficient information so that the prospective purchaser understands the product. It should be noted, however, that the consistent and widespread use of investment-related terms in marketing materials, as opposed to the vocabulary more traditionally used for insurance products, may indicate that the product is being marketed primarily as a security.

An issue might arise under the marketing test if an equity-index insurance product were described as one type of investment that could be directly compared to other types of investments. This issue might arise, for example, if an unregistered equity-index insurance product were compared to securities products such as indexed mutual funds, variable insurance products, or other investment vehicles. Likewise, this issue might arise if an unregistered equity-index product were described as an appropriate investment alternative to such securities products.

The precedents also indicate that undue emphasis should not be placed on the surrender provisions of a contract. For example, Release 6645 indicates that where a deferred annuity provides liberal surrender terms, an issue could arise under the marketing test if the marketing materials emphasized the surrender provisions as a device to provide liquidity, in order to attempt to compete with short-term liquid investments such as money market funds. 105

Finally, in applying the marketing test, no one of the foregoing items is determinative. As discussed above (see pages 14-15), the marketing test depends on the totality of the marketing effort for a product, not on individual marketing pieces, nor on specific words or phrases taken out of context, nor on the improper remarks of a single salesperson. Accordingly, all of the marketing materials should be reviewed together, in order to evaluate the overall emphasis of the marketing effort.

3. Assumption of Mortality Risk

a. Application to Annuity Contracts

The traditional analysis of whether an insurer has assumed a meaningful mortality risk under an annuity contract has been made on the basis of an examination of the permanent annuity purchase rate guarantees, including the likelihood of annuitization. 106 The analysis of the assumption of meaningful mortality risks by an insurer involves matters of degree rather than absolutes. The basic test is whether the guarantees reflect a reasonable possibility that a contract owner, reaching retirement, would "rationally choose to annuitize at those rates, all other factors involved in such a decision held constant." 107 These factors are measured by the level of guarantees and the economic realities of the circumstances under which the contracts are offered, including the maximum issue age and the annuitization age under the contract. The mere existence of an option to annuitize at a rate so low than no rational contract holder would annuitize does not constitute the assumption of a meaningful mortality risk.

As a practical matter, one test is whether the guaranteed annuitization rates under an equity-index annuity contract are similar to the guarantees offered by the insurer on other annuity contracts. This test derives from United Benefit, 108 where in analyzing the meaningfulness of minimum guarantees under a variable annuity contract, the Supreme Court compared the cash value guarantees at issue with those of another product offered by the same insurer and found them to be inferior.

Release 6051 suggests an alternative approach. In Release 6051, the SEC called for a comparison of an insurer's product with products issued by competing insurance companies. 109 It seems clear that the SEC did not intend to question the status of an annuity contract merely because the guarantees are more or less generous than those of other companies. However, the SEC warned that contracts providing for a level of guarantees "significantly lower than those otherwise generally commercially available from other insurance companies would raise serious questions as to whether any meaningful mortality risk will ever be assumed under that context (sic) by the insurance company." 110 The test established by the SEC is whether the guarantees are "so low that the guarantee is in economic reality a sham, such that no reasonable purchaser of the annuity contract would choose to annuitize." 111

Yet another factor is whether the contract includes a "betterment of rates" provision, which provides a guarantee that upon annuitization the insurer will pay the higher of its current annuitization rates or the rates guaranteed in the contract.

In our experience, equity-index annuity contracts meet the foregoing tests. As a general matter, while a range of guaranteed annuity purchase rates is offered by different insurers, the rates offered under current equity-index contracts are comparable to the rates offered by insurers for their other deferred annuity contracts and comparable to the rates offered by other insurers. In addition, in our experience most equity-index annuity contracts include some form of betterment of rates provisions.

We also note that there is some evidence that the demographic characteristics of purchasers of equity-index annuities are consistent with a "reasonable possibility of annuitization." At a recent conference, a representative of an insurer that offers equity-index annuity contracts indicated that the median age of purchasers of his company's product was 59 and that purchasers were almost equally divided among men and women. Since his company offers a product with a seven-year term, these demographics suggest that it would be highly reasonable for purchasers of his company's contract to use the contract proceeds for annuitization. 112

b. Application to Life Insurance Contracts

Life insurance policies by their very nature require an insurer to assume meaningful mortality risks, insofar as they provide offer significant death benefits comparable to the insurer's non-indexed products. In those circumstances, a policy's death benefit provisions entail significant spreading of mortality risks among insureds. Further evidence that equity-index life insurance policies involve assumption of meaningful mortality risks would be a requirement for an insurance underwriting under an insurer's usual life underwriting standards and variations in the charges and benefits under the policy depending on the insured's age, sex, or other actuarial category. 113

We note that in 1971, the SEC proposed a rule exempting variable life insurance ("VLI") from registration under the 1933 Act. 114 Although the rule was proposed through an industry petition, the SEC presumably would not have proposed the rule unless it believed that the idea had merit. The SEC ultimately determined, however, that VLI should be registered under the 1933 Act, even though it "involve(d) important elements of insurance," because the SEC determined that the variable cash value and death benefits under VLI policies would be emphasized in the sale of VLI policies. 115 While the SEC did not exempt VLI from registration under the 1933 Act, we believe that the foregoing history indicates that the intrinsic insurance nature of life insurance is entitled to great weight in analyzing any life insurance product under Section 3(a)(8).

We believe that, for securities law purposes, equity-index life insurance should be regulated like universal life insurance. The investment characteristics of equity-index life insurance policies are significantly different from the investment characteristics of VLI. Under VLI, contract values depend on the investment experience of a separate account and which typically provide none of the guarantees provided by equity-index life insurance. Moreover, universal life insurance policies, which also involve cash value and death benefits but are general account policies, have not been required by the SEC to be registered under the 1933 Act. Finally, unlike variable life insurance, as a result of an equity-index policy's guarantees of premium and credited interest, an equity-index policy does not present a risk that it will lapse as a result in a decline in the market value of the insurer's assets underlying its obligations under the policy.

E. Conclusion

Under our analysis, we believe that most current equity-index insurance products that we have seen qualify as insurance under Section 3(a)(8), as a result of their significant guarantees of principal and minimum interest, their imposition of of significant investment risk on the insurance company in crediting index-based interest, and their attraction to traditional insurance and annuity purchasers for the traditional insurance purposes of providing life insurance protection and long-term planning to meet retirement needs.

As we discussed, we look forward to meeting with you to discuss our letter. If, however, you have any question you feel it would appropriate to address before our meeting, please do not hesitate to call either of the undersigned at the telephone number given above.

Very truly yours,

S/Joan E. Boros

Joan E. Boros

S/Christopher S. Petito

Christopher S. Petito

100941.2


FOOTNOTES

-[1]- "Equity Index Insurance Products", Release No. 33-7438 (Aug. 20, 1997), 65 SEC Docket 451 (Sept. 8, 1997) (the "Concept Release"). 11400 Commerce Park Drive, Suite 220 . Reston, Virginia 20191-1549 . Phone 703-758-1975 . Fax 703-860-8873

-[2]- SEC v. Variable Annuity Life Insurance Co. of America, 359 U.S. 65, 77 (1959) (Brennan, J., concurring); accord: SEC v. United Benefit Life Insurance Co., 387 U.S. 202, 210 (1967).

-[3]- Concept Release, 65 SEC Docket at 454 n.17, citing "Definition of `Annuity Contract or Optional Annuity Contract'", Release No. 33-6558 (Nov. 21, 1984), 31 SEC Docket 908 (Dec. 4, 1984) (proposing Rule 151) ("Release 6558").

-[4]- Supra note 2.

-[5]- Supra note 2.

-[6]- 17 C.F.R. 230.151 (1996).

-[7]- Release 6558 and Release No. 33-6645 (May 29, 1986, 35 SEC Docket 952 (June 10, 1986) (adopting Rule 151).

-[8]- March letter, at 29; infra page 10.

-[9]- See Model Variable Annuity Regulation, Art. II, Par. 1, Model Reg. Serv. 250-1 (Mar. 1980) ("The term `variable annuity' when used in this Regulation, shall mean any policy or contract which provides for annuity benefits which vary according to the investment experience of any separate account or accounts maintained by the insurer . . . .")

-[10]- SEC No-Action Letter (pub. avail. Jan. 30, 1997).

-[11]- The contracts in question were registered under the Securities Act of 1933 because of a market value adjustment feature that imposed certain investment risks on purchasers.

-[12]- Id. at 7.

-[13]- VALIC, supra note 2, 359 U.S. at 77.

-[14]- United Benefit, supra note 2, 387 U.S. at 210.

-[15]- VALIC, supra note 2, 359 U.S. at 77.

-[16]- Supra note 2.

-[17]- Id., 387 U.S. at 205.

-[18]- Release 6558, supra note 3, 31 SEC Docket at 909 n.6.

-[19]- Release 6645, supra note 3, 35 SEC Docket at 962.

-[20]- See VALIC, supra note 2, 359 U.S. at 85 (Brennan, J. concurring) ("But what the investor is participating in during this (accumulation) period, despite its acknowledged `insurance' features, is something quite similar to a conventional open-end management investment company, under a periodic investment plan."); United Benefit, supra note 2, 387 U.S. at 208 ("the insurer promises to serve as an investment agency and allow the policyholder to share in its investment experience").

-[21]- "Insurance" (a term used herein to refer to insurance products generically) is "exempted" from registration by Section 3(a)(8) of the 1933 Act, 15 U.S.C. 77c(a)(8) (1981), which covers "(a)ny insurance or endowment policy or annuity contract or optional annuity contract, issued by a corporation subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia." A "security" that is exempted from the registration provisions of the 1933 Act is, nevertheless, subject to the anti-fraud provisions of the 1933 Act. We point out, however, that there are grounds for concluding that Congress did not intend that "insurance" be subject to the 1933 Act for any purpose, so that the Section 3(a)(8) registration exemption is, in effect, supererogatory. See Tcherepnin v. Knight , 389 U.S. 332, 342 n.30 (7th Cir. 1967); SEC v. Variable Annuity Life Ins. Co. of America , 359 U.S. 65, 67 (1959) (" VALIC "); Grainger v. State Security Life Ins. Co. , 547 F.2d 303, 305, reh'g denied, 563 F.2d 215 (5th Cir. 1977) (per curiam) ( "Grainger" ); Haberman v. Equitable Life Assurance Society of the United States , 224 F.2d 401, 406 (5th Cir. 1955); H.R. Rep. No. 85, 73rd Cong., 1st Sess. 15 (1933) (reporting out the bill that eventually became the 1933 Act); 1 L. Loss, Securities Regulation 496-97 (2d ed. 1961). The Securities and Exchange Commission has espoused this view, as articulated in the release proposing Rule 151 under the 1933 Act, 17 C.F.R. 230.151 (1996) ("Rule 151"). See Release No. 33-6558 (Nov. 21, 1984), 31 SEC Docket 908 (Dec. 4, 1984) ("Release 6558"). Subsequent judicial opinions have stated that Section 3(a)(8) is an exclusion. See, e.g., Berent v. Kemper Corp. , 780 F. Supp. 431, 440-41 (E.D. Mich. 1991).

-[22]- See Section 2(1) of the 1933 Act, 15 U.S.C. 77b(1) (1981).

-[23]- While the issue addressed in this letter is the status of equity-indexed products under Section 3(a)(8), it should be noted that the outcome of this analysis can affect all aspects of an equity-indexed product, including product design, choice of distribution channels and advertising. For example, if a particular equity-indexed product is determined to be a security, it must either be registered with the SEC or sold solely in transactions that qualify for an exemption from registration. See, e.g., Section 4(2) of the 1933 Act (private offering exception). In addition, issues arise as to whether the entities involved in marketing the product are required to be registered as brokers or dealers with the SEC pursuant to the Securities and Exchange Act of 1934 (the "1934 Act"), whether the individuals involved in marketing the product are required to be registered with the National Association of Securities Dealers, Inc. or state securities regulators, and whether the marketing efforts for the product comply with other regulatory requirements applicable to securities.

-[24]- The SEC has expressed its views with regard to such contracts in Release 6558, supra note 1, and the release adopting Rule 151, see Release No. 33-6645 (May 29, 1986), 35 SEC Docket 952 (June 10, 1986) ("Release 6645") (and collectively referred to as the "Rule 151 Releases"). The SEC also set out a general statement of policy in Release No. 33-6051 (April 5, 1979), 17 SEC Docket 190 (April 17, 1979) ("Release 6051") (which it withdrew in Release 6645).

-[25]- See Release No. IC-7644 (Jan. 31, 1973) (among other things, declining to adopt proposed Rule 157, which would have exempted certain variable life insurance contracts from registration under the 1933 Act).

-[26]- In 1981, the SEC solicited information and views as to the status of universal life insurance policies under Section 3(a)(8). These inquiries did not result in any SEC action to require universal life insurance policies to be registered under the 1933 Act.

-[27]- 17 C.F.R. 230.151 (1996).

-[28]- Supra, note 4.

-[29]- Release 6645, supra note 4, 35 SEC Docket at 953 n.4, 963.

-[30]- Id.

-[31]- See L. Koco, "3 More Equity Index Annuities Make Market Debuts", National Underwriter 11 (Life & Health/Financial Services Ed. Dec. 23 and 30, 1996) (reporting equity-indexed annuity using a composite international stock market index created by the insurer).

-[32]- SEC No-Action Letter (pub. avail. Jan. 30, 1997).

-[33]- See SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946) ("an investment contract for purposes of the (1933) Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party . . . .").

-[34]- 359 U.S. 65 (1959).

-[35]- 387 U.S. 202 (1967).

-[36]- SEC v. Variable Life Ins. Co. of America , 155 F. Supp. 521, 534 (D.D.C. 1957).

-[37]- VALIC, supra, note 14, 359 U.S. at 71 (footnotes omitted).

-[38]- United Benefit , supra , note 15, 387 U.S. at 211 (citation omitted).

-[39]- Id., 387 U.S at 211 n.15.

-[40]- 320 U.S. 344, 352-53 (1943).

-[41]- United Benefit , supra , note 15, 387 U.S. at 211.

-[42]- Release 6645, supra note 4, 35 SEC Docket at 963.

-[43]- Id. , 35 SEC Docket at 960.

-[44]- Id. , 35 SEC Docket at 953.

-[45]- Id., 35 SEC Docket at 963 (footnote omitted).

-[46]- Id., 35 SEC Docket at 953 n.4.

-[47]- See Release 6558, supra note 1, 31 SEC Docket at 911 n.19

-[48]- Id.

-[49]- Id.

-[50]- Release 6645, supra note 4, 35 SEC Docket at 961.

-[51]- Id. (footnotes omitted).

-[52]- Id.

-[53]- Release 6645 states that commentators on proposed Rule 151 raised this argument with the SEC. Id.

-[54]- Id., 35 SEC Docket at 960.

-[55]- Id., 35 SEC Docket at 962 and n.47 (footnotes omitted; emphasis in original).

-[56]- Release 6558, supra note 1, 31 SEC Docket at 912 (footnote omitted).

-[57]- Supra note 4, 35 SEC Docket at 962.

-[58]- Id. (footnote omitted).

-[59]- Id. and n.45.

-[60]- Id. (indicating that the test refers to the insurer's "total marketing plan" for the product).

-[61]- Home Life, infra note 51, discussed infra p.17.

-[62]- Release 6645, supra note 4, 35 SEC Docket at 962 n.48, citing Release 6051, supra note 4, 17 SEC Docket at 193 n.13.

-[63]- See Release 6051, supra note 4, 17 SEC Docket at 193.

-[64]- 419 F.2d 1250 (10th Cir. 1969).

-[65]- 547 F.2d 303 (1977), reh'g denied, 563 F.2d 215 (5th Cir. 1977) (per curiam).

-[66]- 698 F.2d 320 (7th Cir. 1983), reh'g denied, id.

-[67]- Id., 698 F.2d at 322.

-[68]- Id., 698 F.2d at 325.

-[69]- 814 F.2d 1127 (7th Cir. 1986).

-[70]- Id., 814 F.2d at 1142.

-[71]- 729 F. Supp. 1162 (N.D. Ill. 1989), aff'd, 941 F.2d 561 (7th Cir. 1991).

-[72]- Id., 729 F. Supp. at 1173-74.

-[73]- Id., 729 F. Supp. at 1174.

-[74]- Id.

-[75]- Id., 729 F. Supp. at 1175.

-[76]- 780 F. Supp. 431 (E.D. Mich. 1991), aff'd, 973 F.2d 1291 (6th Cir. 1992).

-[77]- Id. , 780 F. Supp. at 436 and n.8.

-[78]- Id., 780 F. Supp. at 441-444.

-[79]- Id., 780 F. Supp. at 443.

-[80]- See, e.g., Release 6051, supra note 4.

-[81]- Id., 17 SEC Docket at 191; see also Release 6558, supra note 1, 31 SEC Docket at 910 (acknowledging that there is authority for the proposition that assumption of mortality risk is a necessary feature of insurance, citing Helvering v. Le Gierse, 312 U.S. 531, 539-41 (1941)).

-[82]- Release 6645, supra note 4, 35 SEC Docket at 954 (footnote omitted).

-[83]- Id.

-[84]- Release 6558, supra note 1, 31 SEC Docket at 909 n. 6.

-[85]- Supra note 14.

-[86]- Supra note 15.

-[87]- Release 6558, supra note 1, 31 SEC Docket at 909 n.6, citing United Benefit , supra note 15, 387 U.S. at 210.

-[88]- Release 6558, supra note 1, 31 SEC Docket at 911.

-[89]- Supra note 12.

-[90]- Release 6645, supra note 4, 35 SEC Docket at 955.

-[91]- VALIC, supra note 14, 359 U.S. at 71, 72; United Benefit , supra note 15, 387 U.S. at 210.

-[92]- Release 6645, supra note 4, 35 SEC Docket at 955-956.

-[93]- Release 6645, supra note 4, 35 SEC Docket at 956.

-[94]- Id. (footnote omitted).

-[95]- Release 6558, supra note 1, 31 SEC Docket at 911 (footnote omitted).

-[96]- Rule 151(b)(3).

-[97]- Release 6645, supra note 4, 35 SEC Docket at 961 (footnotes omitted). All of the quotations in this paragraph have the same citation.

-[98]- Cf. Home Life, supra note 51, 941 F.2d at 566 (interpreting VALIC to mean that if an insurer "just pins the label 'annuity' on a mutual fund, in which the buyer bears all of the risk, 3(a)(8) is inapplicable").

-[99]- In this regard, we note that among other issues, the NAIC is currently studying whether to fashion reserve requirements specifically for equity-indexed insurance products. In the meantime, we understand that as part of the approval process for equity-indexed insurance products, certain state insurance regulators require a description and justification of the insurer's intended reserving methodology as well as the submission of periodic reports and actuary's certificates attesting to the adequacy of the reserves. See Letter from D.J. Keating, Oklahoma Insurance Department to: All Companies Desiring to Sell Equity-Indexed Annuities in Oklahoma (Oct. 25, 1996).

-[100]- Release 6558, supra note 1, 31 SEC Docket at 911 n.18 (citation omitted).

-[101]- Release 6645, supra note 4, 35 SEC Docket at 961.

-[102]- Depending on the product design, the payment of a surrender benefit, partial withdrawal, annuitization or death benefit during a term of a contract may be more or less expensive for the insurer than crediting index-based interest to a contract held for an entire term. Insurers typically estimate the likelihood of those events when they determine how to invest their general account assets to meet their obligations under their contracts. These estimates may be incorrect. In theory, an insurer could use the most expensive set of assumptions in investing its general account assets, so as to avoid the risk that its estimates may be low. Our understanding is that in practice, however, if an insurer were to do this, the added expense could require the insurer to offer less competitive contract terms.

-[103]- It should be noted, however, that while this risk may be small with respect to a particular guarantee period, the range of interest rates paid under a traditional fixed - rate annuity might vary greatly over the life of the contract, while still complying with the requirements of Rule 151. For example, where a fixed annuity contract guarantees an excess interest rate for successive one - year periods, subject to a 3% minimum rate guarantee, the interest rate guaranteed and paid in the seventh year of the contract might differ greatly from the rate in earlier years.

-[104]- Release 6558, supra note 1, 31 SEC Docket at 909 n.6.

-[105]- Release 6645, supra note 4, 35 SEC Docket at 962.

-[106]- See Release 6051, supra note 4, 17 SEC Docket at 191, 192.

-[107]- Id., 17 SEC Docket at 192.

-[108]- Supra note 15, 387 U.S. at 208 and n.10.

-[109]- Release 6051, supra note 4, 17 SEC Docket at 192.

-[110]- Id.

-[111]- Id.

-[112]- These figures represent, of course, one company's experience, and may or may not be representative of purchasers of equity-indexed annuity contracts generally.

-[113]- See, e.g., Berent v. Kemper Corp., supra note 56, 780 F. Supp. at 443 (in case holding that the single premium whole life insurance policies at issue were not securities, the court noted, in analyzing the marketing for the policies, that a medical requirement for the issuance of the policies and lower costs for non-smokers were not "things associated with a pure investment").

-[114]- 1933 Act Rel. No. 5234, 37 F.R. 5510 (Mar. 16, 1972).

-[115]- Release IC-7644, supra note 5.