Committee of Annuity Insurers
February 6, 2004
Mr. Jonathan G. Katz
Dear Mr. Katz:
This letter is submitted on behalf of the Committee of Annuity Insurers (the "Committee").1 The Committee is pleased to have the opportunity to offer its comments in response to the request of the Securities and Exchange Commission (the "Commission") in Release Nos. 33-8343; IC-26287 (Dec. 11, 2003) (the "Proposing Release") for comments on its proposal to amend Form N-4, the registration form for insurance company separate accounts that are organized as unit investment trusts and that issue variable annuity contracts, to require prospectus disclosure regarding the risks of frequent transfers of contract values among subaccounts and the separate account's policies and procedures, if any, with respect to such frequent transfers.
The Committee supports the Commission's goal of implementing disclosure reforms intended to shed more light on market timing and its possible harmful effects on investors, including variable contractowners. Committee members are concerned, however, that certain aspects of the Commission's proposal do not take into account the unique challenges that insurance companies issuing and administering variable annuities likely will face if the new disclosure requirements are adopted as proposed without appropriate accommodation of the need for insurance companies to coordinate with underlying funds to reach mutually agreeable and workable market timing policies and procedures. We provide some suggestions below for modifying the Commission's proposal and explain why certain aspects of the proposal, without modification, would be unworkable for variable annuity issuers.
Two-tiered product structure
Background. It is important to understand that there are significant and critical differences between mutual funds and variable annuities. Unlike mutual fund shares, a variable annuity is a written contract between two parties: the insurance company that issues the contract and the owner who purchases the contract. That contract gives each party certain rights, and in general neither party can unilaterally change the terms of the contract or take away a right of the other party. Of particular relevance here, variable annuity contracts generally give the owner certain rights with respect to transfers between investment options (generally called "subaccounts").
Virtually all variable annuities today are issued through a two-tier investment company structure. The top tier is a separate account of the issuing insurance company that is registered under the 1940 Act as a unit investment trust. The separate account is generally divided into subaccounts, and the owner allocates premium payments among the subaccounts and can transfer contract value among the subaccounts. Each subaccount typically invests in shares of a particular underlying registered mutual fund portfolio (the bottom tier). The insurance company, acting as agent for the underlying funds, accepts and aggregates individual contractowner transaction requests received before the time the funds prices their shares (generally, 4:00 p.m. Eastern time), and transmits to the fund the next morning a net, or "omnibus," order for shares of each fund corresponding to the insurance company's subaccounts. Prospectuses for both the top tier describing the separate account and variable annuity contract, and each fund in the bottom tier in which the owner invests, are provided to the variable annuity contractowner.
The Commission's Proposals. The proposed amendments would require disclosure in variable contract prospectuses of whether the separate account that issues the variable annuity contract or its insurance company depositor has policies and procedures with respect to frequent transfers of contract value among subaccounts. If the depositor or separate account has policies and procedures regarding frequent transfers, the proposed amendments would require specific prospectus disclosure about such policies and procedures. Because the unit investment trust does not have a board of directors, the depositor would be responsible for adopting and implementing any policies and procedures. If neither the separate account nor the depositor has adopted any frequent transfer policies and procedures, the proposals would require the contract prospectus to include a statement explaining why the depositor considered it appropriate not have such policies and procedures.
This aspect of the proposal appears to specifically acknowledge that each insurance company depositor will be in an informed position to develop its own market timing policies and procedures, based on an assessment of the characteristics and historical trading patterns of its variable annuity contractowners. The insurance company depositor also will need to assess what market timing restrictions are appropriate in light of specific contractual provisions of the variable annuity contracts in the insurer's various blocks of business. In this regard, it is important to note that insurance companies are bound by and therefore must consider contractual rights regarding transfers given to contractowners under the terms of a variable annuity contract. Variable annuity contracts typically contain a variety of provisions regarding rights of transfer, including in some older contracts issued before market timing developed into a significant industry concern, provisions that permit unlimited transfers. As with insurance contract provisions in general, under state insurance law these transfer provisions generally cannot be unilaterally changed by the insurance company.2
Comments. The Committee's concerns about the Commission's proposed market timing disclosure requirements stem from the fact that the proposal would effectively require specific disclosure in both the separate account prospectus and in each underlying fund prospectus with respect to frequent trading. With respect to mutual funds, including underlying funds, the proposal requires either that the board of directors of each underlying fund adopt policies and procedures with regard to frequent purchases and redemptions of fund shares that are specific to the fund and describe such policies and procedures with specificity in the fund prospectus, or the fund prospectus would be required to include a statement of the specific basis for the view of the board that it is appropriate for the fund not to have policies and procedures with regard to frequent trading.3 Underlying fund prospectuses also would be required to include a description of any policies and procedures of the fund for detecting frequent purchases and redemptions through intermediaries, which presumably would include omnibus account trades from top-tier separate accounts.
However, experience has shown that the specific market timing policies and procedures of the various underlying funds in which the variable annuity separate account invests will almost certainly be inconsistent and possibly conflicting,4 and may go far beyond what is possible for the separate account depositor to administer, especially in the short-term.
Current industry practice is for formal arrangements between the separate account and the underlying funds for the purchase and redemption of fund shares to be negotiated and documented in a "participation agreement" between the parties that is filed with the Commission as an exhibit to Form N-4. The participation agreement embodies what is possible - that is, each party works with its administrative and technical staffs to ensure that the terms of the agreement can be implemented.
However, the new Commission proposals may seriously undermine the arrangements between the separate accounts and the underlying funds by effectively requiring each party to separately adopt specific market timing policies and procedures without consulting the other party. We respectfully recommend that the Commission clarify when it adopts final market timing disclosure rules (either in the adopting release or the rule itself) that given the current constructive and collaborative nature of the negotiated arrangements between separate accounts and underlying funds described above, underlying funds should consult with their participating insurance companies regarding any proposed market timing policies and procedures and that, in appropriate circumstances, underlying funds may even rely on the participating insurance companies' market timing policies and procedures without the fund adopting its own policies and procedures. Rather than a narrow requirement that each board of every underlying fund articulate a specific policy on market timing, we believe that the Commission could stipulate that underlying fund boards are not necessarily expected to adopt their own market timing policies and procedures or to provide specific disclosure regarding such policies and procedures in the fund prospectus.
We believe that it would be appropriate for the Commission to condition this aspect of the rule - that an underlying fund's board not necessarily be required to, and in most cases is not expected to, adopt its own market timing policies and procedures - on a requisite finding by the board that the market timing policies and procedures of the separate accounts to which the fund sells its shares are reasonably designed to detect and deter market timing in the fund. In such instances, the underlying fund would disclose that it had approved the policies and procedures of the participating separate accounts as disclosed in the separate account prospectuses. This formulation would enable insurance company separate account depositors and underlying funds to work together to negotiate a market timing policy that is feasible for the depositor to administer, while still protecting the interests of investors in the underlying funds.
Most underlying fund boards currently have a means of reinforcing this approach. Mutual funds that sell their shares to separate accounts of unaffiliated insurance companies must apply for a "mixed and shared" funding exemptive order from the Commission. In cases where underlying funds have obtained mixed and shared funding relief from the Commission, the board of the fund is required to monitor the fund for the existence of any material irreconcilable conflict among participating insurance companies. If a majority of the board, or a majority of disinterested board members, were to determine that a material irreconcilable conflict existed because one or more insurance companies' market timing policies and procedures, in the Board's view, do not adequately protect contractowners of other insurance companies, the relevant participating insurance company would be required under the participation agreement and by the Commission's mixed and shared funding order, to take whatever steps necessary to remedy or eliminate the material irreconcilable conflict. In this regard, if an insurance company did not respond by adopting appropriate market timing policies and procedures, the fund's board could take action to protect other investors by terminating sales of new shares to the insurance company, imposing fees or taking other actions, as appropriate.
Finally, there is clear Commission precedent for treating mutual funds used as investment options in variable annuities differently than other mutual funds. General Instruction C.3(d) to Form N-1A currently provides that mutual funds used as bottom-tier investment options for variable contracts as defined in Section 817(d) of the Internal Revenue Code may modify or omit certain items, including Items 7(b)-(d), from their prospectus disclosure. Indeed, in order to implement the approach proposed in this letter, we recommend that the Commission simply add the new Item 7(e) to the list of Items set forth in General Instruction C.3(d).
Market timing versus frequent trading
The Proposing Release indicates that the proposed amendments are "intended to shed more light on market timing" and arise from the Commission's concern with the "abuses related to `market timing,' including the alleged overriding of stated market timing policies by fund executives to benefit large investors at the expense of small investors." Yet a careful reading of the proposed amendments reveals that the amendments only require disclosure regarding "frequent" purchases, redemptions and transfers. The Committee questions whether the proposed disclosure requirement on "frequent" trades and transfers is too broad and wide-of-the mark, and will sweep into its scope many behaviors completely unrelated to abusive market timing.
More specifically, the Committee is concerned that the rule as proposed will cause underlying fund boards to adopt specific limits on the frequency of trades and to attempt to define those limitations as applying at the individual contractowner level irrespective of the omnibus nature of the trade orders submitted by the separate account and whether such trades are causing actual damage to the underlying fund.5 One of the attractive features of a variable annuity as a long-term retirement vehicle is the flexibility it gives owners to trade within and among underlying fund options, whether it is a trade to invest new flexible premium payments, to dollar cost average investments, to pay for systematic withdrawals of cash value or annuity payments, to automatically rebalance fund allocations on a regular basis, or to tailor the choice of investments to match an individual's changing financial circumstances. Each of these features requires that the owner at least have the ability to purchase and redeem fund shares with some frequency and regularity. None of these features come close to being the kind of disruptive trading practices that the proposed amendments are designed to address. Yet rigid, prophylactic measures by fund boards that simply limit fund trades to a specific number of trades per month or per year likely would have the serious detrimental effect of undermining the owner's contractual right to add to, withdraw, transfer and rebalance their cash value at will. Annuity issuers believe it is critical that ordinary owners of long-term retirement vehicles, such as variable annuities, be permitted to have the flexibility to invest their cash value without arbitrary limits on the frequency of their purchases and redemptions of underlying fund shares. In the variable annuity context, frequent purchases and frequent redemptions are normal; rarely are they synonymous with abusive market timing.
The Committee therefore asks the Commission to clarify in the adopting release that the policies and procedures that are subject to the rule's disclosure requirements should relate to policies and procedures designed to detect and deter disruptive market timing activities and that the proposed amendments are not asking or encouraging funds and separate accounts to adopt and disclose policies and procedures that simply place arbitrary limits on frequent trades.
The proposals require each of the separate account and the underlying funds to provide specific disclosures regarding its market timing policies. Each entity would be required to provide detailed, specific disclosure of the entity's exact procedures for both detecting and deterring frequent purchases and redemptions. The amendments to Form N-4 would require specific prospectus disclosure regarding:
It is the view of many of the Committee's members that providing disclosure with this level of specificity in many situations may be more harmful, than beneficial, to contract owners. The Committee is concerned, based on the experience of some of its members, that the disclosure of specific information on minimum holding periods and volume/numbers of transfers, etc. in its prospectus will give the market timers all the information they need to continue to avoid detection, providing them with a "road map" on how to "game" a company's policies and procedures.6
In addition, the requirement for specific prospectus disclosure will inhibit the separate account's ability to adapt its policies and procedures and react quickly and with flexibility to market timers. The separate account and underlying funds do not want to have their hands tied by the requirement that they conform to overly-specific disclosure of market timing policies and procedures.
For these reasons, the Committee urges the Commission to reconsider the requirement that any market timing policies and proposals be disclosed with specificity. Rather the Committee would suggest that disclosure be required to be made of the factors7 built into the separate account's market timing policies and procedures, with issuers having the option to include more specific disclosure, if they wish.
Committee members request that the Commission provide registrants with sufficient time to implement any new requirements, including time to renegotiate participation agreements and work with underlying funds to develop cohesive, flexible market timing policies and procedures. Committee members ask that any new disclosure not be required in new registration statements and post-effective amendments until one year after the effective date of the amendments. Committee members also request clarification that the addition of any new disclosures to meet the requirements of the proposed amendments does not, in and of itself, require registrants to file a post-effective amendment under Rule 485(a) under the Securities Act of 1933.
* * *
The Committee appreciates the time and resources that the Commission and its Staff have given to this important issue, and this opportunity to provide our views to the Commission. We also appreciate the careful consideration that you will give to our comments and suggestions.
cc: The Honorable William H. Donaldson, Chairman
Allmerica Financial Company