Speech by SEC Staff:
Remarks before NAVA's 2004 Regulatory Affairs Conference
Mary Ann Gadziala
Associate Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission
June 15, 2004
"The Dawning of a New Era in the Industry: Will You Be Prepared?"
Regulatory Examinations Reveal Both Strong and Weak Practices by Broker-Dealers Selling Variable Insurance Products
The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
Thank you very much for providing me the opportunity to participate in NAVA's 2004 Regulatory Affairs Conference. The timing of this conference is perfect as we just issued the "Joint SEC/NASD Staff Report on Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products." The report is a compilation of findings from our examinations over the past several years in this area. Since we were identifying common deficiencies in many of the exams, we thought it would be beneficial to the industry and to investors to communicate our findings in a public report. Firms should consider the information in the report in assessing their own systems and procedures. We expect firms to make appropriate improvements that will assist in ensuring investors are given appropriate disclosures and sold only suitable variable insurance products.
There is no time like the present for firms to conduct this assessment and make sure procedures and controls are working. Based upon recent sales statistics, it appears that variable insurance products have attracted the attention of both investors and marketers. Recent reports indicate that, as of the end of last year, the combined net assets of U.S. variable annuities had reached more than $985 billion - a 23.7% increase over last year. With assets in a particular product hovering at the one trillion dollar mark, regulators naturally take note.
Variable insurance products have other characteristics that attract regulatory attention. There are significant sales incentives associated with high fees and surrender charges. High profit incentives can engender inappropriate aggressive sales tactics. Therefore, increased vigilance and controls may be appropriate. In addition, the unique tax, insurance, risk and liquidity characteristics of variable insurance products raise complex suitability issues. These require special disclosures, controls, and procedures when selling variable insurance products.
Finally, we saw a recent substantial increase in the number of customer complaints regarding sales of variable insurance products. The complaints generally indicated that the customer was sold a variable product without fully understanding the product. Many customers were surprised they would have to pay a hefty penalty - or surrender charge - to access their funds invested in a variable product. Others complained they were unaware their investment would decrease in value as the market turned downward. And some complained they were not informed of the many fees that thereafter appeared in their statements.
All of these factors - the significant size of the market, the unique characteristics of the product, the high sales incentives, and the substantial increase in customer complaints - led the SEC and NASD examination programs to focus on variable insurance product sales.
Our examinations of broker dealer sales of variable insurance products reviewed five key areas:
- the process firms used to ensure the variable insurance product was suitable for the investor;
- the supervision exercised over registered representatives selling the product;
- relevant disclosure made to investors about the product;
- the books and records maintained by the firm related to sale of variable insurance products; and
- the training provided to the firm employees about variable products.
There were quite a few examples of both weak and sound practices identified by examiners in each of these areas. I will highlight a few of these practices for you this afternoon. If the weak practices have a familiar ring because you have seen them at your firm, you should take action to improve your practices. And if the sound practices are not currently being implemented at your firm, you may want to consider them to further enhance your systems, procedures and controls. Let's now turn to the examination findings in the five key areas that were reviewed.
A. Suitability, Sales Practices, and Conflicts of Interests
As I mentioned, the first area covered by the staff's examinations was suitability, sales practices, and conflicts. A broker-dealer recommending a variable product to an investor must assess the investor's financial status, investment objectives, and other relevant information to determine if the product is suitable. The obligation to recommend only suitable securities arises from the antifraud laws and SRO rules. Most of the enforcement referrals, based on SEC examinations of variable insurance product sales, involved unsuitable recommendations by registered representatives to investors.
Among the suitability problems identified were:
- Registered representatives made unsuitable recommendations of variable insurance products. Examples of unsuitable recommendations included-
- Recommendations that required a customer, who had no other source of available liquid funds, to mortgage his home or borrow from an existing life insurance policy to purchase the variable insurance product;
- Recommendations of the same product to all customers without individual analysis; it is hardly likely that all the customers would have the same set of objectives and the same financial status;
- Recommendations to unsophisticated investors who did not understand the security and its characteristics; and
- Recommendations to customers that needed liquidity, many of whom later incurred surrender charges to get needed funds for current expenses. For example, an 84-year old woman, with "income" as her primary investment objective, was sold a variable annuity that would not even begin payouts until she turned 98 years old.
- Unsuitable and excessive switching took place, often on a regular periodic basis. A large number of the enforcement referrals from SEC exams involved unsuitable switching. Reports show that an estimated 60% of variable annuity gross sales came from exchanges last year; a statistic that supports continued scrutiny of switches and exchanges of variable products.
Some examples of sound practices identified with respect to suitability were:
- Controls and procedures were implemented to help ensure appropriate suitability analysis with respect to all relevant factors and appropriate documentation was maintained.
- Selection of investment advisors for services in this area was based on a thorough due diligence review with appropriate resolution of potential conflicts of interests.
- Suitability determinations were made at two levels for the investor: the contract level and the underlying fund level.
- Reports were generated and appropriate follow-up was done on comparisons of asset-based fees charged vs. commissions to offer what was appropriate for a particular customer's needs.
- Exception reports and other procedures were implemented to screen for specific suitability issues, prior to effecting the transaction. These might be based on the customer's age, investment objectives, percentage of net worth, tax status, and other relevant factors.
The next area reviewed in our examinations was supervision. The Commission can take enforcement action against a firm or person for failure to supervise. SRO rules also require broker-dealers to supervise employees in a way that is reasonably designed to achieve compliance with the law. Many of the enforcement referrals also included a finding of failure to supervise.
What were some of the examples of weak practices in the supervisory area?
- Supervisors did not review suitability determinations, did not follow-up on red flags - such as excessive switching - or did not monitor customer complaints.
- Firms did not identify and prevent manipulative and abusive sales practices, or fraudulent sales to market timers.
- Firms did not use exception reports or reports and services from insurance company issuers that would have identified problems.
Examiners also observed a number of sound supervisory practices. Among the sound practices were -
- Broker-dealers had comprehensive procedures that were regularly updated as business and legal requirements changed.
- Procedures included a detailed description of responsibilities of supervisors, as well as specific information a registered rep must consider in making a suitability determination.
- Procedures included methods to objectively analyze benefits of a variable product over alternative investments.
- Firms had systems in place to identify potential sales practice abuses or violations; exception reports were comprehensive and tailored to identify specific red flags with respect to variable product sales; and identified problems were quickly and appropriately addressed.
- Comprehensive reports, which analyzed trends in problems and complaints, were produced on a periodic basis.
The third area of review during our examinations was disclosure. A broker-dealer is required to deliver a prospectus on or before the transaction settlement date. Antifraud laws prohibit misrepresentations or omissions of material facts in the purchase, offer or sale of securities, including variable insurance products. Broker-dealers have a duty to disclose material conflicts of interests and are also required to maintain documentation of any written disclosures made to customers.
What were some of the weak practices identified in the disclosure area?
- Firms failed to disclose or misrepresented additional costs of insurance features (e.g., "Mortality and Expense" charges, "Costs of Insurance", administrative fees), the amount of the death benefit, the length of surrender periods, and the amount of surrender charges. In one case, an 80-year old client exchanged three variable annuities based on representations that she would incur no surrender charges and would increase her death benefit by $100,000. In fact, she incurred surrender charges of $9600 and her death benefit increased by only $30,000, $70,000 less than the amount represented to her.
- Firms failed to disclose or misrepresented potential market risks, issuer risks, lack of liquidity, and full tax implications. Quite a few customers complained of not understanding the market risk of the product when they received statements showing a reduction in the value of the investment during a market downturn.
- Firms failed to disclose the potential consequences of the investor's use of mortgage proceeds to purchase variable products, including the possibility that investment returns may not be sufficient to cover mortgage payments.
Among the sound practices related to disclosure were-
- Firms gave full and balanced disclosures on all fees, benefits, surrender charges, exchanges, liquidity, etc., as they related to the investor. Forms, which were detailed and in plain English, were provided for disclosure purposes.
- Firms required registered representatives to provide the prospectus for the variable product (and underlying funds, where possible) at the point of sale.
- Customers were referred to information on SEC and NASD websites.
D. Books and Records:
The fourth area of review was the books and records of the broker-dealer with respect to variable product sales. Firms are required to make and keep certain records regarding the sales of variable insurance products. The new books and records rules specify certain customer information that must be kept at branch offices.
Problems identified in the books and records area were -
- Failure to maintain documentation supporting recommendations of variable products and disclosures made to customers.
- Documents and forms required by firm procedures were not maintained.
- Customer complaints were not reported, analyzed or acted upon in a timely manner.
Among the sound practices regarding books and records were -
- Firms had complete, accurate, well-documented and updated customer information.
- Forms documenting customer switching articulated the reasons for the switch and were signed by the customer.
- Information regarding all orders, executed or not, was created and maintained.
The final area of review was training with respect to the sale of variable products. Many of the deficiencies identified by examiners appeared to result from inadequate or inappropriate training of employees. Training and continuing education on the sale of variable insurance products should be included in these programs when the firm offers these products to customers.
Some weak practices in training that contributed to deficiencies with respect to variable product sales were -
- Firms provided only general sales practice training with nothing specific on the unique characteristics of variable products.
- Annual compliance meetings and the "firm element" of continuing education programs did not include variable products.
Sound training practices included -
- Training that specifically covered variable product sales and covered unique suitability responsibilities.
- Training of supervisors to enable them to identify specific problems in this area.
- And finally, careful review by firms of external training for aggressive and inappropriate sales tactics.
These are only a few examples of the findings from SEC and NASD staff examinations of broker-dealer sales of variable insurance products. If you work for a firm that offers variable products to its customers, I urge you to read the full report. Assess your firm's systems, controls, procedures and their implementation. Are the weak practices identified at other firms present at your firm? Do you have sound practices - perhaps similar to those identified in our examinations, or perhaps other sound practices that achieve the same objective in another way? Consider the examination findings and work to design the best controls and procedures tailored to the activities and operations of your firm. Then, should SEC or NASD examiners arrive at your firm to review compliance with respect to sales of variable insurance products, they will find only sound practices and no customer complaints.