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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Understanding the Securities Products
of Insurance Companies

Keynote Address of

Paul Roye

Director, Division of Investment Management
U.S. Securities & Exchange Commission

Before the Practicing Law Institute

January 9, 2001

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Roye and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.


Thank you and good morning. It is a pleasure to be here with you today.

I understand that many of you may be new to the field of variable insurance products regulation. As I'm sure you learned in yesterday's panel discussions, this is an exciting and interesting area of the federal securities laws. But because these products are part insurance, part securities, understanding these products and their regulatory framework is indeed a challenge. And to make it even more complicated, add to this the fact that the securities laws were not enacted with variable insurance products in mind, as well as the need to understand the regulation of the underlying mutual funds in which these products invest. At the risk of offending those lawyers here that are experts in this area, I would analogize developing an understanding of the regulatory framework governing variable insurance products to one of my early law school experiences.

As part of my summer reading, prior to entering my first year of law school, I was urged to read a book by a distinguished Yale law school professor, Karl Llewellyn called the "Bramble Bush," named after a nursery rhyme that was supposed to describe the process of retraining our minds to think like a lawyer. The rhyme goes as follows: There was a man in our town and was wondrous wise.
He jumped into a Bramble Bush and he scratched out both his eyes–
And when he saw that he was blind, with all his might and main,
He jumped into another one, and scratched them in again. Hopefully, after yesterday, you don't feel like your eyes have been scratched out. But if you do, with the balance of this conference and a little work on your part, you can scratch them back in again.

The variable products industry is characterized by rapid change, as increasing competition yields new and innovative product designs. In addition, traditional ways of doing business are changing in response to technological innovations. These developments are changing the variable products landscape at an accelerating pace. These changes, of course, bring great challenges for the industry, and also for those of us who are responsible for the legal and regulatory aspects of the business.

With this in mind, I would like to review with you some of the more important recent developments in the area of federal securities regulation of insurance products. Hopefully, I will provide you some insight into our thinking on many of the current issues facing the industry today.

II. Bonus Products

One product innovation that continues to command a lot of our attention on the staff is the bonus credit feature. As some of you may know, the bonus credit feature offers the investor an immediate credit equal to a percentage of purchase payments, typically in the range of 1% to 5%. From a marketing perspective, these products have substantial appeal. They offer an investor the opportunity to put his or her entire investment and then some to work immediately. But that is not the full story.

We know that investors generally pay for bonus credits one way or another; whether in the form of higher surrender charges, longer surrender charge periods, or higher asset-based charges. We are concerned by the fact that these charges can more than offset the amount of the bonus. We are also concerned with the potential for sales practice abuses because the cost of the bonus may be less visible than the bonus itself. And our concerns are heightened in cases when a bonus is paid to an investor transferring funds from one variable annuity to another in an exchange. Often in these cases, an investor at or near the end of a surrender charge period takes on a new surrender charge schedule as a result of the exchange. Depending on the time horizon for the new investment, the impact of the new surrender charge could outweigh the value of the bonus.

We have been paying close attention to disclosure regarding bonus programs. You can expect us to continue to comment on any presentation of a bonus product that does not fully and fairly disclose the downside, as well as the upside, of the product. To that end, we are asking registrants to disclose the cost to investors of any bonus clearly and upfront. We want investors to be able to weigh the costs as well as the benefits of bonus programs in order to make an informed investment decision.

We are also paying close attention to performance presentations for bonus products because, in our view, bonuses can have the effect of artificially inflating the short-term performance of an annuity. In this regard, we have required all performance presentations that include bonus amounts also to include the impact of contingent deferred sales charges that apply upon the surrender of a bonus contract.

Providing the investor with adequate disclosure addresses only part of our concerns in this area. We are also very concerned with the broker-dealer's responsibility to make suitable recommendations to investors. So, in addition to our scrutiny of bonus disclosure, we are also focusing on the suitability of bonus transactions through the Commission's inspections program. Our Office of Compliance Inspections and Examinations is working with NASD Regulation to examine sales practices used in marketing variable annuities with bonus programs. We expect that any firm engaged in the distribution of bonus products will pay particularly close attention to sales of these products, ensuring that adequate safeguards exist to prevent unsuitable sales of these products.

NASD Regulation, as well as the Insurance Marketplace Standards Association, has joined us in our efforts to heighten attention on bonus products. This past summer, NASD Regulation issued a Regulatory & Compliance Alert to assist member firms in ensuring that their bonus product sales material is presented in a fair and balanced manner. The Insurance Marketplace Standards Association has alerted IMSA members and independent assessors to the importance of focusing on sales practices employed in distributing products with bonus features. You are fortunate to have Paul Mason here to talk to you about IMSA initiatives later this morning. We at the Commission applaud the efforts of the NASDR and IMSA in this area.

While the results of our focus on bonus products are not yet complete, it is fair to say that we have observed practices in the sale of these products by some firms that are problematic.

III. Disclosure Issues

Now, I'd like to talk about disclosure issues. Both the Commission and the industry have identified a number of areas where disclosure improvements could aid investors in understanding variable contracts.

A. Variable Life Insurance Prospectus Improvement

As you may be aware, the Commission has proposed Form N-6 to improve disclosure to variable life insurance investors by developing, for the first time, a disclosure form specifically tailored for variable life insurance products. We are now in the final stage of refining the form for adoption in light of the many thoughtful comments we received from the industry. With the adoption of this form, investors will truly be the beneficiaries of better and more understandable disclosure in this area.

After we move forward with the adoption of Form N-6, we will focus on amendments to Form N-4, the form used for variable annuity prospectuses. Our goal will be to streamline the variable annuity prospectus to focus disclosure on essential information that investors need in deciding whether to purchase a variable annuity contract. We will also focus on ways to streamline the updating of variable annuity prospectuses, similar to our analysis of ways to improve the updating of mutual fund prospectuses.

B. Shareholder Reports

A number of variable annuity issuers have expressed concerns to us about contractholder information overload. Issuers believe contractholders may be overwhelmed by annual reports for all the investment options available under their contract. Variable product issuers have asked us to address this by paring down shareholder report requirements. Our deliberations in this area are grounded in the basic principle that fund shareholders are entitled to receive a shareholder report that tells them what fund management has done for them. We do not require an issuer to send reports for investment options that a contract owner has not chosen. Often, issuers send contractowners annual and semi-annual reports for all the funds offered under the contract because that is how the reports are prepared and printed by the issuers, even though this results in contractowners receiving more reports than our rules require. We hear arguments that it is not feasible for an issuer to prepare different forms of periodic reports so that a contractowner receives reports only for the funds selected under the contract. I am not wholly convinced by these arguments, especially in this time of ever more sophisticated systems and technology.

Having said that, I would also point out that we are not averse to changing our rules in appropriate circumstances. Currently, we are taking a hard look at disclosure of fund portfolio holdings, with the goal of improving the quality of portfolio schedule information. We are looking at both the format and frequency of portfolio disclosure. Our goal here is to provide information to investors when they need it, while avoiding information overload.

C. Mutual Fund Fees

Another important disclosure issue concerns fees. Unfortunately, too many investors today focus on a fund's past performance and pay too little attention to how fund fees and charges (and for that matter variable account fees and charges) affect their investment over time.

The issue of fund fees has been a focus on Capitol Hill, as well as at the Commission. The Commission has undertaken a number of recent and ongoing initiatives in this area, including changes to disclosure requirements to make fee disclosure easier to understand, and increased focus on investor education about mutual fund fees, including the introduction of an interactive web-based mutual fund cost calculator.

At the request of Congress, the General Accounting Office competed a study this past summer of mutual fund fees and expenses. The study concluded that additional disclosure could help increase investor awareness and understanding of mutual fund fees and, thereby, promote additional competition by funds on the basis of fees. The report recommends that the Commission require that periodic account statements include additional disclosure about the portion of mutual fund expenses that the investor has borne. The Division has also recently completed a review of mutual fund fees and expenses, which will be made public shortly. Our report agrees with the GAO that more can be done to make fees more transparent and recommends that funds make the actual impact of fees more visible to shareholders, and allow investors to quickly and effectively determine levels of fund expenses. We believe these measures should help investors make better investment decisions.

D. Annual Prospectus Updates

In the area of annual prospectus updates, we are considering an industry proposal that variable annuity issuers not be required to deliver a complete updated contract prospectus to their investors making additional purchase payments. One possibility is that, instead, issuers could provide a short summary of material changes. Issuers have argued for some time that full annual updates of contract prospectuses are unnecessary and unhelpful because the terms of variable contracts are largely fixed once the contract is issued.

We are also exploring ways to eliminate the need for underlying funds to deliver updated prospectuses to existing shareholders annually. Some in the variable insurance industry have suggested to us that we consider allowing underlying funds to provide a short summary of material changes. We explored this idea with the broader fund industry and, frankly, they indicated that they would be unlikely to use such an updating document. We are, however, continuing to consider whether the profile could serve as an annual updating document for funds, which is another idea that some in the variable insurance industry have suggested. This could be a more effective way of communicating updated information to shareholders than delivering an entire new statutory prospectus and could result in significant savings to funds and their shareholders.

IV. Substantive Investment Company Act Issues

I've been talking about disclosure, which will always be an important theme when we discuss the regulation of variable insurance products; disclosure is the bedrock of the regulatory scheme under the Securities Act, which applies to all public securities offerings. But as investment companies, insurance company separate accounts are subject not only to disclosure requirements, but also to various substantive requirements of the Investment Company Act. So, now let me talk about how trends in the industry are raising challenging issues under certain substantive provisions of the Investment Company Act.

A. Exchanges under Section 11

First, I'd like to talk briefly about exchanges. As a contractowner reaches the end of the surrender charge period under a contract, he or she can exchange the contract value for a new contract, perhaps with new features or with a bonus. You will hear these types of transactions referred to as "1035" exchanges, a reference to the tax law provision that generally allows these to be tax-free transactions. We are concerned about exchange programs because they create a high potential for sales practice abuses, particularly when the compensation arrangements for the broker create an incentive to recommend switching to a new contract

So we are continuing to scrutinize the practice of switching or improper exchanges. In fact, on September 25th, the Commission for the first time instituted proceedings against the principal of a registered investment adviser for switching involving variable annuities. Specifically, the individual is alleged to have induced his investment advisory clients to switch their variable annuity investments by providing them with unfounded, false and misleading justifications for the switches, including false and misleading comparisons of the performance of certain variable annuities and false assurances that the switches would increase the diversification of his clients' portfolios.

The Commission is alleging that the clients in this case, as a result of this alleged fraudulent conduct, incurred unnecessary sales charges of more than $168,000, and in some cases lost a portion of their investment principal, and that a broker-dealer affiliated with the adviser received commissions of more than $210,000 in connection with the switches. Obviously, this is exactly the type of conduct, which not only we at the Commission, but industry participants, must guard against and prevent. Let this case be a reminder that we will be vigilant in policing this type of abuse.

As the variable products industry becomes more competitive, insurance companies are challenged not only to attract new business, but also to retain assets under management. This raises the issue of internal exchange programs. It has come to the staff's attention that, in an effort to retain assets and stem the tide of outgoing 1035 exchanges, some issuers may be taking steps designed to promote internal exchanges of older contracts for newer contracts of the same issuer. Section 11 of the 1940 Act prohibits an insurance company from offering to exchange the securities of its separate account for the securities of any other investment company unless the Commission has approved the terms of the offer by exemptive order or it has complied with Rule 11a-2 under the 1940 Act. The so-called "retail exception" to Section 11 excludes from the scope of Section 11 any offers made by a principal underwriter to an individual investor in the course of its retail business. Apparently, some issuers are taking an expansive view of the "retail exception," as including issuer programs to encourage internal exchanges. We do not share this expansive view of the "retail exception," which is intended to except individual offers from a broker to an investor. With this in mind, we are looking closely at arrangements that may constitute offers of exchange in violation of Section 11. We are also considering publishing guidance providing the staff's views of the scope of the retail exception.

B. Substitution Applications

Another issue that has commanded a lot of attention of the SEC staff recently is the increasing number of applications requesting Section 26(b) approval for the substitution of underlying funds supporting variable annuity and variable life contracts. There are a number of reasons why an insurance company would want to substitute underlying funds; eliminating funds with poor performance, compliance issues, and high expense ratios or to add funds which are more attractive from a marketing standpoint. However, some of these applications have a common theme. A fund unaffiliated with the insurance company is being replaced with an affiliated fund – one managed by an affiliate of the insurance company. Often the substituted fund is a newly created series of the insurance company's proprietary fund group, with investment objectives and policies similar or identical to those of the replaced fund. Even when the substitution is to an unaffiliated fund, often we find substantial revenue sharing arrangements between the insurance company seeking approval of the substitution and management of the proposed new fund.

In its review of these applications, the staff is focusing on situations where the new substitute fund has higher advisory fees or 12b-1 fees that, absent a substitution, could not be imposed without shareholder approval. Under Section 26(b), we can only grant a substitution order if we find it to be consistent with the protection of contract owners and the policies of the statute. It is difficult, at best, for us to make this finding in the kinds of circumstances I have just outlined.

The overall question in these cases is whether a proposed substitution is designed to benefit contract owners in some tangible way. When a proposed substitution could be accomplished by a fund reorganization with shareholder approval of any fee increases, we believe that alternative should be explored. Where a substitution order is sought, we generally are requiring contract owner approval for any fee increases that would normally be subject to a shareholder vote absent the substitution.

V. Underlying Fund Issues

Now I'd like to discuss some other mutual fund developments that are relevant for variable products.

A. Governance

As many of you may know, the Commission recently adopted new rules in the area of fund governance. These rules are designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with better information to assess the independence of directors. The new rules amend certain exemptive rules under the Investment Company Act by adding a number of conditions to the exemptive rules that any fund must meet to rely on the rules. These conditions are: (1) independent directors must constitute at least a majority of their board of directors; (2) independent directors must select and nominate other independent directors; and (3) any legal counsel for the independent directors must be an independent legal counsel. The new rules also prevent qualified individuals from being unnecessarily disqualified from serving as independent directors, protect independent directors from the costs of legal disputes with fund management, and facilitate our monitoring of the independence of directors by requiring funds to keep records of their assessment of director independence.

The new rules also include a number of disclosure requirements that will enhance shareholders' ability to evaluate whether the independent directors can act as an independent, vigorous, and effective force in overseeing fund operations. The rules require funds to provide basic information about directors to shareholders annually so that shareholders will know the identity and experience of all directors. They also require disclosure of directors' ownership of fund shares, information about independent directors' potential conflicts of interest, and information on the board's role in governing the fund.

One of the more controversial parts of the proposed rules was the independent legal counsel requirement. After the release of our original proposal, an ABA Task Force issued a report that reminded lawyers of their obligations under their existing ethics rules to disclose to independent fund directors their potential conflicts of interest, such as work they may perform for the fund's adviser, principal underwriter or administrator or their control persons. The final rule amendments reflect our view, consistent with the ABA report, that independent directors benefit from the advice of counsel who can render objective and unbiased advice, and that independent directors can effectively assess the independence of their counsel only when that counsel has disclosed all of the relevant information regarding conflicts and potential conflicts of interest. The rules require independent directors to obtain an undertaking from their independent counsel to provide them with information on conflicting representations. With this information, independent directors can assess whether their counsel is truly independent meaning that any representation of the fund's management during the previous two fiscal years is sufficiently limited that it is unlikely to impair the professional judgment of the person in providing legal representation to the directors.

Mutual fund directors are an investor's front-line defense against conflicts of interest and other potential abuses. Although no regulation can ensure director independence and effectiveness, we believe the initiatives approved by the Commission represent a significant step in providing fund directors with the tools, the access and the power to faithfully fulfill their legal duty and moral mandate as the shareholders' representative.

B. Names

Another development affecting underlying funds concerns the names used by funds. In February 1997, the Commission proposed new Rule 35d-1 to address certain investment company names that are likely to mislead an investor about a company's principal investment focus. While we feel strongly that investors should not rely on an investment company's name as the sole source of information about a company's investments and risks, we recognize that the name of an investment company may communicate a great deal to an investor. To date, the SEC's staff has sought to deal with potentially misleading investment company names, principally through the process by which we informally comment on fund registration statements. The Division has taken the position that an investment company with a name suggesting that it focuses on a particular type of investment generally is required to invest 65% of its assets in the type of investment suggested by its name.

The proposed rule would require an investment company with a name that suggests a particular investment focus to invest in a manner consistent with its name. The rule, for example, would require an investment company with a name that suggests that the company focuses on a particular type of security to invest at least 80% of its assets in that type of security under normal market conditions. The Acme Bond Fund, for example, would have to have at least 80% of its portfolio invested in bonds rather than 65%. The rule also would address names suggesting that an investment company focuses its investments in a particular country or geographic region, names indicating that a company's distributions are exempt from income tax and names suggesting that a company or its shares are guaranteed or approved by the U.S. government.

By increasing the investment requirement from 65% to 80%, the rule is intended to provide investors greater assurance that an investment company's investments will be consistent with its name. We expect that the Commission will take final action on the names proposal shortly.

VI. Privacy Issues

As we look toward ensuring that regulatory oversight keeps pace with technology, we recognize that issues of privacy must keep pace with technology as well. Whether an investor provides information through traditional or electronic means, the confidentiality of the information is protected by law. This has been brought into focus with new Regulation S-P promulgated under the Gramm-Leach-Bliley Act.

Regulation S-P generally requires every investment adviser and investment company to:

(1)Provide each customer with a notice of its privacy policies and practices (a "privacy notice") when the customer relationship is established and annually thereafter; and
(2)Provide each "consumer" with a privacy notice before disclosing any nonpublic personal information to any nonaffiliated third party, and an opportunity for the consumer to block (or "opt out" of) the sharing of nonpublic personal information to nonaffiliated third parties.

I would point out that a "consumer" for the purpose of this second requirement is not necessarily a customer, but includes anyone who provides nonpublic personal information in connection with obtaining or seeking to obtain financial products or services. An individual does not need to have an ongoing business relationship with an adviser or investment company to be protected by this provision of the rule.

A privacy notice, among other points, must state:

(1)The types of personal information collected and/or disclosed;
(2)The categories of affiliates and nonaffiliated third parties to whom information may be disclosed; and
(3)The right of consumers (and the reasonable means available) to opt out of disclosure to nonaffiliated third parties.

Regulation SP also requires advisers and investment companies to adopt policies and procedures reasonably designed to insure the security and confidentiality of customer information. Compliance with Regulation S-P becomes mandatory by July 1, 2001. I recommend that industry participants address this issue now so that they are prepared six months from now, when they will be required to comply with the privacy rules.

VII. Technology Issues

I would now like to turn to the subject of technology and the Internet. Many companies sponsoring variable products are embracing the Internet as a way to educate the public about variable products, sell variable products directly, provide an array of customer services, and support their distribution channels. The Internet has facilitated new opportunities for the direct sale of variable annuities, making it easier for investors to compare and shop for annuities online. According to one research organization, there are 15.1 million current annuity owners on line, defined as annuity owners who regularly use the Internet and e-mail in connection with their annuity investments.

This past summer, President Clinton signed the Electronic Signatures in Global and National Commerce Act into law. The Act is designed to facilitate the use of electronic records and signatures in interstate and foreign commerce. Among other things, the Act provides that, if a statute or regulation requires that information relating to a transaction in interstate commerce be provided to a consumer in writing, the use of an electronic record to provide the information satisfies the "writing" requirement, as long as the consumer consent requirements of the Act are met. Congress directed the Commission to issue, within 30 days after the enactment of the Act, a rule exempting from the consumer consent requirements of the Act, prospectuses of registered investment companies that are provided to permit sales literature to be given to prospective investors.

In July, the Commission adopted Rule 160 to provide this exemption from the consumer consent requirements of the Act. Consistent with Commission interpretations of existing law, the rule permits a registered investment company to provide its prospectus and supplemental sales literature on its website or by other electronic means without first obtaining an investor's consent to the electronic format of the prospectus.

This is an area where you can expect further activity from the Commission as technology continues to evolve and as we all work with the new scheme adopted by Congress. Some of the issues we have wrestled with in the past – such as the possibility of all-electronic variable products – remain at the center of our attention. Our goal will be to adapt our regulations to technological advances, while maintaining investor protection

VIII. Investor Education

Thinking about the theme of this conference – understanding variable insurance products, I want to mention that the staff is committed to investor education about these products. In that regard, this past summer we designed an investor brochure that describes variable annuities and how they work, and identifies various annuity features, as well as their fees and charges. The brochure also cautions investors in areas where we believe caution is necessary – bonus programs, purchases of variable annuities through tax-deferred accounts, careful scrutiny of fees and charges. The brochure is entitled "Variable Annuities: What You Should Know," and it can be found on our website. A hard copy of the brochure is also available by calling the Commission's Office of Investor Education & Assistance. I commend this brochure to all of you, particularly those of you who may be new to this field. We are pleased that the industry has joined us in this effort to educate investors about variable products.

IX. Conclusion

The variable products industry is changing rapidly, expanding the types of products that are offered, to meet an increasingly competitive environment and evolving to meet the challenge of rapid technological advances. I've outlined some of the regulatory issues associated with these developments, and what I believe are the Commission's priorities in this area. I hope that this discussion has increased your understanding of some of the developments that are shaping the variable products industry. At the Commission, we are committed to keeping pace with these developments under our unchanging mandate of investor protection. And again, to the extent that your eyes have been "scratched out" by the information presented to you in this conference, I urge you to scratch them back in again by spending the time necessary to develop an understanding of these products.

Thank you.