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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Variable Products: Industry Success,
Industry Responsibilities

by Paul F. Roye

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

At the National Association for Variable Annuities Regulatory Affairs Conference

June 28, 1999

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 in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.

I. Introduction

Thank you and good morning. It's a pleasure to be here with you this morning. My first seven months as Director of the Division of Investment Management have been an exciting time for me as I've plunged into the numerous challenges we in the Division face as regulators of the mutual fund and variable product industries.

The last decade has seen tremendous growth in the variable insurance product industry. Assets in variable insurance products have grown from just $31 billion in 1990 to over $670 billion this Spring. Insurance companies are developing new and innovative products to satisfy an ever-increasing demand and to deal with the challenges of ever-intensifying competition in the financial services business.

We are hard at work responding to the new challenges posed by this rapid industry growth. We're finalizing the new Form N-6, which we expect will dramatically improve disclosure for variable life insurance investors. We have undertaken new initiatives in the area of corporate governance aimed at enhancing the effectiveness of independent directors in protecting the interests of investors. We are continuing to prepare for the approach of Y2K, so that services to investors will continue without disruption as we move into the next millennium.

For all the hard work we at the Commission do as regulators, however, one point remains crystal clear: the ultimate responsibility for ensuring the integrity, fairness, and honesty of the variable products industry rests squarely on its own shoulders. It is your industry that must take responsibility for good compliance practices and full and clear disclosure to investors. Fulfilling that responsibility is not only good for investors, but it makes good business sense. It will strengthen investor confidence and foster continued success.

This morning, I would like to address some of the areas that are of critical importance to the variable products industry as we approach the new millennium: disclosure, compliance the year 2000 problem, and corporate governance. I want to discuss some of the exciting initiatives that the Commission is undertaking in these areas. But I'll also be pointing out the responsibilities of the industry and asking you to keep in mind that, in the final analysis, the responsibility for maintaining and building the reputation for fair dealing in the variable products industry rests with the industry.

II. Disclosure

The Commission has recently taken significant steps to improve the quality of disclosure to variable products investors. The Commission's disclosure initiatives are part of its broad undertaking to bring sweeping revisions to prospectus disclosure for all public companies. We are committed to making all prospectuses simpler, clearer, and more useful, and to eliminating highly technical, legal jargon and boilerplate language.

Last year, the Commission proposed Form N-6 to improve disclosure to variable life insurance investors. The Commission's intent was to develop, for the first time, a disclosure form specifically tailored for variable life insurance. Variable life insurance disclosure has long been based on forms that were developed before variable life insurance came onto the scene. While some of the information required by those forms has been useful, they also called for information not relevant to variable life investors and did not ask for other information that is useful. Form N-6 is specifically addressed to the needs of variable life investors, including specific requirements for disclosure on premiums, death benefits, cash values, surrenders, and withdrawals and loans.

Furthermore, Form N-6 will reduce the complexity and length of prospectus disclosure. It will streamline variable life prospectuses by adopting a two-part format consisting of a simplified prospectus, designed to contain information essential to an investment decision, and a statement of additional information that investors could obtain upon request, containing more detailed information.

NAVA and others provided a wealth of thoughtful comments on our proposal. The staff has reviewed the comments, and we are working to resolve the difficult issues raised. For example, fees and charges associated with variable life insurance are notoriously complex. Our challenge is to ensure that investors receive clear, understandable information about this essential component of the investment decision.

The Commission proposed to require a uniform, tabular presentation of fees and charges, similar to the current fee table requirement for mutual fund and variable annuity disclosure. Some commenters supported the proposal. Some objected, arguing that the complexity of variable life insurance charges renders them unsuitable for disclosure in a tabular, uniform format. Determining how to disclose the cost of insurance charges presents an especially knotty problem. As we consider the different views in designing a final approach, we will be guided by our goal of providing, to the greatest extent possible, uniformity, simplicity and comparability in variable life fee disclosure. We'll also build in flexibility where it's needed.

The proposed requirements for illustrations in Form N-6 also raise hard questions. The Commission proposed permitting, but not requiring, hypothetical illustrations in the prospectus or in the SAI. The Commission also proposed parameters for any illustrations that are included. Commenters supported the proposal to make illustrations optional, but raised a number of issues about the proposed requirements. For example, what rate of assumed return should be used? Would a 12% maximum rate of return favored by several of the commenters invite unrealistic investor expectations? How can expenses of underlying funds best be reflected? What action should the Commission take, if any, on personalized illustrations? We recognize that illustrations have both advantages and limitations in providing investors with information. Our goal in working out the details of the N-6 provisions on illustrations is to maximize the advantages and minimize the limitations so that illustrations will be as useful as possible.

In view of the substantial benefits we expect to see once Form N-6 goes into effect, we are working to finalize the Form as expeditiously as possible. We are working to resolve the remaining issues in a way that will result in the best possible disclosure for variable life investors.

In addition to Form N-6, we at the Commission are working to improve disclosure on other fronts as well. We're gaining experience with the new requirements of revised Form N-1A for mutual funds and, as necessary, we're helping educate the industry on those new requirements. The same is true of the Commission's plain English initiatives. We're continuing to encourage and assist the industry in presenting prospectus information clearly, concisely, and in a user-friendly format. Meeting the Commission's Plain English mandate is particularly important for the variable product industry in view of the complexity of those products and the prevalence of technical jargon.

At the same time it adopted amended Form N-1A, the Commission also adopted the rule to permit mutual funds to provide investors with a "profile," a disclosure document summarizing key information about a fund. Under the rule, investors have the option to purchase the fund's shares after reviewing the profile, or after requesting and reviewing the fund's prospectus. We are open to considering whether to extend the profile rule to variable products. Before we can decide whether to extend the rule to variable products, though, we must assess the use of profiles by retail funds and whether the variable products industry is interested in using profiles. We are looking forward to input from NAVA and the industry on that subject.

New challenges in the area of disclosure arise as the industry continues to innovate to meet the demands of a changing marketplace. For example, variable products are offering more and more investment options. How do you disclose the information that investors need to make informed choices without overwhelming them? In another area, immediate annuities are becoming increasingly prevalent as the industry adapts its products to meet the needs of aging baby boomers. These products do not always fit perfectly within the current disclosure regime. The staff has worked with some registrants to develop disclosure of expenses tailored to immediate annuities that we believe will help investors understand the costs of those products.

One concern that runs through all of the disclosure initiatives that the Commission has undertaken with regard to mutual funds and variable products is that fees and charges be clearly disclosed to the investor. This is of particular importance in the area of variable products, where special attention and effort is often necessary to explain clearly the relatively complex fees and charges. We at the Commission are focused on the need for clear disclosure of fees and charges as we finalize fee disclosure requirements for the N-6 and as we work on other disclosure initiatives. Even more importantly, the industry also must make clear disclosure of fees and charges a top priority.

In this regard, the Commission recently developed and placed on its website the Mutual Fund Cost Calculator, which is designed to close the gap between the fee table for mutual funds and investors' ability to use the fee table to make a real-world investment decision. Using the new tool, an investor can sit down with the prospectus for a fund he or she is considering and compute the effect of fund costs over the period the investor expects to hold the fund -- in dollars and cents. And the investor can compare that dollars and cents number to the dollars and cents number for another fund. We encourage you to consider developing tools like this for variable products.

As I indicated at the outset, responsibility is the theme that must guide the industry in the area of disclosure, including, and especially, disclosure of fees and charges. The Commission cannot bring about clear and understandable disclosure on its own. Neither Form N-6, nor the amended N-1A, nor the plain English rule, nor staff comment on filings will ever by themselves bring about high quality disclosure. The industry must be fully committed to that goal. Insurers should take the initiative and redouble their efforts now to ensure that investors receive the information they need in a way that is understandable.

III. Compliance

Compliance is the next issue, or perhaps it should be the foremost issue. I believe that compliance with the law, and the high standards it imposes, is vital for the long-term success of the industry. In my mind, the one factor that is at the very heart of an industry's success is its fundamental integrity and credibility. With the growth in the variable insurance product industry, the industry needs to expend even more effort to meet its compliance responsibilities.

An effective compliance system involves two important steps: one, putting in place good compliance systems and, two, devoting the necessary resources to make sure that those systems are working. As insurance companies devote more and more resources to new product development and marketing, it is also essential that they devote substantial resources to compliance.

Companies today are challenged with the need to oversee far-flung sales forces selling an ever-growing number of new and complex products. Whether a life insurance company has a captive or independent sales force, or distributes its products through other intermediaries, controls must be in place to prevent sales practice abuses to the greatest extent possible. Effective internal controls to prevent, detect, and correct misleading or abusive sales practices are essential, and will prevent irreparable harm to the company's reputation.

It is your job to make sure that compliance efforts do not fall short of the high standards set by the securities laws and required to inspire confidence among investors. For example, while nothing is inherently wrong with "1035" exchanges -- some of which may work to the advantage of customers who receive enhanced products -- you need to be sure that these exchanges do not involve churning of policies to generate commissions or the sale of unsuitable products to unwary investors.

Several recent press stories have focused on potential problems with the sale of variable annuities to IRAs and other tax-deferred retirement plans. The NASD recently cautioned members about this practice -- in its May Notice to Members. The Notice emphasized the fact that variable annuities provide no additional tax deferred treatment of earnings other than that provided by the tax-qualified retirement plan. The NASD stated that sales agents should not only disclose this fact to customers before placing them in a variable annuity investment option for a tax-qualified retirement plan, but also recommend a variable annuity only when its other benefits, such as lifetime income payments, family protection through the death benefit, and guaranteed fees, support the recommendation.

The NASD's approach is right on target. Each time you make a sale, remember that the individual investor's needs and objectives should be paramount.

You can expect that the Commission's examination program will continue to focus on the sales and marketing activities of agents and the supervision they receive in the sale of variable products. The inspections staff looks to see if appropriate systems are in place to ensure that agents are asking the right questions to determine the suitability of a variable insurance product, and whether those systems are working.

We recognize that the industry is concerned about compliance, and is taking its own steps toward improving compliance practices. For example, the Insurance Marketplace Standards Association, encourages member companies to develop sales and marketing procedures that reflect high ethical standards -- with the ultimate goal being to strengthen consumer confidence in the life insurance business. We encourage industry efforts like this that promote good sales and marketing practices.


It is nearly the end of June. Y2K is only six months away. By now your internal remediation efforts should be complete. You should be confident that come January 1 you will be able to process new orders, allocate incoming funds to the proper subaccounts, and process redemptions in a timely fashion.

Finalizing your computer remediation efforts, however, should not be the end of your Y2K efforts. You still have a responsibility to your customers to engage in some serious and practical contingency planning. Now is the time to ask yourselves tough questions like: What if, despite all of our efforts, our systems are unable to allocate incoming funds or process redemption requests internally? What will we do if we cannot effectively communicate with an underlying fund or other service providers?

In addition, ask yourselves what happens if there are difficulties with one or more of your underlying funds. For example, what if one of your underlying funds is temporarily unable to accept and invest incoming funds? What will you do with incoming money? What if an underlying fund, because of Y2K problems, is unable to properly and timely price its securities? How will you calculate unit values in the interim? How will you meet your redemption requirements if a fund is unable to redeem?

These are the types of hard questions that you should be asking yourselves. We, at the Commission, are thinking about these issues as well. We are considering possible Y2K-related problems and their possible consequences, and the ways in which we might respond. We are also consulting with other regulators as well as industry representatives, including NAVA, to try to identify potential scenarios and discuss practical solutions. We welcome your input to our Y2K thought process as you are going through your own planning exercises.

Also, I should tell you that the Commission will have staff available throughout the New Year's weekend to consult with the industry and respond to any particular concerns or needs. I urge you to plan ahead also and to continue to prepare well in advance of the new year.

V. Corporate Governance

Another topic that the Commission and the staff have been focusing on of late is corporate governance, and the effectiveness of independent directors in protecting the interests of investors. This issue has received a great deal of attention recently in the press, in the courts, and at the Commission. Stories have been published criticizing mutual fund directors and the amounts that some independent directors are paid. Lawsuits have been filed challenging the independence of directors, based on the number of boards on which they serve and the compensation they receive.

The Commission has undertaken a broad initiative, including hosting a roundtable last February on the role of independent investment company directors, to determine what problems independent directors are encountering and how their effectiveness can be enhanced. The issue of enhancing the effectiveness of independent directors can be summarized in three questions. First, how can we more closely align independent directors' and shareholders' interests? Second, what additional authority and protections do independent directors need to better fulfill their responsibilities? And third, what steps are necessary to ensure that independent directors have unbiased information on which to base their decisions?

Chairman Levitt outlined in a speech last March four broad proposals that we believe will improve the effectiveness of independent directors. The first proposal was that fund boards should have a majority of independent directors. I think that majority independent boards can have a positive effect on fund governance, improve the dynamics of the decision-making process, and thereby make management more responsive to the interests of shareholders. The second proposal was that independent directors should be self-nominating -- that is, the selection and nomination of new independent directors should be left to a fund's current independent directors. Over time, as a fund's original independent directors leave and are replaced by new independent directors who don't have prior relationships with management, self-nomination can have a positive effect on a board's independence.

Third, the Chairman proposed that outside counsel for independent directors should be independent from management. Our goal in encouraging independent directors to have counsel that does not also represent management would be to ensure that the hard questions get asked and that the directors receive truly disinterested advice when carrying out their fiduciary duties. And, finally, the fourth proposal was that shareholders should be given more information about directors, so that they can judge the independence of fund directors for themselves. Shareholders have the right to know whether one of their directors, while technically independent, has a prior or ongoing relationship with management, whether their interests are in line with the directors, and whether their directors own shares in the funds they oversee. I think that additional disclosure about directors may have the effect of discouraging certain relationships or activities which raise questions about a director's effectiveness.

This brings me to another point I'd like to make about independent directors -- fulfilling their important responsibility under the 40 Act as "watchdogs" in reviewing and approving fund fees. Directors who serve on boards of funds that are investment options for variable products must understand and appreciate how these products work. For example, the use of a 12b-1 plan by an underlying fund of a variable insurance product raises important issues. Distribution expenses for these products often are paid for at both the separate account level and the fund level. The fund board should consider this in making a determination whether a 12b-1 plan will benefit the fund and its shareholders. To make this finding, directors must assure themselves that legitimate services will be rendered in return for payments under the plan.

In response to Chairman Levitt's call for action in this area, the Investment Company Institute's Advisory Group on Best Practices for Fund Directors last week issued its Report on improving fund governance. The Report responds to many of the fund governance issues raised by Chairman Levitt and is an important step forward in enhancing the effectiveness of fund directors. I urge your fund boards to give serious consideration to the "best practices" outlined in the Report.

We expect that later this summer we will be recommending that the Commission propose rules that strengthen fund boards. As we move forward on this important initiative, we will continue to seek your input and ideas. It is important that we all keep in mind this central premise: that enhancing the independence of directors is good for shareholders, and ultimately what's good for shareholders is also good for your industry.

VI. Conclusion

I look forward to working together on addressing the many significant issues before us. Today, the variable products industry is a dynamic, highly successful industry, working hard to create products to meet the evolving investment needs of many Americans. To retain and improve this position, the industry needs to continue to improve disclosure, and to maintain a reputation for integrity and fair dealing. Good disclosure, compliance, and adherence to the highest professional standards will serve as the most valuable assets in assuring the continued success of this industry. Thank you.