Regulation of Insurance Products
Oct. 15, 1996
Audit No. 242
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Regulation of Insurance Products
Audit Report No. 242
October 15, 1996
The Office of Insurance Products (OIP) is responsible for the regulation of variable insurance under the Investment Company Act of 1940. The Office consists of 13 staff and is part of the Division of Investment Management. The primary objective of the audit was to evaluate the efficiency and effectiveness of the Office of Insurance Products.
Variable insurance products, which include variable annuities and variable life insurance, differ from traditional "fixed dollar" insurance contracts in the way in which benefits are funded. Premium payments are held in a "separate account" that provides the contract owner with a variety of investment options. The benefits ultimately realized by the contract owner depend on the investment performance of the separate account. Sales of variable annuities and life insurance have grown significantly in the past few years.
We found that in general the Office of Insurance Products does a satisfactory job of regulating variable insurance. However, delays in performing certain tasks suggest that OIP needs to improve the management of its workload to assure the timely completion of its work.
Our recommendations to improve the effectiveness and efficiency of the Office of Insurance Products include: preparing a plan to reduce their backlog of filings; detailing staff from other parts of the Division to reduce and prevent backlogs; considering sampling or excluding certain filings to better manage workload; encouraging more requests for selective review; developing improved guidance for reviewers; determining whether NRSI searches should be conducted when reviewing new registrations; and reviewing its recordkeeping policies.
We are also recommending: replacing its filing log system; reviewing the adequacy of performance measures used in the budget; ensuring that certain workload data reported in the budget is accurate; hiring more staff with financial and actuarial skills; reviewing the adequacy of job elements and performance standards of staff; establishing regular communications with the NASD to coordinate policies; and sponsoring training about variable life insurance for staff.
OBJECTIVES AND SCOPE
The primary objective of the audit was to evaluate the efficiency and effectiveness of the Office of Insurance Products which has primary responsibility for the Commission's regulation of variable insurance products.
During the audit, we conducted interviews with staff from OIP and other offices within the Commission. We also reviewed files containing comment letters, management reports, and other relevant documentation. Where appropriate, we attempted to compare the performance of OIP with other offices within the Commission that are engaged in similar activities. We also interviewed 13 private attorneys, including representatives of the American Council of Life Insurance, the National Association of Variable Annuities, and several former Commission staff to obtain their perspective about the performance of the office.
The audit was conducted between February 1996 and July 1996 in accordance with generally accepted government auditing standards.
The Office of Insurance Products (OIP) is responsible for the regulation of variable insurance under the Investment Company Act of 1940.
The Office consists of 13 staff and is part of the Division of Investment Management. While most IM staff are involved in one aspect of the regulation of mutual funds, OIP staff handle all matters relating to the regulation of variable insurance including the review of disclosure filings, the issuance of exemptive applications, no-action letters, and rulemaking. In FY 1995, OIP staff spent 58% of their time on disclosure related matters and 30% on exemptive applications.
In recent years, the continuity of OIP's program operations has been hindered by staff turnover. The office has had 3 Assistant Directors in less than 2 years with additional turnover occurring among less senior supervisors. Within the past year, a new Associate Director and Assistant Director have assumed responsibility for OIP.
Staff turnover is one of the reasons why OIP has not been able to complete work on several important priorities described in the Division of Investment Management's 1992 study, Protecting Investors: A Half Century of Investment Company Regulation. The study recommended that the Commission propose legislation to exempt variable insurance contracts from specific charge limitations and instead establish restrictions against unreasonable aggregate fees. It also recognized the need to develop a registration form for variable life insurance.
Variable insurance products, which include variable annuities and variable life insurance, differ from traditional "fixed dollar" insurance contracts in the way in which benefits are funded. Premium payments are held in a "separate account" that provides the contract owner with a variety of investment options such as money market, equity and bond funds, not available to purchasers of traditional insurance. The assets are segregated from the insurer's general account which is restricted by state laws from making certain types of investments. The benefits ultimately realized by the contract owner depend on the investment performance of the separate account.
The SEC began regulating variable insurance products soon after their introduction in the 1950's. While traditional insurance products are exempt from the securities laws, the courts have agreed with the Commission that variable insurance contracts are not exempt, because the contract owner rather than the insurance company bears the investment risk.
Sales of variable annuities and life insurance, which tend to increase when the stock and bond markets are rising, have grown significantly in the past few years. At the end of 1994, assets held in the separate accounts of life insurance companies totaled over $350 billion. There were 4 million variable life insurance policies in force and about 6.5 million individual variable annuities.
We found that, in general, the Office of Insurance Products does a satisfactory job of regulating variable insurance. Internal controls designed to ensure the protection of investors appear adequate. In fact, under the management of a new Assistant Director, the office has strengthened its supervisory review to assure that appropriate positions are taken on all matters submitted to the Office.
In addition, interviews with outside attorneys who work closely with OIP indicate that the Office's work is well regarded. Staff were complimented on their work ethic and the quality of their comments. Industry representatives commended the Office and the Division of Investment Management for its responsiveness to a recent request for relief from excessive filing fees.
However, delays in performing certain tasks suggest that OIP needs to improve the management of its workload to assure the timely completion of its work. Recommendations for improving these and other management controls follow. As noted in the report, OIP management has already begun to address many of the problems identified.
Insurance Filings Prone to Delay
Filings related to insurance products take longer to complete than mutual fund filings because OIP staff have to contend with a perpetual backlog of work. Staff comments are generally issued well after the time frame recommended in division guidelines. The backlogs are mainly due to the increasing number and complexity of insurance product filings, as well as high staff turnover within OIP.
Although division guidelines specify a goal of 30 days for issuing comments for registration statements, OIP averaged 80 days to formulate first comments during FY 1995. In contrast, the Office of Disclosure and Review, responsible for the review of mutual fund registrations, issued comments within 26 days. Similarly, OIP took 97 days on average to issue comments for exemptive applications, while mutual funds that filed exemptive applications received comments within 49 days. Division guidelines suggest a goal of 45 days for exemptive applications.
The Division says that in the past, insurance product registration statements were lengthier than those filed for mutual funds and warranted more time for review. Therefore, the informal policy of the Office has been to issue comments within 60 days. But they acknowledge that presently the difference in length between the two types of filings is not as great as it once was.
Until recently, work on non-routine assignments such as rulemaking and other special projects was mostly deferred to permit staff to work on filings and other time-sensitive tasks. According to the STATS database, during FY 1995 OIP staff spent less than 1% of their time (148 hours) on rulemaking and special projects. But OIP's new management has made the completion of non-routine projects an important priority for the coming year.
For example, the American Council of Life Insurance presented a proposal for a new registration form for variable life insurance in January 1993. Although the division listed the new form as a priority in its 1992 study Protecting Investors, the ACLI's proposal is still under review. Similarly the division has been trying to make a rule to address mortality and expense risk charges since the 1980's. Both projects are receiving increased attention from OIP staff who hope to complete their work by the end of the year.
Despite these delays, private attorneys we interviewed were understanding of the division's efforts to cope with the increase in the insurance product workload. But the disparity between the handling of mutual fund and insurance product filings has fostered a perception within the industry that mutual funds receive preferred treatment from the division. We believe that IM should attempt to reduce the disparity between the two types of filings by shortening the timeline for the review of insurance product filings.
The Division of Investment Management should prepare a plan to: a) reduce the backlog of work that has accumulated in OIP; b) determine an appropriate time frame for the review of insurance product filings; and c) ensure that most future filings for insurance products are processed within that time frame. When preparing the plan, the division should consider adopting the subsequent recommendations presented in this report.
Staff Turnover and Seasonal Filings Contribute to Delays
Periodic imbalances in workload caused by staff turnover and seasonal filings have been a continuing problem for OIP. Because of its small size, productivity is affected by the loss of even a few staff and when managers leave, the impact is increased. When OIP lost three senior managers in 1994, the backlog of work grew as key policy decisions were put on hold. It can take as long as a year for replacement staff to become familiar with the more complex issues associated with variable insurance.
The filing of post-effective amendments also poses a unique problem for OIP. Many registrants under the Investment Company Act are required to file post-effective amendments annually within 120 days of the close of their fiscal year. Since most insurance companies are on a calendar fiscal year, many filings are made between February and April. In FY 1995, OIP reviewed 289 post-effective amendments during this period, 71% of the total for the year. To review these filings within the 45 day timeline established by the division, most other types of review work cease during a 10 week period.
Temporary imbalances between workload and staff are likely to continue and should be planned for in advance. In the past, OIP has occasionally received help from other IM offices when workload imbalances developed. But we believe that the office should seek help from the division on a more proactive and frequent basis to better manage its workload. Although there is a steep learning curve associated with some work assignments, OIP also receives routine filings that don't require extensive experience or knowledge of variable insurance.
IM is planning to implement a staff rotation and detail program first recommended in 1995 by a committee of professional staff. The program provides for the temporary reassignment of staff to other offices within IM. IM should accelerate this program and use it to develop a more flexible workforce that can help OIP and the rest of the division handle spikes in workload.
IM should accelerate the implementation of its staff rotation and detail program and make active use of the program to help OIP reduce its backlog and cope with imbalances between work and staff.
Management of Workload Needs Attention
OIP has historically sought to review all insurance product registration statements filed with the Commission with only a few exceptions. But several Commission staff and outside attorneys have suggested that more of the burden of compliance could be shifted on to the registrants by performing fewer reviews and encouraging the use of selective reviews. A selective review is a narrower exam, normally requested by the registrant, which focuses on material changes from prior filings as opposed to a de novo review of the entire filing.
The experience of the Division of Corporation Finance is cited as an example. Prior to 1980, the Division contemplated that most if not all documents would be examined by the staff. But as the number of filings surpassed the Division's ability to review them, they acknowledged that not all filings could be reviewed. In 1980, the Division changed to a system which subjects all new issuers to a full review but reviews most other filings on a test basis according to selection criteria established periodically. Like the review system it replaced, it provides for several types of limited scope reviews.
OIP's growing workload suggests that at some point they too will be compelled to review filings more selectively. Among the recommendations that we received from Commission staff and outside attorneys for how OIP can conduct more efficient reviews, were the following:
- Review fewer post-effective amendments: OIP should consider sampling post effective amendments, or excluding certain types of these filings from review. For example, the Office of Disclosure and Review does not review post-effective amendments that result from changes in investment policy, or the offering of a new class of shares to mutual fund investors. In FY 1995, the Office of Disclosure was able to exclude 36% of post-effective amendments from review.
Last year, OIP staff devoted 3,145 hours or 15% of their staff time to the review of post-effective amendments, indicating that the Office could save a significant amount of time by reviewing fewer of these filings.
- More strategic management of the review process: Like managers in Corporation Finance, OIP managers should be given more discretion to order limited scope reviews, or "no review" of filings. Determinations about what type of review to conduct would be based on the type of filing, the past history of the registrant, prevailing industry trends, and the types of disclosure issues management wants to emphasize.
- Promote use of selective review: Some attorneys we interviewed said that there is no incentive to request selective review from OIP because the filing isn't reviewed any sooner. It is not unusual for it to take 3-4 months to receive comments resulting from a selective review. This is because most OIP staff review everything in strict order of receipt, except for the most time-sensitive filings. Other offices within the Commission adhere roughly to order of receipt but will frequently process filings that are less time-consuming out of turn.
OIP should explore ways to better manage its workload by: (a) considering sampling or excluding certain types of registration statements; and/or (b) giving managers the discretion to conduct more focused, strategic reviews based on criteria defined by OIP.
OIP should more actively promote the use of selective review among registrants to preclude the review of material already seen. As an incentive, OIP should inform staff that selective reviews can be conducted out of turn, in between more lengthy reviews.
OIP Should Review Policies and Procedures
Policies and procedures intended to guide the review of registration statements should be complete and relevant. Although a compendium of policies and procedures was created in 1994 for use in reviewing disclosure documents, some parts of the manual are inadequate. Problems that were identified during our audit are described below:
- Checklists developed to assist in the review of registration statements are not utilized because they simply restate the filing form instructions.
- OIP staff do not conduct name searches on NRSI as part of their review although such searches are required by division policy. Name searches are supposed to be performed on new fund directors to check their backgrounds for past violations. But OIP staff say that the searches are not useful and the policy is not enforced by management.
- With respect to policy issues, OIP has not always documented their positions for future reference. One staff attorney commented that "a lot of information is passed along orally and never written down." Another said that "a lot is dependent on people remembering things." The new management of OIP has begun to address this problem by requiring that staff write a memo for future reference whenever a significant issue arises during a review.
A related problem is that staff are not required to maintain records of oral comments. In the past, OIP has made extensive use of oral comments in reviewing applications and registration statements.
OIP should develop guidance for reviewers of registration statements to help them focus on significant issues and thus perform a more efficient and effective examination.
The Division of Investment Management should determine the utility of the NRSI policy with respect to OIP filings and either modify the policy or enforce compliance.
OIP should review its policies pertaining to recordkeeping paying particular attention to the need for creating a record of oral comments.
OIP Filing Log Is Inadequate
The automated system that OIP uses to monitor filings does not generate adequate information about the workload of the office. While it is useful to managers in tracking individual filings, it is cumbersome and time-consuming to use, and cannot manipulate data from multiple filings. As a result, meaningful information about the overall performance of the office or of individual staff is difficult to obtain and frequently not tracked.
For example, OIP is lacking a historical record of the number and types of reviews it conducts. Common performance measures, such as average time for the office to issue first comments, are not tracked. Nor are managers able to generate a record of an individual's workload which is useful in developing work assignments and doing performance evaluations.
The primary use of an office management information system is to monitor its current workload. But managers also rely on their systems to provide information for the budget, evaluate the performance of personnel, and identify changes in workload over time. None of this type of information is readily available to OIP and some is not available at all.
The OIP filing log was originally created by an OIP manager to maintain his own records. It is based on an outdated spreadsheet application that is not suited to OIP's needs. Use of the system was expanded in 1994 when the tracking system developed for OIP by a forerunner of the Office of Information Technology was abandoned due to poor reliability and support.
During our audit, OIP managers told us of their intention to replace the system. After consulting with the OIG and others, OIP management has decided to replace the system with another based on a database application rather than a spreadsheet. The new system should be in place by the end of 1996.
OIP should replace its management information and tracking system with one capable of providing better and more accessible information about the workload of the office.
Budget Data Need Improvement
The main performance measures reported in the Commission budget related to the Division's disclosure review function, are not well suited to OIP. OIP is one of two offices within the Division of Investment Management that perform disclosure review activities.
The measures report the number of investment portfolios contained in registration statements. This information is meaningful to the mutual fund industry. But the performance measures lose significance when applied to insurance product filings because the principal investment instrument being registered is an insurance contract, not an investment portfolio.
In order to report its production in terms of investment portfolios, OIP counts portfolios from some types of filings and insurance contracts from others. However, including insurance contracts in portfolio statistics may cause confusion about what is being counted and diminish the utility of the information.
Some staff suggest that the performance measures should include information about the number of full reviews and selective reviews performed by staff. For example, the Division of Corporation Finance enumerates each type of filing received and the different types of reviews conducted, in their performance measures. The Office of Executive Director says that they will approve most reasonable requests for changes in performance measures that comply with the Government Performance and Results Act of 1993.
Casting further doubt on the validity of the data, both OIP and the Office of Disclosure and Review employed estimates to calculate the number of portfolios listed in the budget as actual workload data for 1995. Part of the data had to be estimated because management had never tracked some of the numbers required.
IM should review the disclosure activity performance measures used in the budget to ensure that they are appropriate for both OIP and the Office of Disclosure and Review. As part of the review, IM should consider adding more performance measures such as number of filings and reviews, and types of reviews. Moreover, the Division should consider reporting workload data separately for OIP and the Office of Disclosure and Review whenever doing so would enhance the clarity of what is being measured.
IM should ensure that the actual number of portfolios presented in the budget, is correctly characterized as being based on an actual count and is not estimated.
Diverse Skills Needed for a Comprehensive Review
OIP does not have enough financial professionals on staff to review financial information as thoroughly as other Commission offices. While most disclosure review organizations employ an equal number of legal and financial professionals, OIP is comprised of 11 lawyers, 1 financial analyst, and 1 legal technician. Financial and analytical issues are as likely to emerge from a review as are legal issues.
Lawyers are preferred by OIP because legal training is needed to perform certain reviews, such as requests for exemptions and no-action letters. But the review of disclosure filings now comprises 58% of the Office's workload and seems likely to increase. The review of financial information is an important part of a disclosure program.
The Division of Corporation Finance conducts separate legal and accounting reviews for each filing as part of its "full review" process. The accounting review focuses on the financial statements, management discussion and analysis, and whether the data comply with GAAP and applicable regulations. Like Corporation Finance, the Office of Disclosure and Review enlists an equal number of lawyers and financial professionals to review disclosure documents.
In contrast, almost all reviews in OIP are conducted by attorneys who perform no financial review other than to check that the required financial statements are included. OIP's financial analyst is able to review no more than 10% of the portfolios submitted in filings. Yet IM noted in the 1996 Budget Estimate that "adequate review of filings of investment companies, especially financial statements, helps determine if investment companies are conducting their activities in accordance with prospectus disclosures."
In the past, financial analysts working in OIP have proven to be particularly useful in reviewing the calculation of performance illustrations and fee tables, management discussion and analysis, and the financial statements of the separate accounts and insurance companies.
Someone with actuarial experience and skills would also add a valuable perspective to OIP's staff. In the private sector, actuaries play an important role in developing new insurance products and investment policies. Their knowledge would be useful not only in the review of filings, but also in helping to formulate policies related to new products.
OIP should diversify its staff by adding more financial analysts, accountants, and/or actuaries to assist in the review of disclosure filings.
Job Elements and Performance Standards Need to Be Revised
Parts of the performance standards of OIP staff are disregarded during performance evaluations because they contain detailed numerical goals for reviewing comments. The goals are currently considered unrealistic due to the backlog of work. The standards do not provide for circumstances like the current backlog of filings, that are beyond the control of staff. Moreover, the information needed to apply these standards is not available in the internal tracking system.
For example, to attain a minimally satisfactory rating, reviewers responsible for exemptive applications are supposed to be prepared to discuss the filing with their supervisors within 30 days of receipt and then have comments ready 2 days later. But with the issuance of initial comments averaging 97 days, this standard has been set aside. Moreover, the OIP tracking system does not contain information about when comments are given to supervisors or how long supervisors take to review them.
In addition, the job elements and performance standards of OIP managers do not always reflect each supervisor's current responsibilities and their relative importance. In one case, the important responsibility for office management controls which includes supervising the filing log, designing and generating management reports and preparing performance appraisals, received only a 2% weighting.
Soon after assuming the job, the Assistant Director of OIP became aware of problems with the job elements and performance standards and has already started to revise them.
OIP should review all job elements and performance standards to ensure that they: a) adequately reflect staff's current responsibilities and their relative importance; b) do not hold staff responsible for events outside their control; and c) are capable of being tracked, when appropriate.
Improve Communication with NASD
The National Association of Security Dealers (NASD) is responsible for reviewing advertising materials and sales literature that are used by broker-dealers. Traditionally, the NASD follows Commission rules and policies in determining the appropriateness of the sales literature. For example, the SEC has promulgated clear rules that prescribe the historic performance data to be used in mutual fund and variable annuity advertising which the NASD follows.
But in the case of variable life insurance the SEC position is more ambiguous. The issue of how to use performance data related to variable life insurance is complicated and is one of several that are being studied in connection with the development of Form N-6, a variable life insurance registration form. In the meantime, the NASD has determined that it will allow past performance data in an informative context, such as semi-annual and quarterly reports. But for sales and promotional purposes, the NASD significantly restricts the use of performance data.
The NASD's position has confused many private attorneys we spoke to who are also concerned that the NASD may be misinterpreting the views of Commission staff. They consider the SEC to be more knowledgeable about variable insurance than the NASD. Until the issues related to Form N-6 are resolved, IM staff should engage in regular contacts with the NASD to ensure that NASD policies reflect the current views of the Commission.
The Division of Investment Management and the NASD should establish regular communications to coordinate their policies concerning variable life insurance products.
More Training Needed about Variable Life Insurance
OIP staff need to receive additional training about variable life insurance in order to effectively guide regulatory policy, according to outside attorneys we interviewed. Variable life insurance is a complicated product that will continue to gain in importance as the number of policies issued proliferate. The number of variable life insurance policies sold increased 65% between 1991 and 1994 from 434,000 to 719,000.
OIP should invite experts from industry and academia to assist in training staff about variable life insurance. OIP should also consider inviting NASD staff to participate in training related to variable life insurance.