Committee of Annuity Insurers

February 6, 2004

Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609

Re: Release No. IC-26288; File No. S7-27-03
Proposed Amendments to Rule 22c-1
under the Investment Company Act of 1940

Dear Mr. Katz:

These comments on the proposed amendments to Rule 22c-1 under the Investment Company Act of 1940 (the "1940 Act") are respectfully submitted on behalf of the Committee of Annuity Insurers (the "Committee").1 The Committee and its member companies strongly endorse the efforts of the Securities and Exchange Commission (the "Commission") to protect investors in various types of investment companies from the damaging effects of improper and illegal `late trading' that has been occurring in certain mutual funds. However, with respect to variable annuities, for the reasons stated below, the Committee believes that in certain respects the proposed amendments are overbroad, may have significant negative consequences for certain investors, and may place significant unanticipated business and economic risks on insurance companies issuing variable annuity contracts.

I. Background

It is important to understand that there are significant and critical differences between mutual funds and variable annuities. Unlike mutual fund shares, a variable annuity is a written contract between two parties: the insurance company that issues the contract and the owner who purchases the contract. That contract gives each party certain rights, and in general neither party can unilaterally change the terms of the contract or take away a right of the other party. Of particular relevance here, variable annuity contracts generally give the owner certain rights with respect to the pricing of purchases, redemptions, and transfers between investment options (generally called "subaccounts"). Those rights are based on and consistent with the 1940
Act and rules thereunder, including Rule 22c-1 as currently in effect.

Virtually all variable annuities today are issued through a two-tier investment company structure. The top tier is a separate account of the issuing insurance company that is registered under the 1940 Act as a unit investment trust. The separate account is generally divided into subaccounts, and the owner allocates premium payments among the subaccounts and can transfer contract value among the subaccounts. Each subaccount typically invests in shares of a particular registered mutual fund portfolio (the bottom tier). Since a registered variable annuity is a redeemable security, all investments in the annuity, all redemptions, and transfers between subaccounts are fully subject to the pricing requirements of Rule 22c-1 under the 1940 Act.

In most cases, the annuity contract obligates the insurance company to process and price transaction requests from contract owners based on the closing net asset value ("NAV") of the designated underlying mutual fund portfolio calculated on the same day that the insurance company receives the transaction order from the owner. Typically, a contract between the insurance company and the underlying mutual fund (a "Participation Agreement") designates the insurance company as the agent of the fund for purposes of receipt of transaction orders from contract owners (in accordance with New York Life Fund, Inc., pub. avail. May 6, 1971).

II. Summary of the Committee's Position

  • The Committee fully supports appropriate Commission action to prevent mutual fund late trading abuses.

  • The `conduit fund' provision is absolutely essential for variable annuities issued through separate accounts registered as unit investment trusts under the 1940 Act. This provision is consistent with the protection of investors and furthers marketplace competition. The Committee endorses this provision.

  • In addition, a similar provision (referred to as the "alternative approach") should be available for unregistered variable annuity separate accounts, subject to appropriate safeguards and protections to prevent late trading abuses.

  • The safeguards and protections for the alternative approach should be feasible and should not give any one segment of the financial services industry a competitive advantage over other segments. The Committee is suggesting certain modifications to the alternative approach to achieve this objective while also effectively preventing late trading abuses.

III. The Commission's Proposed `Conduit Fund' Exception

The proposed amendments to Rule 22c-1 include an exception to the "hard close" pricing requirements for transactions received through "conduit funds," defined as registered investment companies that invest in another registered investment company in reliance on Section 12(d)(1)(E) of the 1940 Act. The conduit fund exception would permit an underlying fund to deem receipt of an order to have occurred immediately before the applicable pricing time if the order is received from a conduit fund and the conduit fund received the order before the applicable pricing time.

The Committee very strongly supports the conduit fund provision. Indeed, some provision of that type appears essential for insurance companies to continue to meet their contractual obligations under most variable annuities in force today without incurring significant unanticipated and indeterminate business risks as a result of "breakage" that would occur if underlying fund shares cannot be purchased at the price computed on the day of receipt by the insurance company of transaction orders. This breakage would be caused by the fact that variable annuity contracts typically place a contractual obligation on the issuing insurance company to price contract owner transactions by valuing subaccount "accumulation unit values" ("AUVs") used to measure a contract owner's contract or cash value, based on the NAV of the underlying mutual fund portfolio on the valuation day (typically defined in the contract to be the period from 4:00 p.m. Eastern time on one business day to 4:00 p.m. on the succeeding business day) ("Valuation Day") that the insurance company receives a transaction order from a contract owner.

State insurance laws generally require that variable annuities contain pricing formulae. For example, Section 6.D.(1) of the National Association of Insurance Commissioner's Model Variable Annuity Regulation (the "Model Regulation") requires variable annuity contracts to stipulate the "investment increment factors" to be used in computing the dollar amount of variable benefits or other contractual payments or values thereunder. To comply with the Model Regulation, variable annuity contracts typically contain detailed provisions specifying how transaction requests are priced. Based on the current requirements of Rule 22c-1 and the New York Life no-action letter noted above, variable annuity contracts (and related prospectuses) typically contain pricing provisions similar to the following:

"ACCUMULATION UNIT -- Accumulation Units shall be used to account for all amounts allocated to or withdrawn from a Subaccount of the Separate Account as a result of Purchase Payments, withdrawals, transfers, or fees and charges. We will determine the number of Accumulation Units of a Subaccount purchased or canceled. This is done by dividing the amount allocated to (or the amount withdrawn from) the Subaccount, by the dollar value of one Accumulation Unit of the Subaccount as of the end of the Business Day during which the Notice for the transaction is received at the Annuity Service Office."

In other words, many variable annuity contracts guarantee that a contract owner will receive the AUV calculated as of 4:00 p.m. for transaction requests received by the insurance company by 4:00 p.m. Eastern Time. Such contracts generally go on to specify that the AUV will be calculated based on that Valuation Day's NAV of the underlying fund, as follows:

ACCUMULATION UNIT VALUE -- The initial Accumulation Unit Value for each Subaccount was set by us. Subsequent Accumulation Unit values for each Subaccount are determined by multiplying the Accumulation Unit Value for the immediately preceding Valuation Day by the Net Investment Factor of the Subaccount for the current Valuation Day.

NET INVESTMENT FACTOR -- The Net Investment Factor for each Subaccount is determined by dividing A by B and multiplying by (1-C) where:

A is

    (i) the net asset value per share of the Underlying Fund held by the Subaccount at the end of the current Valuation Day; plus

    (ii) any dividend or capital gains per share declared on behalf of such Underlying Fund that has an ex-dividend date as of the current Valuation Day;

B is the net asset value per share of the Underlying Fund held by this Subaccount for the immediately preceding Valuation Day; and

C is

    (i) the Separate Account Product Charges which are shown on the Contract Schedule for each day since the last Valuation Day. The daily charge is equal to the annual Separate Account Product Charges divided by 365; plus

    (ii) a charge factor, if any, for any taxes or any tax reserve we have established as a result of the operation of the Subaccount.

In short, these types of contractual pricing provisions require insurance companies to calculate AUVs under a contract based on an underlying fund's NAVs for the same day the insurer receives transaction requests. The proposed amendments to Rule 22c-1, absent concurrent adoption of the conduit fund exception, would mean that an insurance company could not purchase or redeem such underlying fund shares until the next Valuation Day, while remaining obligated under the contract to calculate the AUV based on the same day's NAV. This would create "breakage," which while undetermined, would have to be borne by the insurance company.

While some annuity contracts permit the contract to be unilaterally amended "to comply with applicable law," it is very doubtful that state insurance commissioners would interpret the proposed amendments to Rule 22c-1 as imposing a legal requirement on insurance companies to price transaction requests based on the next day's NAVs of underlying funds, since an insurance company could price on the current day's NAVs as required under its annuity contracts and make up any "breakage" out of its general account assets. Moreover, state insurance departments generally refuse to allow insurance companies to amend, or endorse, in-force contracts unilaterally in any way that might reduce the contract owner's rights, and as explained above most annuity contracts in force today provide a right to same-day pricing based on the current day's NAV for the underlying mutual fund portfolio. More importantly, perhaps, and regardless of any position taken by state insurance regulators, there is no reason to believe that variable annuity contract owners would simply give up their rights under the contracts to same-day pricing; as noted above, and unlike mutual fund shareholders, annuity contract owners do have an actual, enforceable contract with the insurance company.

We note additionally that, putting contractual obligations aside, unlike other intermediaries that sell mutual fund shares, insurance companies would not be able to solve the problems described above by "cutting off" contract transaction requests earlier in the day so as to be in a position to transmit omnibus orders to underlying funds before 4:00 p.m. Eastern Time. During each business day, an insurance company receives numerous transaction orders from contract owners, up until the 4:00 p.m. Eastern Time cut-off. Each order is date and time stamped. Thereafter, (that is, after 4:00 p.m.) the insurance company receives the net asset values per share from the various underlying mutual fund portfolios. Only then can the insurance company process the contract owner transactions, using the portfolio's net asset value per share to calculate the AUVs for each subaccount. A typical variable annuity issuer will need to calculate thousands of different accumulation unit values each night, due to the number of subaccounts and numerous optional features in the annuity contracts, with varying charges. It is only after receiving the current day's NAVs from the underlying mutual funds and using them to calculate the AUVs for each subaccount that the insurance company can actually process the contract owner transactions. Those transactions for each portfolio are `netted out' at the subaccount level, and then the net order is transmitted by the insurance company2 to the underlying mutual fund, typically the next morning. Accordingly, there simply must be some mechanism by which the insurance company issuing a variable annuity can purchase or redeem shares of the underlying mutual fund portfolios at the price calculated for the day the insurance company receives the contract owner transaction order, which it must fulfill based on that day's underlying portfolio's NAV. Therefore the conduit provision is necessary and appropriate for registered variable annuities.

IV. Alternative Approach

The Commission requested comment on an "alternative approach," which would permit certain intermediaries to submit orders to mutual funds (or the fund's transfer agent or Fund/SERV) after 4:00 p.m., provided certain protections designed to prevent late trading are in place. As discussed below, the Committee and its member companies strongly urge the Commission to adopt some form of the alternative approach to avoid creating, for insurers issuing unregistered variable annuity contracts that invest in registered underlying mutual funds, the same problems noted above in the context of registered variable annuity contracts.

A. General

The Commission suggested that the alternative approach might include the following protections:

  • Electronic or physical time-stamping of orders in a manner that cannot be altered or discarded once the order is entered into the trading system;

  • Annual certification that the intermediary has policies and procedures in place designed to prevent late trades;

  • Annual certification that no late trades were submitted during the period;

  • An annual audit of the intermediary's controls by an independent public accountant; and

  • Submission of the accountant's audit report to the fund's chief compliance officer3.

The Committee supports such an alternative approach for unregistered separate accounts (as well as for other intermediaries), with certain clarifications and modifications.4 However, as noted below there are concerns regarding the requirement for time-stamping "in a manner that cannot be altered or discarded."

As indicated above, many variable annuities are registered with the Commission as securities and are issued through separate accounts that are registered investment companies under the 1940 Act (and could therefore transmit omnibus purchase or sale orders to underlying funds in accordance with the Conduit Fund exception proposed by the Commission). However, there are also many variable annuities that are not registered as securities, and that are issued through separate accounts not registered as investment companies. These unregistered variable annuities are issued as private placements (issued through separate accounts that rely on the section 3(c)(1) or 3(c)(7) exclusions) or in connection with qualified retirement plan arrangements (not registered in reliance on section 3(c)(11)). Unregistered separate accounts, particularly retirement plan accounts, represent a very substantial portion of the variable annuity business.

In many cases, these unregistered variable annuities have the same contractual pricing requirements as those discussed above (i.e., a contractual obligation of the insurance company to process transaction requests and provide cash values based on the underlying fund's NAV as of the day of receipt of the order by the insurance company). In addition, insurance companies may use the same administrative procedures, policies, and computer programs for both their registered and unregistered variable annuities. With respect to order processing and transactions in underlying mutual fund shares, the concepts imbedded in the "alternative" approach discussed herein would provide strong protection against late trading abuses. The alternative approach, at least for unregistered separate accounts, is appropriate in light of the unique and compelling extenuating circumstances described above. Under the alternative approach, unregistered separate accounts would be subject to at least the same requirements and investor protections as registered separate accounts.

B. Time-Stamping

With respect to a requirement for physical or electronic time-stamping of orders, the Committee agrees that there should be some highly reliable method of verifying the time of receipt of transaction orders. However, the Committee has two concerns regarding the suggested requirement that the time-stamping be "in a manner that cannot be altered or discarded." First, we understand that there may be some uncertainty as to how advanced current technology is and how fool-proof current systems are. Indeed, in proposing the amendments to Rule 22c-1, the Commission noted that "broker-dealers appear to have easily circumvented current system controls, including the time-stamping required by our rules." In any event, any system or technology that is viewed as 100% fool-proof today could be vulnerable to new technology that is developed in the future. Computer hackers manage to penetrate even some of the most secure computer systems. Accordingly, any standard for time-stamping must be realistic and practical.

Second, in its laudable efforts to address the late trading that has occurred in mutual funds and in which broker-dealers have participated, we urge the Commission to be fair in its treatment of all participants in this marketplace. The Committee believes very strongly that any alternative approach should not include such onerous requirements that it places issuers of unregistered variable annuities at an unfair competitive advantage verses mutual funds. If the Commission is given authority to inspect the transaction order processing activities (and related records) of unregistered separate accounts (as discussed below), then such accounts should be subject only to the same time-stamping requirements as mutual funds and not held to a more onerous standard.

With this in mind, there should be some reasonableness standard incorporated into a requirement for time-stamping. There should be policies and procedures for physical or electronic time-stamping that are reasonably designed to preclude altering or discarding orders after they are placed. Insurance companies should be allowed - or even required - to have the same standards, policies and procedures for unregistered separate accounts as they use for registered separate accounts which are fully subject to Rule 22c-1. And, as noted above, whatever standards for time-stamping that are satisfactory for the mutual fund industry should be satisfactory for unregistered variable annuities.5

C. Commission Inspections

Assuming that unregistered variable annuity separate accounts (and other intermediaries) are held to the same time-stamping standards as mutual funds, then (and only then) the Commission might consider, as a condition to relying on the alternative approach, a limited consent by the intermediary to permit the Commission (and, of course, its staff) to conduct inspections of the intermediary's transaction order processing as it relates to transactions in mutual fund shares, including related books and records.

With respect to granting the Commission inspection and examination authority over transaction order processing by or with respect to unregistered separate accounts that wish to act as intermediaries and therefore consent to such oversight, we acknowledge that the Commission has limited resources. However, we suggest that unregistered separate accounts can be inspected as part of an inspection of registered separate accounts with only a marginal increase in work, especially since in many instances the insurance company would be using the same administrative systems and procedures.

Also, we suggest that the Commission's authority over an insurance company's activities with respect to unregistered separate accounts must be clearly limited to transaction order processing in order to prevent late trading in registered mutual funds. Insurance companies are clearly subject to comprehensive regulation by state insurance departments, and with certain limited exceptions insurance regulation is reserved for the states. Moreover, limiting Commission authority in this manner would also serve to limit the expenditure of resources in this area.

We also note that in considering the alternative approach discussed herein, the Commission might wish to consider a provision giving it the explicit authority to prohibit mutual funds from accepting orders after 4:00 p.m. Eastern Time from identified entities (e.g., entities that do not have adequate procedures and controls) provided of course that there is cause and appropriate procedural safeguards for such entities. Accordingly, if a Commission inspection of an intermediary's transaction order processing revealed deficiencies that were not resolved to the Commission's satisfaction, then the Commission could bar all mutual funds from utilizing that entity as an intermediary.

D. Rule 38a-1 Compliance Programs

The Commission recently adopted Rule 38a-1 under the 1940 Act, requiring registered investment companies to adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws and to designate a chief compliance officer. Rule 38a-1 also requires a fund's board of directors to approve the compliance policies and procedures of the fund's service providers, such as administrators. The fund must review those policies and procedures at least annually, and the chief compliance officer must provide a written report to the fund's board at least annually that addresses, among other things, the compliance policies and procedures of service providers.

With respect to transaction order processing for unregistered separate accounts, consideration might be given to an explicit requirement that the insurance company be considered a service provider to the fund, for purposes of recently adopted Rule 38a-1 under the 1940 Act, with respect to transaction order processing that relates to the fund, in order to rely on the alternative approach.6 This would subject these activities to the full panoply of compliance safeguards in Rule 38a-1, including approval by the fund's board of directors of the insurance company's transaction order processing compliance policies and procedures and an annual report thereon by the fund's chief compliance officer.

E. Participation Agreements

We note that the alternative approach (like the proposed Conduit Fund exception) would involve an exception that would allow an underlying fund to accept the orders from unregistered separate accounts after the fund's pricing time. Accordingly, the alternative approach could be further conditioned on the fund's obtaining certain contractual commitments from the insurance company on behalf of its separate accounts, presumably in the respective Participation Agreement. Such contractual obligations could include the certifications and reports referred to above, consent to Commission inspections and examinations, etc.7 Such contracts or Participation Agreements could be required to be filed with the Commission as an exhibit to the fund's Form N-1A registration statement.

F. Congressional Support

Finally, it appears that adoption of the alternative approach would have the support of the United States Congress. Section 205(b) of H.R. 2420 (the "Mutual Funds Integrity and Fee Transparency Act of 2003," sponsored by Rep. Baker) would direct the Commission to adopt rules permitting receipt of orders by intermediaries in a manner very similar to the alternative approach discussed here. H.R. 2420 was passed by the House of Representatives in November by a vote of 418 to 2. Similarly, section 306(b) of S. 1971 (the "Mutual Fund Investor Confidence Restoration Act of 2003," sponsored by Senators Corzine, Dodd, and Lieberman) would also require the Commission to adopt rules permitting receipt by certain intermediaries (and, indeed, names insurance companies as a permitted intermediary).

V. Transition Period

Regardless of whether the alternative approach is adopted, it appears that new requirements will require very significant changes in certain well-established operating procedures, that substantial changes will be required in any number of computer programs and administrative systems (indeed, new programs and systems may be required), and that operating procedures and policies between various unaffiliated entities will be significantly affected and re-negotiations of business relationships will be required. In addition, development of new technology could very well be required. Moreover, insurance companies may be required to develop new variable annuity policy forms, which would then be required to be filed with and approved by up to 50 or more insurance departments. Making the transition may very well take more than the one year that the Commission suggested.

VI. Conclusion

The Committee supports the Commission's efforts to protect investors by combating late trading in investment company securities. However, the proposed amendments to Rule 22c-1 in their current form would give an unfair competitive advantage to mutual funds. While the conduit provision is necessary and appropriate and does limit somewhat the scope of the competitive advantage, the conduit fund provision does not address that advantage in all situations. Accordingly, at least with respect to variable annuities, the alternative approach discussed above contains protections that are more than sufficient to combat late trading.

The Committee appreciates the time and resources that the Commission and its staff have devoted to this important initiative, and this opportunity to provide our views to the Commission. We also appreciate your careful consideration of our comments and positions and what we hope is your commitment to not giving any particular industry an unfair competitive advantage over any other while also protecting investors and furthering the policies and purposes of the 1940 Act and the other federal securities laws.

Respectfully Submitted,

Sutherland Asbill & Brennan LLP

By: /s/ Stephen E. Roth

/s/ Frederick R. Bellamy


cc: The Honorable William H. Donaldson, Chairman
The Honorable Paul S. Atkins
The Honorable Roel C. Campos
The Honorable Cynthia A. Glassman
The Honorable Harvey J. Goldschmid
Paul F. Roye, Esq., Director, Division of Investment Management
Robert E. Plaze, Esq., Associate Director, Division of Investment Management
Susan Nash, Esq., Associate Director, Division of Investment Management


Allmerica Financial Company
Allstate Financial
American International Group, Inc.
AmerUs Annuity Group Co.
Equitable Life Assurance Society of the United States
F & G Life Insurance
Fidelity Investments Life Insurance Company
GE Financial Assurance
Great American Life Insurance Co.
Hartford Life Insurance Company
ING North America Insurance Corporation
Jackson National Life Insurance Company
Life Insurance Company of the Southwest
Lincoln Financial Group
ManuLife Financial
Merrill Lynch Life Insurance Company
Metropolitan Life Insurance Company
Mutual of Omaha Companies
Nationwide Life Insurance Companies
New York Life Insurance Company
Northwestern Mutual Life Insurance Company
Ohio National Financial Services
Pacific Life Insurance Company
The Phoenix Life Insurance Company
Protective Life Insurance Company
Sun Life of Canada
Travelers Insurance Companies
USAA Life Insurance Company
Zurich Kemper Life Insurance Companies

1 The Committee of Annuity Insurers is a coalition of life insurance companies that issue fixed and variable annuities. The Committee was formed in 1981 to participate in the development of federal securities law regulation and federal tax policy affecting annuities. The member companies of the Committee represent approximately half of the annuity business in the United States. A list of 29 of the Committee's member companies is attached as Appendix A.

This comment letter addresses variable annuities only, since fixed annuities are not subject to the provisions of the 1940 Act. References herein to "annuities" or "annuity contracts" mean variable annuities or annuity contracts unless otherwise noted.

2 We believe that the Commission should clarify that the "from a registered investment company" language in the conduit fund provision would encompass orders received from the insurance companies sponsoring the separate account, since UIT separate accounts do not have employees.
3 In its release, the Commission used three bullets for these five items.
4 Although it is labeled an "alternative" approach, it should be in addition to, and not in lieu of, the conduit fund provision.
5 In this regard, we note that the alternative approach under consideration would impose other procedural safeguards (such as annual certifications and special audits) on unregistered separate accounts (and other intermediaries) that do not currently apply to mutual funds.
6 In many cases, the insurance company might be an "administrator" for the underlying mutual fund for purposes of Rule 38a-1 even without such treatment being a condition of the alternative approach. Nevertheless, for purposes of the alternative approach, it might still be prudent to adopt such treatment as an explicit condition, if only to eliminate any possible doubt.
7 We note that there is precedent for this approach, of requiring that certain investor protections be imbedded in contractual provisions with registered investment companies, in Commission exemptive orders issued to mutual funds selling their shares to variable annuity and variable life insurance separate accounts of unaffiliated insurance companies, to allow so-called "mixed and shared" funding.