NU Online News Service, June 26, 3:00 p.m.Washington

The Securities and Exchange Commission has issued guidelines for determining the “retail exception” to Section 11 of the Investment Company Act, arguing that some insurance companies may be interpreting the exception too broadly.

“We are very concerned with potential insurer violations of Section 11 because of the possibility that contract owners will be induced to make disadvantageous exchanges that result in the payment of additional sales charges and broker compensation,” the SEC says in a letter to three insurance trade groups.

SEC says it believes some insurance companies may undertake initiatives designed to encourage exchanges from one variable annuity contract to another from the same company, relying on the “retail exception” to avoid either seeking SEC approval or complying with Section 11.

“We wish to emphasize that we view abusive switching of variable annuity contracts very seriously,” SEC says.

“Section 11 provides important protections against the imposition of additional sales charges to contract owners, and we would be very concerned with any insurer initiative that is designed to encourage exchanges among variable annuity contracts without either complying with rule 11a-2 or seeking a Commission order approving the terms of the exchange offer,” SEC says.

In general, Section 11 bars insurance companies from offering to exchange existing variable annuity contracts for other variable annuity contracts issued by the same insurer, unless the SEC has approved of the terms of the offer or the offer complies with the rules governing exchange offers.

The purpose of Section 11, the SEC says, is to prevent exchanges that are offered solely to exact additional sales charges.

However, there is a limited exception to Section 11 called the “retail exception.” The “retail exception,” SEC says, in general applies to communications between an individual broker and an individual customer.

It does not apply, SEC says, to a group or class of contract owners or to any exchange offer by an insurance company separate account.

But in recent years, SEC says, estimates are that up to 40% of new sales of variable annuities are attributable to contract exchanges.

This, SEC says, is due largely to the increasing popularity of bonus annuities, which add an up-front bonus usually ranging from 1% to 5% to the contract value.

A contract owner may not benefit from the exchange, however, because bonus annuities often have higher surrender and asset-based charges, as well as longer surrender charge periods, SEC says.

Nonetheless, SEC says, brokers who handle these transactions often receive substantial commissions.

To prevent any abuse, SEC is outlining several factors insurers should consider to determine whether an exchange offer qualifies for the retail exception.

These include:

1. Whether the insurer has a plan to promote exchanges.

2. Whether and how an insurer dedicates resources to programs designed to discourage investors from surrendering.

3. Whether an insurer has initiated direct communication with a contract owner regarding a new contract and the nature of the communication.

4. Whether an insurer provides a list of contract owners to a broker-dealer who had no previous business relationship with those customers, the purpose for which the list is provided and how the list is used.

5. The nature of any written or oral communication from an insurer to brokers about new contracts or contract exchanges.

6. The amount of compensation, if any, paid to brokers who engage in contract exchanges.

7. The amount of broker compensation in relation to the services the broker performs in connection with an exchange.

8. Whether exchanges are offered on terms designed to encourage exchange activity, such as waiver of the surrender charge.

9. Whether an insurer communicates about a new contract or the availability of an exchange to all existing contract owners or a group of existing owners, and the nature of the communication.

10. The nature of any marketing by an insurer of a new contract or the availability of an exchange that is designed or is likely to reach all existing contract owners of a groups of existing owners.

SEC says that these factors are useful analytically, but are not intended to be exhaustive. Other factors may also be considered depending on the facts and circumstances, SEC says.

“We would expect any insurer that relies on the ?retail exception’ to monitor its exchange activity on an ongoing basis to evaluate whether this activity falls within the ?retail exception,’” SEC says.

For industry reaction to the SEC’s interpretation, see the July 2 National Underwriter.