If you sell a variable insurance product like variable life insurance or variable annuities, you must be a registered representative of a broker/dealer who is a member of the National Association of Security Dealers (NASD). This means that you must abide by the NASDs rules and regulations.
Ensuring that members of the NASD abide by those rules and regulations is the job of NASD Regulations, Inc, an independent subsidiary of the NASD.
A large part of those regulations deal with suitability, because suitability at its core involves providing recommendations that meet clients’ needs, objectives and situation. Often, protecting the client from financial harm and damage begins with suitability.
Yet, many agents and managers, registered reps and their registered principals, are not fully aware of the extent of the NASDRs regulations regarding suitability. Many will tell you that so long as they document the information required on the new customer account record form–e.g., risk tolerance and investment experience–they are in compliance with NASDR regulations.
However, there is much more to suitability than that.
NASDR Suitability Regulations
The NASDR provides guidance and direction on suitability in its conduct rules and its notices to members. See the chart for the ones that have the most direct impact.
Each of these rules and notices sheds a little more light on what the NASDR considers proper suitability. However, some do not get the attention they deserve.
The following is a summary of key points in these regulations and notices as they pertain to suitability.
Conduct Rule 2310Suitability Rule
Often this market conduct rule is the one that registered representatives and principals are most familiar with. It requires that:
*The representative has reasonable grounds for believing that a recommendation is suitable.
*Customer information should be collected and used to make the recommendation.
*The information mentioned is the clients:
–investment objectives and
–other information considered to be reasonable in making recommendations to a client, such as the clients financial situation and needs.
*This information is typically collected along with signatures and Social Security number on the new customer account form.
*An associated person of the broker/dealer should make an independent determination as to whether the sale is suitable for a particular customer, taking into account the customers investment objectives and financial needs.
Concept of Fair Dealing
The concept of “fair dealing” is part of Conduct Rule 2310. It requires that member firms have the responsibility for fair dealing with customers. Examples of practices that should be avoided are excessive trading, trading that is inconsistent with the expectation that the client can pay periodic payments, misstatement of material facts, manipulations and various deceptions. Recommendations that are unsuitable could be considered to be examples of a failure to deal fairly with clients.
Conduct Rule 3110Customer Account Rule
This rule requires that the member have an officer or manager “accept” (i.e., approve) a new customer account. This entails the review and evaluation of the account information. The required customer account information is the information identified in Conduct Rule 2310. Subsequent notices have expanded the need to collect and document information.
Conduct Rule 3010Supervision Rule
This rule requires member firms to have a process for the “review and endorsement” of all transactions by a designated registered principal. It assumes that the firm has standards and requirements for the review process as well as maintains a record of the process. Supervision should apply to all aspects of the transaction including the suitability of the recommendation.
Notice to Members 96-86–”VLI Notice I”
This notice, published in 1996, reinforces the requirement of fair dealing. It informs the member of the need to collect and use more information than is required for the basic client account form in assessing suitability. It specifies the following supplemental suitability factors that could be considered in assessing suitability.
*Whether the customer had represented that his or her life insurance needs were already adequately met.
*Whether the customer had expressed a preference for an investment other than an insurance product.
*Whether the customer had the ability to fully understand the complexity of the variable insurance product and whether he or she could appreciate how much the purchase payment is allocated to cover insurance and other costs.
*Customers willingness to invest a set amount on a yearly basis.
*Customers need for liquidity and short term investment.
*Customers immediate need for retirement income.
*Customers investment sophistication and whether he or she is able to monitor the investment experience of the separate account.
This notice also identifies unsuitable replacements as an example of unfair dealing with a client and compares it to excessive trading and churning or security accounts.
Notice to Members 99-35–”VA Notice”
This notice, published in 1999, reinforces the need for supervisory review of suitability, especially for replacements and qualified sales. It also reinforces the need to collect and use more information than is required for the basic client account in assessing suitability and identifies eight additional supplemental suitability factors that should be considered when selling annuities:
–Number of dependents
–Previous investment experience
–Liquid net worth
–Other investments and savings
This notice also reinforces the need for a review by a registered principal of the suitability of both the product and the underlying sub-accounts recommended to the client.
This notice also provides recommendations for disclosures, supervision and approval and exception reporting for variable annuity replacements. It recommends a replacement disclosure form be used that includes a comparative analysis. Additionally, it recommends that special attention be paid to “over age” customers (i.e., elderly or senior), including special procedures to screen for suitability.
The notice directs broker/dealers to establish standards for evaluating suitability so that they can identify variable annuity investments that exceed a stated percentage of the customers net worth, and any contract in which a customer is investing more than a stated dollar amount.
Notice to Members 00-44–”VLI Notice II”
This notice, published in 2000, recommends that members use an extensive suitability review process, including use of parameters and ratios to identify sales that warrant additional scrutiny. It reinforces the need to collect and use more information than is required for the basic client account in assessing suitability. It identifies three additional suitability factors that can be used to assess suitability:
–Sources of funds for the investment
–Existing life insurance
This notice to members also uses the term “best interest” as a criterion for evaluating life insurance replacements. It recommends a replacement disclosure form be used that includes a comparative analysis.
This notice also reiterates that a registered principal should review the client information and verify that the recommendation of both the policy and the sub-account allocation is consistent with the customers investment objectives and risk tolerance.
NASD Investor Alert, 2/01″Should You Exchange Your Variable Annuity”
Though not an office notice to members, this consumer-oriented document provides insight into the NASDs thinking about the suitability of replacements and suitability, in general.
It specifically warns customers that a broker is permitted to recommend an exchange only if it is in “your best interest” and only after evaluating your personal and financial situation and needs, tolerance for risk and financial ability to pay for the recommended contract.
This suggests that suitability for any recommendation should also be based on the same standard and involve the same evaluation process.
Dennis M. Groner is a principal in Groner & Associates, a Livingston, N.J. consulting firm providing compliance and market conduct support to the financial services industry. He can be reached via e-mail at [email protected]
Reproduced from National Underwriter Life & Health/Financial Services Edition, May 20, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.