Kentucky District Court Rules That Index Annuities Are Not Securities

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Is an index annuity a security? The question has been quietly kicking about ever since index annuities–which link their growth to increases in an equity or bond index–first made their debut in the mid-1990s.

The developers say index products having guarantees are not securities, but others have wondered if perhaps they might be securities anyhow.

Now, at least one official answer has emerged. It comes from a recent ruling from the U.S. District Court in Kentucky–a ruling that essentially says index annuities having underlying guarantees are not securities.

Given that sales of such annuities have been on a fast track in the past year, totaling over $8 billion by the end of the third quarter, the district courts finding is sure to draw industry attention because it supports what index annuity marketers have been saying all along.

Here is the background: In late September 2002, Chief Judge John G. Heyburn II of the United States District Court in the Western District of Kentucky in Louisville signed an order dismissing a lawsuit that involved index annuities. In so doing, the court said the products in question are “exempt from federal securities laws both under Section 32(a)(8) and Rule 151.”

Because of that, the court found no legal basis for the plaintiffs complaints of securities fraud and it dismissed the charges in the suit.

The decision, and the reasoning behind it, are important for the index annuity business, contends Joan Boros. A partner in the Washington, D.C., law firm of Jorden Burt, she closely follows the index annuity scene.

For one thing, had the decision gone the other way, it would have become a class-action lawsuit, Boros says.

More importantly, she says, the 18-page document is exceedingly thorough. It lays out various court decisions and related reasons why the products it examined are not securities. For example, the court not only analyzed relevant sections of federal securities law but also cited various Supreme Court and other key court decisions, she says. In addition, it “visited, examined and analyzed” whether the three-prong test under Safe Harbor Rule 151 applies.

In beginning its review of relevant cases, the court pointed out that the “threshold question in any action brought pursuant to the Securities Acts is whether a security exists.” Since the complaint was that the annuity contracts in question were securities, the court said it had to decide whether a fixed indexed deferred annuity is a security within the meaning of the federal laws.

The courts decision, that the products are not securities, has several important points for insurers, according to Boros.

For one thing, “I thought it was particularly interesting to see that the court found that, in these products, the insurance company, not the policyowner, bears the majority of the investment risk,” she says.

Another key finding, she says, is that “the court found the insurance company is the one that shoulders the risk of the policys interest rate guarantee,” not the policyholder.

Finally, she says, the courts assessment of whether the index annuities were marketed primarily as investments is telling.

The court reviewed various marketing materials related to the products, Boros explains, and it found that statements in those materials about the “companys sound financial management” had to do with the companys promise of stability and flexibility, not to investment experience. Further, the court noted that the contract itself requires the policyholder to sign a statement saying that the person understands the past index activity “is not intended to predict future activity. “

These marketing comments are very helpful to insurance people and their counsel, says Boros, because the issues involved are potentially subjective.

In a few places in the decision, the court points out the confusion that has existed about the status of index annuities.

For instance, after reciting the various charges brought against the insurance marketer, the court notes that “the modern day differences between fixed and variable annuities are not always immediately apparent in the context of indexed deferred annuities, such as this one, where the purchaser is guaranteed a fixed payment at a later date subject to an increase based on a stock index.”

Therefore, the court said it would give “particular attention to the instrument at issue,” drawing on criteria applied by the Supreme Court and other circuits.

Later, in a footnote, the court pointed out that, in 1997, the SEC had requested comments on the status of equity index annuities but, since then, the SEC has made no further comment on the status of this request.

The take from Boros is that the court, finding no clarity concerning whether index annuity products are securities, voluntarily took it upon itself to do a review of the matter.

Will the decision be appealed? There is no word as of yet, but Boros thinks appeal is unlikely.

The case is Civil Action No. 3:01-CV-259(H), Beverly S. Malone v. Addison Insurance Marketing Inc., et al. It is at: http://www.kywd.uscourts.gov/scripts/usdckyw/judicialopinion/searchresults2.pl.


Reproduced from National Underwriter Life & Health/Financial Services Edition, January 13, 2003. Copyright 2003 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.