Principal Protection: A Lighthouse For Consumers Seeking Security?

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Lighthouses have become the new talisman for financial products. Even a casual survey of the pages of any finance publication will yield examples of lighthouses prominently featured in advertisements for all sorts of financial products.

In this time of economic and social turbulence, the reason for the potency of this image is not hard to discern. Lighthouses symbolize guidance to a safe place in uncharted or choppy seas. Safety and security are what insurance issuers and consumers are seeking.

In addition to losing market share in the past two years, innumerable variable annuity issuers have suffered losses caused by the payouts or reserving requirements attributable to optional enhanced income and death benefit features. VA premiums have declined significantly in the last two years–down approximately 15%. Meanwhile, indexed annuity issuers, like other fixed annuity issuers, have faced the rocks of state required non-forfeiture rates.

Additionally, consumers have seen a serious erosion of their retirement savings and few prospects for security.

Some financial product providers have recognized this need for security by offering principal protected mutual funds. This development has put added pressure on insurance companies to design products that capture the interest of consumers.

Fixed annuities were the traditional haven for insurers and consumers when the economy got rough. With interest rates as low as they now are, however, insurers are reluctant, if not unable, to provide fixed products with yields high enough to attract purchasers.

Several VA issuers have responded by launching or designing products that offer a safe haven by promising a return of principal.

In the mutual fund world, such products bear the label of principal protected funds. In the variable insurance market, no catch-all phrase has yet been adopted, though the words principal, protection, and guaranteed are all popular and the phrase “principal protection” is starting to become a universal moniker.

In any case, VA insurers are using two general methods to provide this protection. Some are following the mutual fund model by adding a principal protected fund to the investment options. Others are providing a guarantee of premium at the separate account or contract level. Within each model are additional variations.

The principal protected underlying mutual fund model has had somewhat rough going with the Securities and Exchange Commission. The SEC looks at two basic issues: Is the guarantee an affiliated transaction? And is the guarantee itself a security that should be registered under the Securities Act of 1933?

If the guarantee is provided by an affiliate, product rollout can suffer devastating delays occasioned by the need to obtain an order of exemption from the SEC.

As for the separate security issue, it is more manageable. However, the usual price tag to make it so is for the carrier to include the financial statements of the guarantor in the prospectus. For variable product buyers, the price tag generally takes two forms: higher charges and a lock-up period of several years if they are to enjoy the benefit of the guarantee.

A last note on the principal protected underlying mutual fund model: Several design variations do exist. They typically vary by who is provided the guarantee and how.

At the separate account or contract level, principal protection has had somewhat easier going. Currently, the most common form of contract level protection takes the form of permissible annual withdrawals of 7% of premium payments, regardless of level of account value. Thus, for example, assuming adverse investment results have reduced account value to $50,000 from its original premium payment level of $100,000, the contract owner will get back $100,000 in about 14 years.

The SEC staff is accustomed to seeing guarantees from insurers under a variety of optional benefits, so the SEC clearance process has been easier for these products. Of course, if the guarantee were provided by a separate affiliated entity, then the affiliated transaction issue would blossom, as well as the separate security issue.

In all cases, the insurer charges a fee for the guarantee, although the wide range of fees among available products is notable. The guarantee has an additional price tag–it is a lock-up as to which investment options the owner may invest in. As one would expect, the permissible asset allocation mix generally includes only the less volatile investment choices, thereby also limiting upside potential.

A second front on which annuity issuers may meet the security needs of consumers is with equity indexed products. Since their inception, equity indexed products have offered consumers a guarantee of principal plus a stipulated rate of interest.

Recent developments point to design of equity indexed products that rebalance the risk assumption equation as between insurer and owner. If the rebalancing shifts what a securities lawyer would label “too much” investment risk to the owner, these products will require registration under the 1933 Act and sale only by registered representatives of registered broker-dealers. One such product has been registered and reports are that it is doing well.

Issuers of equity indexed products, like all issuers of fixed annuities, are waiting for final action by the National Association of Insurance Commissioners on a change to the required nonforfeiture rate before deciding which course to steer.

By developing the new principal protected products, the insurance industry is responding to competitive pressure as well as serving an important consumer need. With a little bit of luck, many ships will steer a course toward the industrys lighthouse.

Joan E. Boros, Esq., is a partner in the Washington, D.C., law firm of Jorden Burt, LLC. You can e-mail her at JEB@wdc.jordenusa.com.


Reproduced from National Underwriter Edition, February 3, 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.