The Mutual Fund Trading Scandal
Are Insurers Next?

By Jim Connolly

When insurance industry observers look at the current travails that mutual funds are experiencing, do they see a foretaste of what the insurance business is in for? The answer, after a wide-ranging series of interviews, is that such a scenario is conceivable but not necessarily so.

After months of findings of illegalities and alleged wrongdoing among mutual fund complexes that run the gamut from after-hours trading and market timing to not adhering to policies stated in fund prospectuses, the Securities and Exchange Commission on Dec. 3 proposed some reforms.

Among these is a rule requiring that fund orders be received by 4 p.m. in order to receive that days price. The commission also approved a rule that will require funds and advisors to establish compliance procedures and designate a compliance officer who will report to the board of directors.

Additionally, the SEC also proposed enhanced disclosure requirements.

These actions also followed reports of an SEC request that insurers provide information on variable annuities.

During the last few months, New York State Attorney General Eliot Spitzer has assailed brand-name fund families such as Putnam, an asset management division of insurance broker Marsh & McLennan, to Invesco mutual funds.

Spitzers office declined to comment on whether the insurance industry faces similar issues, but many familiar with the business offered their view on a potential ripple effect.

Interviews suggest that the question needs to be looked at from a number of perspectives: the implications for subaccounts in variable products; for insurers own family of funds; for defined contribution plans offered by insurers; and any potential effect on revenue and volatility of earnings.

While late trading and market timing activity could surface in variable annuity subaccounts, Robert Riegel, managing director with Moodys Investor Service, New York, says VAs are, by and large, retail, not institutional, money, which makes it less likely for abuses to be as prevalent.

However, he notes, similar abuses are not impossible to imagine. “A year ago people thought the mutual fund industry was pristine,” Riegel says. “No one could have envisioned what has come out in the last 6 months in the mutual fund industry.”

The problems of the asset management businesses of insurers are not likely to spill over into the insurance operations, he adds. However, if problems do develop in a unit, it could have an impact on the amount and volatility of earnings, Riegel continues. This would be particularly so if the division contributed significant earnings to the insurer, and those earnings were reduced by settlement and restitution costs or lower fees resulting from redemptions and thus, smaller asset totals under management, he says.

There are 2 types of considerations for insurers, says Steven Buller, national director of asset management services with Ernst & Young, New York. The first would be whether there was a violation by an insurer and the second consideration, he continues, would be whether a hedge or mutual fund that the insurer used in its product was involved in an infraction.

An insurer can limit market timing in variable annuities by establishing restrictions such as redemption fees, minimum holding periods and limits on the number of exchanges within a given time period, Buller adds. However, for contracts already in existence, an imposition of new restrictions could be considered a violation of the original contract, he explains.

There are certain actions insurers can take that will help them avoid wrongdoing, Buller says. Insurers can make sure their variable products are in compliance with prospectuses, and they can make sure there is good disclosure to consumers, he emphasizes.

Insurers will see some of the same issues mutual funds are experiencing, but they just havent surfaced yet, according to Geoff Bobroff, president of Bobroff Consulting, Warwick, R.I. Some VA providers, particularly smaller insurers with their own captive sales force may be less likely to have market timing activity because it will be more readily noticeable with smaller portfolios.

Bobroff offers two solutions to the problems that have surfaced: Treat investors fairly and uniformly.

Proper disclosure in a prospectus followed by adherence to the guidance in a prospectus is important for insurers, says Norse Blazzard of Blazzard, Grodd and Hasenauer, a law firm in Fort Lauderdale, Fla.

Blazzard says market timing within a variable account is not illegal and if companies put more restrictions in place, the contract owner could be placed at a disadvantage.

Disclosure is a concept that Judith Hasenauer of the Blazzard law firm also advocates. Additionally, she says, fair valuation for any mutual fund also is important.

If new structures are put in place for variable products, costs will increase, says Hasenauer, and these costs may not be commensurate with benefits.

One size of oversight does not fit all, Hasenauer adds, so guidelines on issues such as market timing would depend on whether the fund has $60 million, $200 million or $4 billion in assets.

In fact, certain VAs and mutual funds are structurally designed to appeal to market timers, she explains. The test is whether market timing causes harm to the mutual fund or subaccount, she says.

Although Blazzard says insurers probably would not be held liable for activities of outside funds that are subaccount choices, he says there can be no certainty with the trial bar.

However, he adds that insurers usually have very strong indemnification agreements with outside fund families.

Michael Barry, a managing director with Fitch Ratings, New York, does not see potential legal liability for insurers whose subaccount providers face questions as having a major impact on ratings.

But, he does distinguish between insurers that have their own fund complexes and those who use outside funds.

Kevin Ahearn, an analyst with Standard & Poors Corp., New York, anticipates that the level and severity of problems will be “nowhere near the level in the mutual fund industry.” However, insurers with asset management operations will be interviewed, he says.

New York Insurance Superintendent Greg Serio says VAs are well regulated when they are sold as insurance products with sales practices and other regulatory requirements.

In addition to regulatory oversight, Serio says one could expect self-regulatory agencies such as the Insurance Marketplace Standards Association “to carefully evaluate the sales practices of the industry.”

Enhancing market conduct oversight is timely work right now, he says.

Joel Ario, Oregon insurance administrator and secretary treasurer with the National Association of Insurance Commissioners, Kansas City, Mo., says market conduct work currently being developed could help regulators monitor potential problems that mutual funds now are addressing.

While self-regulatory bodies such as IMSA are important for looking at how market conduct issues are handled down the chain of command, the current market conduct work can test behavior to see if it is actually being enforced at the ground level.

The problems mutual funds are facing are “directly on point” in demonstrating what insurance regulation needs to accomplish, according to Birny Birnbaum, executive director with the Center for Economic Justice, Austin, Texas.

Insurance regulation should actively identify problems, he says. If the mutual fund industry had been looking for problems such as after-hours trading, it would have seen it years ago, Birnbaum adds.

A key to early detection is thorough market conduct analysis, he says.

Kevin Hennosy, publisher of SpreadtheRisk.org, Kansas City, Mo., says that “greed and self-dealing” can cut across industries. “Is what we are seeing in the mutual fund industry, what we saw in the insurance industry 10 years ago? Which came first?”

The problem starts with a corporate culture and “while it ends with the producer, it doesnt start with the producer,” he adds. It starts all the way up the system and is reflected in points such as how the product is designed, Hennosy explains.


Reproduced from National Underwriter Life & Health/Financial Services Edition, December 12, 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.