The current scandal affecting the mutual fund business now has spilled over into the variable annuity and variable life insurance business.
The Securities and Exchange Commission as well as the New York attorney general and several other state attorneys general have launched investigations into the VA and VL insurance business to determine if illegal activities involving abuses in after-hours trading and market timing have adversely affected variable contract owners.
The SEC also has launched rule-making procedures involving registered investment company shares that will, if adopted, have the potential to affect variable contracts.
This flurry of activity comes amid congressional legislative actions that are attempting to change laws affecting mutual funds that seem likely to be applied to variable contracts and the insurance companies that issue them. It is too early to predict the specific results, but it is possible to predict certain likely developments almost sure to take place and which will have significant impact on VA and VL policies.
The trade associations for the industry are deeply involved in attempting to educate regulators, state prosecutors and Congress about variable contracts and how they work. They also are attempting to point out that in designing new regulations and laws, “one size does not fit all.”
It is particularly important for everyone involved to understand that variable insurance products are materially different from mutual funds. The variable products are, for example, designed as much longer term savings and financial planning vehicles, not as short-term trading products. That fact alone requires different procedures for each.
Even so, changes are coming in the way the variable insurance industry does business. Right now, insurers, broker-dealers and other distributors are busy rethinking their control procedures and the methods by which they ensure compliance with current laws and regulations as well as trying to adapt themselves to what they think will be implemented later on.
It is likely that the current way the products are priced will change. These changes may well come about in response to regulatory initiatives and enforcement proceedings.
Broker-dealers already have been put on notice about several things (see box). Also, one currently pending proposal would require that the actual dollar amount of commission paid on a sale, along with other sources of remuneration to the broker-dealer, be reported to purchasers on confirmations.
Current pricing strategies in the variable product industry have led to multiple classes of contracts to service multiple distribution systems, so broker-dealers now have numerous products available to sell with differing features, pricing and compensation. As a result, it may well be that insurers will begin to offer front-end loaded products once again. Such a practice would certainly simplify the compliance issues.
Another short-term result from this regulatory and prosecutorial scrutiny will be that insurers and broker-dealers will re-examine what levels of disclosures currently are being made to customers–both at point of sale and in ongoing communications.
Insurers have, for quite some time, felt they were only responsible for general disclosure regarding compensation. Broker-dealers have gone blissfully on their way with little regard or concern about such disclosure. This was on the assumption that the disclosure was adequate. But regulators have sounded a very loud wakeup call for the industryincluding both mutual funds and variable insurance products.
Now, all parties involved in manufacture and distribution of investment company products must take action to see that proper disclosure is in place. Broker-dealers in particular must disclose all relevant information to purchasers, including disclosure about conflicts of interest and any incentives or differentiated compensation.
The SEC recently adopted a new rule relating to compliance. This requires that mutual funds, insurers issuing variable contracts and investment advisors must adopt and implement written policies and procedures that are reasonably designed to prevent violation of the federal securities laws and regulations. They must review these policies and procedures annually to assure adequacy and effectiveness, and they must designate a chief compliance officer to be responsible for administering the policies and procedures. This CCO and the newly required policies and procedures must be in place by Oct. 4, 2004.
This seems to be the perfect time for serious self-examination. The written policies and procedures are not just to be drafted by junior staff and filed away. The CCO must report to the board of directors or similar body at least annually, or more often in event of serious compliance issues. To make the process truly effective, the highest level of management needs to send a message to all personnel stating that only the tightest standards of conduct are acceptable.
No article about the current regulatory issues can be complete without a discussion about market timing. It is incumbent upon the industry to work with the regulators to achieve some middle ground on this issue.
Many insurers have come to rely on professionals to oversee their investment allocations in mutual funds and in variable contracts. The sheer number of investment choices is often overwhelming. As regulatory and legislative initiatives are considered to resolve these market timing issues, it is important that these initiatives are not so overbroad that they deny the average contract owner access to professional talent they could not otherwise afford.
In the meantime, insurers and mutual fund managers must work together to put into place workable procedures that prevent the trading practices of a few investors from causing significant harm to the others. The “bunker mentality” observed in several segments of the industry must end so meaningful dialogue can occur among all affected parties.
It is readily apparent that variable insurance companies are approaching a whole new era in the way they design, manufacture and operate their businesses and products. It should go without saying that everyone involved in this important industry needs to monitor the developments, provide input to the process, and rethink their product designs, compliance and operational procedures. They need to do this so they will not be caught off guard when the current activity finally results in new laws and regulations to which the business must adapt.
Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are attorneys in the Pompano Beach, Fla., office of Blazzard, Grodd & Hasenauer, P.C. Hasenauer chairs the Regulatory Affairs Committee of the National Association for Variable Annuities. Their e-mail is [email protected]
Reproduced from National Underwriter Life & Health/Financial Services Edition, March 25, 2004. Copyright 2004 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.