New SEC Requirements Should Prompt Variable Insurer Talks With Underlying Funds

The Securities and Exchange Commission has adopted new requirements for prospectus disclosure of policies and procedures pertaining to frequent transfers of variable product account values. The new requirements make it advisable for variable product issuers to begin discussing this subject promptly with their underlying funds.

As originally proposed, and as ultimately adopted, essentially identical disclosure requirements will apply to each SEC-registered separate account and to each underlying fund. Under the new requirements, the prospectus must disclose whether the separate account or the fund has policies and procedures with respect to frequent transfer activity. If so, considerable detail about those policies and procedures must also be disclosed. The new requirements do not mandate that a separate account or a fund have any such policies and procedures. However, the absence of such policies and procedures must be disclosed, as well as the reasons why none have been adopted.

Commenters on the proposals pointed out certain potential problems. For example, a single underlying fund frequently has many different participating insurers. In such a case, the participating insurers can be expected to differ considerably in the extent to which the terms of their variable contracts and their computer systems permit them to implement whatever frequent transfer policies and procedures an underlying fund might adopt.

For example, if an underlying fund seeks to discourage frequent transfers by imposing a withdrawal charge on redemptions made within a specified number of days following a purchase, it would be necessary for an insurer participating in the fund to administer this restriction and impose the fee at the contract owner level. In many cases, however, the terms of the insurers variable contracts will not permit the insurer to impose such fees on its customers. Similarly, an underlying fund could adopt other types of transfer restrictions that are more severe than permitted under the terms of at least some of the affected variable contracts or that would require costly systems modifications for the insurer to implement.

In theory, such problems could be addressed if a fund adopted different policies and procedures for different insurers, to the extent necessary to accommodate each insurers circumstances. Such an arrangement, however, would result in awkward and voluminous fund disclosure, because the SECs new requirements effectively would require the specifics of the procedures applicable to each insurer to be set forth in the funds prospectus.

Furthermore, an insurer may, for any one variable product, use multiple (often unrelated) underlying funds that might adopt different policies and procedures to address the problem of frequent transfers. The more underlying funds involved, the greater the likelihood that the insurer would be unable to implement at least some of such procedures at the contract owner level. At a minimum, the insurer could be exposed to the cost and “prospectus clutter” associated with administering several different sets of procedures.

An insurer that merely implements at the contract owner level the policies and procedures that the relevant underlying funds have imposed could argue it has not itself adopted any policies and procedures for its separate account. Rather, such an insurer arguably is merely cooperating in the implementation of the policies and procedures of the underlying funds.

The SECs new requirements contemplate that an insurer will refrain from adopting frequent transfer policies and procedures for its separate account only if the insurer, as the separate accounts “depositor,” has concluded that this is appropriate. Deference by an insurer to underlying fund policies and procedures may be appropriate on the grounds that each underlying fund is in the best position to judge what type of transfer activity is or is not in the interest of all the participants in that fund.

Also, an insurer may have reason to believe that most other insurers that participate in a particular fund will simply be implementing that funds policies and procedures. If so, the insurer may consider it contrary to its own contract owners best interest to subject them to any stricter procedures.

If the insurer in these circumstances successfully argues that it has not adopted any policies or procedures concerning frequent transfers, the variable contract prospectus could perhaps simply refer to the relevant fund prospectuses for the details of the frequent transfer policies and procedures that would apply. This would at least result in somewhat manageable and non-duplicative prospectus disclosure.

Also, if a particular underlying fund has relatively few unrelated insurer participants and if those insurers use relatively few unrelated funds, it may be practical for those insurers and funds to agree upon a common set of policies and procedures that are adopted and disclosed with specificity at both the separate account and underlying fund level. It seems probable, however, that only a small percentage of variable product issuers will find this approach to be feasible.

Some underlying funds may decide not to adopt any policies and procedures for frequent transfers. The SECs new requirements contemplate that an underlying fund will refrain from adopting policies and procedures only if its board of directors has concluded that this is appropriate. An underlying fund might evaluate the relevant policies and procedures of each of its participating insurers, as well as the implementation of those procedures, and conclude that the combined effect thereof adequately protects the interests of all investors participating in the fund. This could provide a basis to conclude that it would be appropriate for the underlying fund not to adopt any frequent transfer policies or procedures of its own.

An alternative (but substantively similar) approach would be for an underlying fund to adopt policies and procedures that, rather than imposing specific limits or restrictions on transfer activity, provide instead for periodic monitoring and evaluation of the substance and operation of the procedures of participating insurance companies, with a view to ensuring that the interests of all participants in the fund are adequately protected.

Under either of these approaches, participating insurers could have considerable autonomy in designing and implementing their own procedures. The fund and its board would, however, have oversight and monitoring responsibilities that would be significant. Moreover, if a participating insurers procedures were deemed to be inadequate, the fund would need to take action. Either the insurer would be required to improve its procedures or, presumably, it would be denied further access to the fund.

Most underlying funds operate pursuant to what are commonly called “mixed and shared funding” orders of exemption granted by the SEC to permit different types of variable contracts issued by unrelated insurers to be invested in the same underlying fund. These orders have been granted subject to numerous conditions that are effectively binding on each participating insurer. Among the conditions are that the funds board will monitor for “material irreconcilable conflicts” between the interests of the variable contract owners of different participating insurers. Moreover, if the board finds such a conflict exists, a further condition enables the board to take necessary action to cure the conflict, including requiring the responsible insurer to withdraw its investment.

If an underlying fund board concluded that a participating insurers procedures were, by their terms or in their operation, materially inferior to those of the funds other participating insurers, and if that insurer were unwilling or unable to rectify the problem, the funds board could conclude this constituted a “material irreconcilable conflict” for purposes of any mixed and shared funding order the fund had obtained. In that case, the orders conditions would give the fund board ample means for taking appropriate remedial action.

An underlying fund board may have a responsibility to monitor for such conflicts even if it adopts policies and procedures for frequent transfers. In that case, a material irreconcilable conflict might arise if some participating insurers implement the funds procedures, while others do not (or do so less perfectly). The SEC itself has thrust this issue into prominence by adding language in the final requirements that, in effect, requires an underlying fund to provide prospectus disclosure about whether the funds procedures will be imposed on owners of variable contracts that participate in the fund.

The prospectus disclosures mandated by the new requirements must be included in new registration statements or amendments thereto filed on or after Dec. 5, 2004. It is clear that developing the necessary policies, procedures and disclosures will, in many cases, involve difficult issues and may necessitate coordination between variable contract issuers and underlying funds.

Mr. Lauerman is a partner of Foley & Lardner LLP, in Washington, and specializes in investment company and variable insurance product matters. He can be reached via e-mail at TLauerman@foley.com.


Reproduced from National Underwriter Edition, July 22, 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.