by Joan E. Boros

It has been over 40 years since the federal courts held that variable annuities were securities and subject to the Investment Company Act of 1940.

Even so, the square peg/round hole rule hasnt changed. The square peg, in this case, is variable insurance contracts. The situation for these contracts in this area generally has not gotten any rounder.

The most recent example is the March 11, 2005, release issued by the Securities and Exchange Commission regarding the SECs adoption of final Rule 22c-2. This rule addresses the imposition of “voluntary” redemption fees by mutual funds, and it requests additional comments on certain issues.

The rules provisions (and the SECs requests for comments) do reflect recognition, albeit limited, of some of the special features and structures of variable insurance products. However, this recognition does not go deep enough to accommodate the products unique features. The result is that the rule imposes special burdens on much of the industry. And, it does not resolve potential conflicts between the rule and state insurance laws pertaining to redemption fees.

The rule, definitions and requirements are extremely detailed and best reviewed in whole. (Go to http://www.sec.gov/rules/final.shtml and click on Release IC-26782.)

The March 11, 2005, release that accompanies the rule seeks to address variable insurance contract features as well as the special circumstances of separate accounts inside variable contracts (such as full or partial withdrawals, and periodic rebalancing). Furthermore, it acknowledges that the IRS received a number of comments raising the issue of potential conflict with state insurance law that a mandatory redemption fee could raise.

But the release also requests comments on other possible provisions that dont seem to acknowledge adequately the variable insurance/separate account structure. In view of that, the only reasonable course of action for the industry is to request that the associated administrative burdens be addressed. (It is difficult to imagine that most, if not numerous, underlying unaffiliated fund boards would be comfortable concluding they arent compelled to impose a redemption fee.)

The administrative burdens on separate accounts do differ from those required of other financial intermediaries. Contract owner transactions entail a far more complex processing and tracking system than a broker-dealer omnibus account as a result of the 2 investment company tiers. Each separate account is registered as a unit investment trust that is subject to the 1940 Act requirements.

Immediate real-time identification of contract owners who are included in a composite order to a fund is not the standard in the industry. It would take time-consuming and costly system changes to implement this. Even the Oct. 16, 2006, compliance date would be too soon. Insurers need to think about alternative methods of controlling short-term trading or calculating applicable redemption fees.

Other major administrative burdens are lurking, too. They do not accommodate the complex funding arrangements of variable contractsprimarily those arising out of the fact that the underlying funds may either be affiliated or unaffiliated with the separate account. Which entity would collect the redemption fee is a prime example of the burdens placed on separate accounts and funds if unaffiliated and no uniform method of collection prevails.

Even if there is one selected method for collecting redemption fees and it is through the separate account, systems will have to be reprogrammed to accommodate the differences between the myriad funds with redemption fees that may differ in timing and amount.

Additionally, if a variety of collection methods are permitted and the financial intermediary can decide how to collect the fee, this would place an extraordinary burden on the funds to accommodate the various methods that its numerous investing separate accounts may select. Conversely, if the fund is given the decision-making, this will place an extraordinary burden on the separate account to accommodate the various methods that the different underlying funds will select.

The only answer is for insurers and funds to file comment with the SEC, identifying common concerns and proposing solutions that address investor protection while accommodating valid business purposes. Hopefully, this will show the SEC how diverse and complex are the structures of variable insurance products. The big business issue, if resolution is not achieved, is that the final rule could constrict the investment options available to the public in variable insurance contracts.

Joan E. Boros, Esq., is a partner with Jorden Burt LLP, Washington, D.C. Her e-mail address is JEB@jordenusa.com.


Reproduced from National Underwriter Edition, April 1, 2005. Copyright 2005 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.