On June 25, the Securities and Exchange Commission proposed Rule 151A, which would reclassify equity indexed annuities as securities rather than simply insurance products. It is particularly troubling that the language of the new Rule 151A could apply equally to all deferred annuities, including traditional declared rate annuities and perhaps even to equity indexed life insurance policies.

In 1987, the SEC adopted Rule 151, known as the “safe harbor” rule for exempting certain types of annuities from securities laws. The safe harbor rule is based on Section 3(a)(8) of the federal Securities Act, which provides exemption from regulation under the federal Securities Act “any insurance or endowment policy or annuity contract or optional contract issued by a corporation subject to supervision of the appropriate insurance regulatory of any state.”

To qualify under the safe harbor of Rule 151: (1) the annuity contract must be subject to supervision by the state insurance commissioner and satisfy minimum state nonforfeiture requirements; (2) the insurer must assume the investment risk under the annuity; and (3) the annuity must not be marketed primarily as an investment.

If adopted, Rule 151A would eliminate the safe harbor by imposing in its place a broad standard called the more-likely-than-not test. The proposed rule states that if both (1) amounts payable by the insurance company are calculated by reference to the performance of a security or a group or an index of securities; and (2) amounts payable under the contract are more likely than not to exceed the amounts guaranteed under the contract, then the annuity will be regulated as a security.

Although the SEC refers to equity indexed annuities, the expansive language of the new Rule on its face applies to any annuity product, including traditional declared rate annuities, if the annuity meets both parts of the test. Nearly all annuities will satisfy the more-likely-than-not test because fixed annuities are generally designed to exceed the legal guaranteed minimum rates.

Although the SEC has expressed concern regarding an equity indexed annuity’s effect of shifting “investment risk” to buyers, it has placed particular focus on alleged abusive sales practices towards senior citizens. However, the proposed Rule does not address these perceived marketing problems, and in juxtaposition eliminates the third prong in the current Rule 151–the annuity contract may not be marketed primarily as an investment.

The SEC’s apparent rationale for proposing Rule 151A is that the insurance regulatory oversight of equity indexed annuities does not adequately protect consumers. According to the SEC, it is because when amounts payable by the buyer to the insurer under the contract are more likely than not to exceed the amounts guaranteed by the insurer under the contract, the buyers assume the investment risk, which risk is more likely than not to fluctuate and move with changes in the securities markets.

However, the SEC fails to acknowledge that the bulk of the investment risk in the case of a fixed, equity indexed annuity is not borne by the owner because there is no risk of loss to the buyer’s principal and the buyer’s principal is guaranteed to increase at a minimum interest rate. On the other hand, other security products experience a direct correlation with market fluctuations, lacking the guaranteed minimum interest feature of a fixed, equity indexed annuity.

The SEC has also said that because equity indexed annuities are in many ways similar to mutual funds, variable annuities and other securities, the proposed rule meets the Securities Act’s regulatory objectives. However, the purchase of fixed, equity indexed annuities does not present the same risks associated with investing in mutual funds, variable annuities and other securities. For example, the buyer of an equity indexed annuity does not have a separate account that fluctuates based on the securities market’s movement–up and down; instead, all credited interest gains are guaranteed and locked-in, protecting the principal.

Equity indexed annuity owners do not experience a loss in value from their principal according to negative fluctuations in the financial markets. Instead, they experience only the positive fluctuation in changes to a market index above.

In addition, equity indexed annuities do not benefit from dividend payments and instead receive an interest credit from a set portion of a positive market fluctuation. In addition to the minimum interest rate, an equity indexed product may credit additional interest beyond the minimum guarantee.

The SEC’s argument seems to be that the buyer needs protection from the risk of earning too little. That is, because equity indexed annuities do not put at risk the initial purchase price paid for the contract, the actual risk is that the buyer may have obtained a better deal elsewhere. However, the “could have obtained a better deal elsewhere” risk is not the type of risk central to determining whether an annuity or insurance product is a security

The SEC stated, as its rationale for the proposed rule, that it wants greater clarity regarding the status of equity indexed annuities under the federal securities laws; yet because the more-likely-than-not test does not derive from case law, the proposed rule presents instead an inconsistent analysis for determining when an annuity is a security. Thus, instead of clarifying the status of equity indexed annuities, Rule 151A confuses the status of all annuities and, ultimately, accumulation life insurance policies as regulated securities products.

Proposed Rule 151A has a broader application beyond fixed, equity indexed annuities. Indeed, declared rate annuities calculate amounts payable by the insurance company in whole or in part by reference to the performance of a security or a group of securities, e.g., securities owned by the insurance company in its investment portfolio. Furthermore, while the SEC has not publicly voiced concerns about equity indexed or traditional accumulation life insurance products, the SEC’s rationale arguably applies equally to them. Stay tuned as the SEC’s comment deadline for the proposed rule just ended on Sept. 10, 2008.