Whether equity-indexed annuities will be subject to federal or state regulation will likely hinge on a federal appeals court panel’s view on how much risk in a product currently sold as insurance “is too much risk” to be exempt from federal oversight.

That was the impression left by Judge David Sentelle, chief judge of the U.S. Court of Appeals for the D.C. Circuit, at the close of spirited oral arguments May 8 in a case brought by the EIA industry that seeks to vacate a rule approved by the Securities and Exchange Commission in December.

The case, American Equity Investment Life Insurance Company, et al, v. SEC, is being heard on an expedited basis, but a final decision is not expected for several months.

The oral arguments were held just as the National Association for Fixed Annuities, whose members sell EIAs, concluded its 2009 annual meeting & annuity summit in Washington.

At the meeting, the trade group unveiled a two-pronged strategy for ensuring that EIAs remain state-regulated.

Specifically, Rep. Greg Meeks, D-N.Y., and Rep. Tom Price, R-Ga., disclosed that they have agreed to be co-sponsors of legislation expected to be introduced soon in the House clarifying that EIAs are exempt from federal regulation.

Danette Kennedy, government relations chair for NAFA and senior product counsel at Aviva Insurance Company in Des Moines, Iowa, said the industry seeks to ensure that even if it wins the legal case, “it wants to shut down the possibility” that the SEC will seek to assert jurisdiction over EIAs on other grounds in the future.

The legislation will seek to nullify Rule 151A and clarify that Sec. 3(a)(8), the exception which reserves to the states regulation of fixed annuities, governs EIAs.

Rule 151A would impose SEC regulation on certain EIAs as of Jan. 11, 2011.

In response to the contention of Rodney Page, a lawyer for the National Association of Insurance Commissioners, that SEC action constituted an inappropriate attempt to “trump state regulation,” Judge Sentelle cautioned, “We have not said how much risk is too much risk.”

Page, a lawyer at Bryan Cave, Washington, D.C., also represents the National Conference of Insurance Legislators in the litigation.

Page told the court that state regulation adequately protects consumers from the risk of loss from EIAs, and that the insurer, not the insured, bears most of the risk on EIAs.

Eugene Scalia, a lawyer with Gibson, Dunn & Crutcher in Washington, D.C., also argued that the SEC was basing its rule on theories rather than facts.

To that argument, Judge Sentelle asked Scalia whether he was asking for rule to be vacated because the SEC “can’t act on an economic theory.

“Isn’t it their job to determine if there is investment risk?” the judge asked.

Scalia and Page argued that EIAs provide a guaranteed return of principal, pose little investment risk, are not securities and are adequately regulated by the states through a comprehensive set of regulations that include suitability requirements.

Responding to an argument by Michael Conley, a litigation lawyer with the SEC, that EIAs are not uniformly regulated by the states, Scalia said that Iowa and Minnesota account for two-thirds of the sales of EIAs and their regulation “provides the most robust regulation” imposed by states.

In his argument, Conley argued that because investors don’t know what kind of return they will get, they cannot weigh the costs and benefits of keeping their money in the annuity or paying a fee to surrender the plan.

EIAs offer a guaranteed minimum value, but also offer an additional return tied to the performance of a stock index, a benefit that Conley said constituted some level of “risk” to the insured that brought it under the SEC’s authority to regulate.

Conley also noted that there is a ‘bright line” between regulation of fixed annuities, regulation of which is reserved to the states through Section 3(a)(8) of the Securities Act of 1933, which reserves regulation of fixed annuities to the states, and variable annuities, which are regulated as securities by the SEC.

EIAs are “hybrid” instruments, not covered by a “bright line,” but one which the agency can regulate through its authority under the Chevron doctrine to interpret “ambiguity.”

In reviewing the case, Chief Judge Sentelle, and Judges Douglas Ginsburg and Judith Rogers are also weighing whether the SEC is exceeding its authority in deciding to preempt Section 3(a)(8) of the Securities Act of 1933.

Besides dealing with the issue of risk, Judge Ginsburg questioned whether the SEC in its rule had adequately determined the impact of the regulation on capital accumulation and competition in publishing the rule.

He asked the SEC’s Conley whether the rule should be sent back to the SEC for further consideration in light of the potential impact on competition by imposing dual regulation on EIAs.

Judge Sentelle also questioned Conley as to whether the agency had adequately complied with the Administrative Procedures Act by considering the views of commentators to the proposed rule.

He specifically honed in on an argument made by Sclaia that the American Academy of Actuaries had commented that EIAs are clearly fixed annuities.

On that issue, Conley assured Judge Sentelle that the agency had reviewed the comments by the actuaries before publishing its regulation.