Annuities are hybrid financial products. They are insurance products, and, as such, are regulated by state insurance departments. Some annuities are also considered to be securities, subject to regulation by federal and state securities agencies. Furthermore, some rules are applied by Federal regulatory bodies, while others are established and administered by states. Thus, the rules governing the sale and marketing of annuities are a matter of jurisdiction, and the rules are not entirely consistent from one jurisdiction to another. This can make compliance with relevant rules complicated and difficult. Adding to the difficulty is the fact that the standard of care required of those who recommend annuities is not uniform.
At the present time, there are actually two standards of care in the financial services industry: suitability and the fiduciary standard.
Suitability can be defined as “the quality of having the properties that are right for a specific purpose or situation.” That is a general definition, but the term suitability has a more specific meaning when applied to recommendations of insurance, investment, and annuity products, a meaning which is evolving constantly. Until recently, there was little, if any, precision as to when the sale or recommendation of an annuity would be considered suitable. Virtually no jurisdictions offered rules with any intentional definitions — that is, specifications of the necessary and sufficient conditions that must apply for the transaction in question to be qualified as suitable — or providing concrete examples. Many state statutes were simply self-recursive; they simply defined a suitable transaction as one that is suitable.
These suitability standards generally apply, at the present time, both to: (a) insurance agents recommending insurance and annuity products that are not securities and to; (b) registered representatives recommending insurance, annuity, and/or investment products that are securities so long as the advice that they render, in the course of making those securities recommendations, is solely incidental to their activities as securities salespersons (in many regulations, the term used is “brokers”).
The other standard of care that may apply when an annuity is recommended is the fiduciary standard. This is a much higher standard and applies to investment advisers under the Investment Advisers Act of 1940. Section 202(a)(11) of that Act generally defines an investment adviser as any person or firm that: (1) for compensation; (2) is engaged in the business of; (3) providing advice, making recommendations, issuing reports, or furnishing analyses on securities, either directly or through publications. It does not generally apply to registered representatives to whom the broker exclusion of Section 202(a)(11)(C) of the Act applies. That section excludes from the Act’s definition of investment advisor registered representatives offering advice in connection with the recommendation of a security provided that two conditions are satisfied:
1. no special compensation is received (for the advice); and
2. the advice is solely incidental to the broker’s brokerage activities.
Rules dealing with annuities that are securities
Variable annuities, as annuity contracts, are subject to regulation by state insurance departments — and, indirectly, by the NAIC — and, as securities, are subject to regulation by state securities departments and Federal securities regulators. Over the years, rulings by the NASD and FINRA have sought to provide guidance as to when a variable annuity is suitable.
FINRA Rule 2090
The FINRA Rule 2090 Know Your Customer rule, announced in FINRA’s Regulatory Notice 11–02 in January, 2011, is modeled after NYSE Rule 405(1). It requires FINRA members to use reasonable diligence and to know the essential facts concerning their customers. The Rule explains that essential facts are: “those required to (a) effectively service the customer’s account, (b) act in accordance with any special handling instructions for the account, (c) understand the authority of each person acting on behalf of the customer and (d) comply with applicable laws, regulations, and rules.”
The know-your-customer obligation arises at the beginning of the customer-broker relationship and does not depend on whether the broker has made a recommendation.
FINRA Rule 2111
FINRA Rule 2111 is both a “know your customer” and suitability rule. Announced in regulatory notice 11–02, and effective on October 7, 2011, it requires that registered representatives and the firms for which they work have a reasonable basis to believe that a recommended transaction or investment strategy involving a security is suitable for the customer, based upon “the information obtained through the reasonable diligence of the [FINRA] member or associated person to ascertain the customer’s investment profile.” It is significant that this rule, unlike previous rulings, applies both to recommendations of product and of investment strategy.
The Rule declares that investment profile “includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.” The factors identified in that list are very similar to those identified in SATMR. This is a common condition in regulatory language. Often, the authors of an NAIC rule will adopt the language of rules previously issued by other regulatory authorities such as FINRA.
FINRA Rule 2330
The current FINRA suitability rule applicable to deferred variable annuities “to recommended purchases and exchanges of deferred variable annuities and recommended initial subaccount allocations,” is FINRA Rule 2330, modeled after NASD rule 2821. It provides that:
“No member or person associated with a member shall recommend to any customer the purchase or exchange of a deferred variable annuity unless such member or person associated with a member has a reasonable basis to believe
(A) that the transaction is suitable in accordance with Rule 2111 and, in particular, that there is a reasonable basis to believe that
(i) the customer has been informed, in general terms, of various features of deferred variable annuities, such as the potential surrender period and surrender charge; potential tax penalty if customers sell or redeem deferred variable annuities before reaching the age of fifty-nine-and a half; mortality and expense fees; investment advisory fees; potential charges for and features of riders; the insurance and investment components of deferred variable annuities; and market risk;
(ii) the customer would benefit from certain features of deferred variable annuities, such as tax-deferred growth, annuitization, or a death or living benefit; and
(iii) the particular deferred variable annuity as a whole, the underlying subaccounts to which funds are allocated at the time of the purchase or exchange of the deferred variable annuity, and riders and similar product enhancements, if any, are suitable (and, in the case of an exchange, the transaction as a whole also is suitable) for the particular customer based on the information required by paragraph (b)(2) of this Rule; and
(B) in the case of an exchange of a deferred variable annuity, the exchange also is consistent with the suitability determination required by paragraph (b)(1)(A) of this Rule, taking into consideration whether
(i) the customer would incur a surrender charge, be subject to commencement of a new surrender period, lose existing benefits (such as death, living, or other contractual benefits), or be subject to increased fees or charges (such as mortality and expense fees, investment advisory fees, or charges for riders and similar product enhancements);
(ii) the customer would benefit from product enhancements and improvements; and
(iii) the customer has had another deferred variable annuity exchange within the preceding thirty-six months.
Like the NAIC’s “Suitability in Annuities Transactions Model Regulation” (SATMR), FINRA Rule 2330 provides guidance as to the factors that should be considered before the recommendation of an annuity. Indeed, the factors that it cites are virtually identical to those cited in SATMR, which took them from the earlier NASD Rule 2821. Section (b)(2) of Rule 2330 states that:
“Prior to recommending the purchase or exchange of a deferred variable annuity, a member or person associated with a member shall make reasonable efforts to obtain, at a minimum, information concerning the customer’s age, annual income, financial situation and needs, investment experience, investment objectives, intended use of the deferred variable annuity, investment time horizon, existing assets (including investment and life insurance holdings), liquidity needs, liquid net worth, risk tolerance, tax status, and such other information used or considered to be reasonable by the member or person associated with the member in making recommendations to customers.”
Notwithstanding the similarity of language in FINRA Rule 2330 and SATMR, the regulatory implications are very different. SATMR applies, in those states that have adopted it, to the sale of all annuities, while the FINRA Rule applies only to the sale of variable contracts. As we shall see, however, Section 989J of Dodd-Frank applies the suitability rules of SATMR, including these suitability factors to the sale of all annuity contracts, and, arguably, to the sale of insurance products other than annuities.