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Life and Health Insurance
Industry Brief
Steven D. Schwartz, CFA
Jason Royer
Res. Assoc.
Index Annuities: Insurance Product or Security
Recent headlines suggesting that the NASD has been questioning insurance and brokerage firms regarding marketing of index annuities once again brings up the issue of whether these new annuity products should be exempt from registration.
Although the NASD has no regulatory authority over insurance companies, publicity surrounding the issue could force the SEC to refocus on this growth area of the insurance market.
We would note, however, that what case law does exist on this question would favor the insurance industry in any battle. Further, it seems likely that the SEC could not “blanket” all index annuities, but rather decide whether registration was called for on an ad hoc individual product basis.
While headline risk may remain, we think it unlikely that index annuities will become registered products.

NASD Seeks Equity Index Annuity Marketing Info; But Does It Have Jurisdiction?
Yesterday's headline on the tape - that the NASD is requesting marketing information from broker/dealers regarding the sale of index annuities, isn't new news and has been reported on extensively in the insurance trade press. According to reports, the NASD is concerned about "selling away," registered reps selling unregistered product. By asking broker/dealers to treat index annuities as “securities,” registered reps would be forced to deal with the same suitability and compliance issues as with other, registered, investments. And let’s face it; this wouldn’t necessarily be a bad thing.
However, just because the NASD says that index annuities should be treated as securities doesn’t make registration of these products a fact. Remember, life insurance companies are not under the regulatory purview of the NASD, but of their respective state insurance commissioners.
Nevertheless, yesterday morning's headlines brings up the issue of whether or not index annuities should be treated as securities and be registered or be considered an insurance product and remain exempt from registration. This is an issue that has concerned a number of insurance investors.
Whether or not the NASD believes that index annuities should be treated as securities is immaterial. The real question is what the SEC and the courts believe.
The SEC sent out a questionnaire to interested parties in 1997. Eight years later, there has been no followup.

Case Law Suggests Index Annuities are Insurance Products and Exempt From Registration
What little case law there is would suggest that index annuities are fixed annuities and exempt from
registration. To the best of our knowledge, there is only one case –
Malone v. Addison Insurance Marketing
(2002) in which this issue has been decided. In Malone, which is primarily a "living trust" case, plaintiff
attorney attempted to argue that the sale of index annuities was improper in that these products were
securities and should have only been sold by a registered representative. The actual decision is only with regards to the issue of exemption; in fact,
Malone continues to be litigated with regards to suitability issues.
American Equity (AEL/$11.81/Strong Buy) is a named defendant in this case.
Malone, the U.S. District Court for the Western District of Kentucky used two guideposts, the language of the Securities Act of 1933 itself as well as SEC "Safe Harbor" Rule 151.
Sec. 3(a)
To paraphrase the Securities Act (to quote verbatim would be way too long), Sec. 3(a) 10 states that any security approved by an insurance commissioner (among others) is exempt. Sec. 3(a) 8 states that any insurance, endowment policy or annuity contract issued by a corporation subject to the supervision of the insurance commissioner (again among others) is exempt.
However, and rightfully so, the U.S. Supreme Court has acknowledged that just because an insurance
company calls something an annuity doesn't make it so. The court emphasized substance over form. Two cases are of key importance and are cited in Malone.

S.E.C. v. VALIC: Who has the Risk?
In S.E.C v. VALIC (1959), the court decided that a variable annuity was in fact a security. The court noted that "benefit payments vary with success of the investment policy" and "the holder of a variable annuity cannot look forward to a fixed monthly or yearly may be greater or less depending on the wisdom of the investment policy." The court also stated that, "In hard reality, the issuer of a variable annuity that has no element of a fixed return assumes no true risk in the insurance sense."
VALIC, the court asks two key questions: 1) Can the holder of an annuity look forward to a fixed monthly or yearly amount upon annuitization, and 2) does the insurer bear the risk of the product underperforming? If the answer is yes to both, than the product is a fixed annuity and exempt from registration. If the answer is no to either question, then we have a variable annuity.

SEC v. United Benefit Life: Promises, Separate Accounts and Marketing
In SEC v. United Benefit Life (1967), the court decided that the legal analysis of whether an annuity
constituted a security should proceed in two parts if there was direct investment of the principal during the accumulation phase coupled with a minimum guaranteed payout at the end of the contract term. As an aside, it is interesting to note that the GMIB product was invented in the 1960's; there really is nothing new under the sun.
United Benefit Life, the court also asked two key questions with regards to the accumulation phase of an annuity:
1) Does the insurer promise the policyholder a fixed amount of his savings plus interest, and 2) are
assets placed in a general account and does the insurer have a dollar target to meet? If the answer is yes to both, then the product is a fixed annuity exempt from registration.
The court, in finding that the United Benefit Life product was a variable annuity, noted that there was no
guarantee of savings plus interest and that customer assets were placed in a separate account.
United Benefit Life, the court also touched on how the product was sold, noting that the UBL product was pitched to the consumer interested "in growth through professionally managed investment." The court noted that in a prior case SEC v. Joiner Leasing Company (1943), it had decided that, "The what character the instrument is given in commerce by the terms of the offer, the plan of distribution and the economic inducements held out to the prospect. In the enforcement of an act such as this it is not inappropriate that promoters' offering be judged as being what they were represented to be." Basically, if a product is sold as an investment, it's an investment.

Malone v. Addison Insurance Marketing: AEL Index Annuities Exempt Under Securities Act
Referring back to Malone, the judge found that the American Equity index annuity was exempt from
registration under the Securities Act.
First, the judge noted that, per Sec 3(a) 8, American Equity (a defendant in the case) was subject to the
supervision of an insurance regulator and that its index annuity was subject to the approval of an
insurance commissioner per 3(a) 10.
Second, the district court also found that the plaintiff's effort to have her American Equity contracts declared as variable annuities failed for two reasons: (1) By guaranteeing the plaintiff a minimum 3% return irrespective of the performance of the S&P 500 index, the district court found that American Equity took the investment risk and not plaintiff who stood to be credited 3% annually no matter how the market performed; and (2) Annuitization payments were fixed in advance. Thus, both questions in
VALIC were answered properly.
Third, the district court found that American Equity did promise the plaintiff a fixed amount of her savings plus interest (the return of premium plus 3% annually credited interest less any surrender charges) and that her assets were not kept in a separate account - "the keystone characteristic of all variable annuity contracts" according to the judge. Thus, both key questions asked in
United Benefit Life were answered in the affirmative.
Fourth, the plaintiff's argument that her return over and above the minimum guarantee was variable, and thus did involve an element of risk and uncertainty, was found to be inconclusive. American Equity was found to bear substantially more risk as it can actually take a loss on the product if it was unable to surpass the minimum guaranteed crediting rate in its own investments. On the other hand, plaintiff's risk was not that she would lose the value of her initial investment, but rather the risk that had she chosen a different contract her money might have been worth more." Again, according to the judge, "That type of risk - that she could have gotten a better deal but for the pressure she encountered to enter into this particular contract - is not the type of risk central to determining whether a security exists.”
Interestingly, the district court said it could end its deliberation there and find that the "plaintiff's American Equity contracts are more like 'fixed annuities' and therefore are excluded from the definition of 'security' under the Supreme Court's opinions in
VALIC and United Benefit" without considering how the product was sold.

SEC Safe Harbor Rule 151: AEL Index Annuities Also Exempt
However, the district court did decide to continue and examine SEC Safe Harbor Rule 151. SEC Safe
Harbor Rule 151 was adopted in 1986 to quickly deal with the issue of what is and isn't a security under the Securities Act. The rule reads as follows:
Any annuity contract or optional annuity contract (a contract) shall be deemed to be within the
provisions of section 3(a)(8) of the Securities Act of 1933 (15 U.S.C. 77c(a)(8)), Provided,
(1) The annuity or optional annuity contract is issued by a corporation (the insurer) subject to
the supervision of the insurance commissioner, bank commissioner, or any agency or officer
performing like functions, of any State or Territory of the United States or the District of
Columbia; (2) The insurer assumes the investment risk under the contract as prescribed in paragraph (b)
of this section; and (3) The Contract is not marketed primarily as an investment
Criterion 1 was, of course, easily satisfied.
Criterion 2 is met if:
(1) The value of the contract does not vary according to the investment experience of a
separate account;
(2) The insurer for the life of the contract
(i) Guarantees the principal amount of the purchase payments and interest
credited thereto, less any deduction (without regard to its timing) for sales
administrative or other expenses or charges; and
(ii) Credits a specified rate of interest (as defined in paragraph (c) of this
section) to net purchase payments and interest credited thereto; and
(3) The insurer guarantees that the rate of any interest to be credited in excess of that
described in paragraph (b)(2)(ii) of this section will not be modified more frequently than
once per year.
Subcriterion (1) was satisfied as funds are commingled. Plaintiff's funds are not invested in a
separate account. Subcriterion (2) was satisfied as the district court found that the American Equity
contracts did guarantee the principal amount of the purchase payment and interest credited and that a
specified rate of interest was stated. Subcriterion (3) was met as participation rates -which determine excess credited interest above the minimum 3%- are changed only once per year.
Having found the first two criteria satisfied, the judge went on to Criterion 3 and contrasted the Supreme
Court's findings in
United Benefit Life to that of another case - Otto v. Variable Annuity Life Ins. Co. (1987) decided by the Seventh Circuit Court...
…The Supreme Court cited United Benefit's reliance on the possibility of investment
return as evidence of an "appeal to the purchaser not on the usual basis of stability and
security but on the prospect of 'growth' through sound investment management." In
contrast, in
Otto, the Seventh Circuit concluded, "Although the award of discretionary
excess interest and VALIC's investment experience were given some emphasis, the fixed
annuity ... was marketed primarily on the basis of its stability and security." 814 F.2d at
Thus, the judge wrote that his court must determine if American Equity's marketing emphasis was more
clearly related to the prospects of growth or to that of stability.
While the judge noted that plaintiff was correct that, "...the American Equity brochure and contract made reference to the success of the American Equity portfolio and that it advertised the S&P 500 indexing
feature," he also noted that this can be done in "the context of assuring the security of an annuitant's premium."

The district court, in deciding that American Equity had satisfied criterion 3, noted that while the company promised "sound financial management," it did so only in the context of "...explaining that the company promises flexibility and stability."
In addition, the district court found that the contract itself states plainly just before plaintiff's signature, "[I] understand that past S&P 500 Index activity is not intended to predict future activity and that the S&P 500 Index does not include dividends." Further, the judge noted that the one-page summary plaintiff signed, which focused on how her contract value was calculated at any one point to assure her the initial principal plus interest,"...did not emphasize the potential increase in her assets, but focused on explaining to her that she was guaranteed her principal plus three percent interest.”
Thus, having decided that criterion 3 was met, the district court found that the American Equity product had satisfied all three criteria necessary under Rule 151 and was also exempt from registration under this basis.

Our Take: Registration Fears Overblown
We believe that the key consideration going forward will be the third criterion of Rule 151 - whether or not an index annuity product is marketed as an investment - as the first two criteria are easily met.
The decision by the district court in
Malone should not be surprising. SEC Rule 151 is nearly 20 years old and the VALIC and United Benefit Life cases were decided before many of today’s investment professionals were born. The management team at American Equity is experienced and intelligent - as are the teams at other major index annuity providers we cover like AmerUs (AMH/$47.77/Outperform), FBL Financial (FFG/$28.08/Market Perform) and Jefferson-Pilot (JP/$50.91/Underperform). All are aware of Rule 151 and have the ability to develop their marketing programs and literature appropriately.
If the SEC cannot require registration of index annuities on criteria 1 and 2, it strikes us that it would have to do so ad hoc - looking at the particulars of the marketing for each individual contract - to make a case based on criterion 3.
Admittedly, we’re not securities lawyers and try to stay as clear from the SEC as humanly possible, but we can’t imagine that this is something that the agency would particularly like to do. Hence, we don’t see registration of index annuities as a major threat to this fast growing segment of the insurance industry.
Posted with permission from the author 8/23/05.
Specific Investment Risks Related to the Industry or Issuer
Life and Health Insurance Industry Risks
Life and Health Insurers face many risks including but not limited to poor equity market performance (and the related
effect on fees, guaranteed minimum death benefit reserves, and deferred acquisition cost amortization), interest spread
compression, deteriorating credit quality, adverse mortality and morbidity experience, and continuing pressure from rating
agencies. Providers of tax-deferred asset accumulation products face uncertainty in the face of passage of the dividend
tax cut, which could lead to a decline in sales as insurance products would, to some extent, lose the advantage of taxdeferral
over equity mutual funds and direct equity investment.
Investors should consider this report as only a single factor in making their investment decision.
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Last Updated: 8/23/2005 1:19:00 PM