Besides being governed by the state regulatory framework, absent an exemption, variable annuities are regulated as securities under the federal securities laws. The primary federal securities laws that regulate variable annuities and the separate accounts through which they are issued are the Securities Act of 1933 (1933 Act), the Securities Exchange Act of 1934 (1934 Act), and the Investment Company Act of 1940 (1940 Act). The SEC administers these acts. Fixed annuities, with which the insurance company guarantees a specific rate of return to the contract owner, generally are not subject to these laws. In addition, the Dodd-Frank Act (which is discussed below) effectively exempts fixed indexed annuities from the 1933 Act, subject to compliance with certain conditions.
In summary, the federal securities laws require that certain disclosure documents, including a prospectus and certain periodic reports, must be filed with the SEC and given to investors. In addition, written marketing materials such as advertisements are subject to regulation under SEC and FINRA rules. These requirements are discussed in more detail on the following pages.
Securities Act of 1933
Because variable annuities are securities, they must be registered with the SEC under the 1933 Act before they can be offered to the public (with two exceptions noted below). The SEC staff reviews and comments on registration statements, which usually must be amended in response to staff comments before they will be declared effective. (The SEC does not, however, approve or disapprove of any securities, including variable annuities, and does not pass on the accuracy or adequacy of any prospectus.) A “post-effective” amendment updating the variable annuities registration statement generally must be filed at least annually.
The first registration exception is for variable annuity contracts issued in connection with certain qualified plans, such as 401(k) plans. The second exception is for private placement variable annuities, which are contracts that, among other things, are offered only to sophisticated investors who meet certain requirements under the federal securities laws (and not to members of the general public). Even with these exceptions, however, issuers and others involved in marketing non-registered variable annuities remain subject to the anti-fraud provisions of the 1933 Act.
When someone purchases a registered variable annuity, he or she receives a prospectus. Prospectuses are updated regularly. Separate prospectuses describe underlying investment options—the funds to which the purchaser may allocate his or her investments. This can result in a purchaser receiving numerous prospectuses. However, in 2009, the SEC adopted a rule permitting the delivery of “summary prospectuses” for mutual funds, which are shorter and intended to be more “user-friendly” than full fund prospectuses. The SEC staff is also considering a similar rule that would allow the use of summary prospectuses for variable annuities.
Disclosure of Fees and Expenses
Variable annuity prospectuses contain fee tables that disclose the maximum guaranteed charge for all contract transaction expenses and recurring charges. These amounts are expressed in dollars or percentages of the contract value so purchasers will know what they will pay if they buy the contract. The fee tables also list the range of total operating expenses for the underlying funds offered by the contract. In addition, variable annuity prospectuses contain numerical examples showing in dollars per $10,000 what a hypothetical contract owner would pay for the contract and the maximum fees and expenses charged by any of the funds over one-, three-, five-, and 10-year periods. These examples assume a 5% return and that the contract is surrendered at the end of the relevant period. Additional examples are required that assume the investor does not surrender the contract if a sales load or other fee is charged upon surrender. This format shows the effect of any surrender charge.
Securities Exchange Act of 1934
The 1934 Act generally requires variable annuities to be distributed through registered broker-dealer firms and their registered representatives. Broker-dealers and their representatives are subject to extensive operational and financial rules that cover minimum net capital requirements, reporting, recordkeeping, supervision, advertising, and sales activities.
In addition to the broker-dealer regulatory framework established by the 1934 Act, registered broker-dealer firms that sell variable annuities also must be members of FINRA. FINRA is a self-regulatory organization overseen by the SEC. It has an extensive body of rules with which broker-dealers must comply. For example, examinations are required; fingerprints must be provided; and numerous supervisory, suitability, advertising, recordkeeping, and reporting rules apply.
A 1934 Act rule requires broker-dealers to send confirmation statements to contract owners after each purchase and sale transaction made involving a variable annuity contract. In addition, insurance companies send contract owners periodic account statements showing a beginning balance, transactions during the period, and an ending balance so that the owner will have a record of all activity in his or her contract.
Investment Company Act of 1940
The 1940 Act imposes an extensive federal regulatory structure on investment companies, including variable annuity separate accounts and underlying funds. (Some separate accounts and funds however, such as those used in connection with tax-qualified retirement plans, are not subject to the 1940 Act.) For example, the Act governs how variable annuities and shares of underlying funds are issued and redeemed. There are also corporate governance requirements and prohibitions against self-dealing.
Each separate account regulated under the 1940 Act must file a report on its operations annually with the SEC. In addition, an annual and semi-annual report containing information about the underlying mutual funds that serve as investment options for the variable annuities must be sent to contract owners. In some cases, these reports also contain information on the variable annuities themselves.
The SEC follows a risk-based approach in inspecting variable annuity separate account operations. The SEC and FINRA also inspect various locations, such as broker-dealer branch offices, from which variable annuities are sold. Recommendations are made and any deficiencies are noted. If the situation is serious enough, it may lead to regulatory enforcement.
Regulation of Fees and Charges
Currently, the SEC does not regulate individual variable annuity fees and charges. However, the 1940 Act makes it unlawful for any registered separate account funding variable annuity contracts, or for the sponsoring insurance company, to sell any such contract unless the fees and charges deducted under the contract are, in the aggregate, reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company. The insurer must represent in the annuity contract’s registration statement that the fees and charges are reasonable.
SEC and FINRA Rules Governing Advertising and Communications With the Public
SEC rules govern variable annuity advertising. Among other things, if past performance of a fund or variable annuity is presented, performance must be calculated according to standardized formulas. “Non-standardized” performance may also be shown, but must be presented along with standardized performance. In addition, if an advertisement contains performance information, total returns current to the most recent month end must be made available within seven business days of the end of the month at a toll-free or collect telephone number or on a website.
FINRA rules govern broker-dealer communications with the public about variable annuities. Broker-dealer firms that disseminate retail communications about variable annuities must file these communications with FINRA and take into account comments provided by FINRA staff.
Use of Social Media
Both the SEC and FINRA, as well as state insurance regulators, have taken a keen interest in the use of social media by financial services firms, including insurance companies and insurance producers. In January 2012, the SEC issued four pronouncements relating to social media: an Investor Alert that warns investors to use caution using social media when considering an investment; an Investor Bulletin that provides investors with a number of tips when establishing an account on a social media website, such as Facebook or Twitter; a National Examination Risk Alert, which identifies a list of 13 factors pertaining to social media for investment advisors to consider in evaluating the effectiveness of their compliance programs; and an SEC Order instituting administrative and cease-and-desist proceedings against a registered investment advisor alleging that the advisor made fraudulent offers of securities through social media websites and engaged in other federal securities law violations.
Similarly, in 2010 and 2011, FINRA issued a pair of regulatory notices that provide guidance on the application of FINRA rules governing communications with the public to the use of social media sites, including blogs and social networking sites, by member firms and registered representatives. Among other things, these notices address responsibilities with respect to recordkeeping; suitability; third party posts, links, and content; interactive electronic forums; supervision; and personal communications and other devices.
FINRA Suitability Rule for Deferred Variable Annuities—Rule 2330
FINRA Rule 2330 imposes a wide range of requirements tailored specifically to deferred variable annuity transactions, including suitability, principal review, supervision, and training. This Rule provides that, in recommending a deferred variable annuity, a registered representative must have a reasonable basis to believe that (a) the customer has been informed in general terms of various features of a deferred variable annuity; (b) the customer would benefit from certain features of deferred variable annuities, such as deferred growth, annuitization, or a death or living benefit; and (c) the particular deferred variable annuity as a whole, the underlying subaccounts to which funds are allocated, and riders and product enhancements, if any, are suitable for the particular customer based on required customer information. These specific requirements are in addition to the requirements of FINRA Rule 2111 governing suitability generally. As discussed above, the NAIC Suitability Model is patterned after FINRA’s suitability standards.
Dodd-Frank Act Reforms
The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in 2010, includes comprehensive and far-reaching reforms in the regulation of the financial services industry, including insurance companies that issue annuities and the financial intermediaries that sell them. Many of these reforms are predicated on further study and rulemaking by various federal agencies, such as the SEC. Some recent developments include the following:
Federal Insurance Office
The Dodd-Frank Act created a Federal Insurance Office within the Treasury Department to monitor all aspects of the insurance industry and to identify issues or gaps in insurance regulation that could contribute to a systemic crisis in the insurance industry or the U.S. financial system. The Dodd-Frank Act required the Federal Insurance Office to report to Congress on how to improve and modernize the system of insurance regulation in the United States by January 21, 2012. As of the date of publication, the Federal Insurance Office has not issued this congressionally mandated report.
Fiduciary Standard of Care
The Dodd-Frank Act directed the SEC to study the effectiveness of the current standard of care for broker-dealers and investment advisors in providing personalized investment advice and recommendations about securities to retail customers. It also empowered (but did not require) the SEC to subject broker-dealers to the same standard as investment advisors when providing such personalized investment advice to retail customers. To harmonize enforcement, the Dodd-Frank Act directed the SEC to prosecute and sanction violators of the standard, whether broker-dealers or investment advisors, to the same extent. In January 2011, the SEC staff issued a study in which it recommended that the SEC exercise its rulemaking authority to implement a uniform fiduciary standard of conduct for broker-dealers and investment advisors when providing personalized investment advice about securities to retail customers. The uniform fiduciary standard would require broker-dealers and investment advisors to act in the best interest of the customer without regard to the financial or other interest of the broker-dealer or investment advisor providing the advice. In December 2011, in testimony before Congress, then SEC Chairwoman Mary Schapiro stated that the SEC staff was working on a rule following on the study. In January 2012, Congressman Scott Garrett, Chairman of the House Subcommittee on Capital Markets and Government Sponsored Entities, inquired about the progress of SEC economists in gathering, reviewing, and analyzing the data and information necessary for a meaningful consideration of potential standard of conduct regulations. Schapiro responded that the SEC staff was drafting a public request for information to obtain data pertaining to the provision of retail financial advice and the regulatory alternatives. To date, the SEC has not issued such a public request for information.
Swaps and Other Derivatives
The Dodd-Frank Act established a new comprehensive framework for the regulation of swaps and other derivatives, with potential implications for financial companies, such as insurers, that use derivatives for hedging or other investment purposes. The SEC and the Commodity Futures Trading Commission (CFTC) are responsible under the Dodd-Frank Act for promulgating regulations to implement the new framework. In July 2012, the SEC and CFTC jointly adopted regulations and interpretations that provide a non-exclusive safe harbor that excludes variable life insurance and annuity products from the definition of “swap” and “security-based swap.”
Financial Literacy Report
As required by the Dodd-Frank Act, in August 2012, the SEC submitted to Congress a report on its study of financial literacy and disclosure improvement. Among other things, the report concluded that retail investors lack basic financial literacy and have a “weak grasp of elementary financial concepts.” The report also noted that investors prefer receiving information before making an investment decision. Regarding the format of disclosures, the report noted that investors favor “’layered’ disclosure and, wherever possible, the use of a summary document containing key information about an investment product or service.”
In May and December 2012, FINRA staff published notices providing substantive guidance, in question and answer format, on the suitability obligations of member firms and registered representatives under new FINRA Rule 2111, including with respect to hold recommendations, implicit recommendations, investment strategies, non-securities products, and recordkeeping, among other things.