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Insurance Companies Take Steps to Reduce Their Risks Under Guarantees in Outstanding Variable Contracts

The 2008-2009 financial crisis, ongoing market volatility and persistently low interest rates have significantly increased the risks and costs to insurance companies of the lifetime income guarantee provisions in their variable annuity contracts.  Insurance companies have responded in a number of ways.  Some have exited the variable annuity market altogether.  Others have redesigned the products they offer by reducing guarantee rates, increasing fees, limiting available investment options and/or tightening asset allocation programs.

A few have taken steps recently to reduce their risks under outstanding contracts by:

  • refusing to accept additional purchase payments from existing contract holders;1
  • offering incentive payments to terminate lifetime income riders or exchange into new contracts with less generous benefits; 2 or
  • offering to buy-out contracts in exchange for an “enhanced” surrender value.3

These strategies raise a number of issues, including certain issues under the federal securities laws.  As noted by Norm Champ, the Director of the SEC’s Division of Investment Management (the Division), these include suitability and the adequacy of risk disclosure.4   For variable annuity contracts that involve registration under the Securities Act of 1933 (1933 Act) and the Investment Company Act of 1940 (1940 Act), other issues include determining the appropriate manner of reflecting the strategy in 1933 Act registration statements and complying with 1940 Act provisions governing contract exchanges.

1933 Act Filings

A company pursuing one of these strategies will have to reflect it in the offering documents for the affected contracts.  Recent SEC filings suggest that a decision to no longer accept purchase payments from existing contract holders may be included in a 1933 Act Rule 497 supplement, 5 which typically is not reviewed by the SEC staff and may be used as soon as filed with the SEC, while offers of incentive payments to exchange or buy-out contracts should be filed as 1933 Act Rule 485(a) post-effective amendments,6 which are subject to SEC staff review and become effective after 60 days unless accelerated by the staff.

Suitability

Sales of variable annuity contracts are subject to Financial Industry Regulatory Authority (FINRA) Rule 2111, the general suitability rule, and FINRA Rule 2330, which applies specifically to sales and exchanges of variable annuities.  Rule 2330 requires that a selling broker-dealer have a reasonable basis to believe that the customer has been informed of, and would benefit from, the various contract features, and that the particular contract as a whole (including any riders) is suitable for the particular customer.  In the case of a contract exchange, the suitability determination must also take into account whether the customer would incur surrender charges, be subject to a new surrender period or increased fees or charges or lose existing benefits, and whether the customer would benefit from product enhancements and improvements in the new contract.

The SEC staff has stated that offers to exchange existing contracts for newer contracts offering less generous benefits, as well as offering incentive payments for the surrender of a contractor the termination of guaranteed benefit riders, raise suitability questions.  Susan Nash, the Associate Director of the Division, has pointed out that, while such exchanges might benefit contract owners who do not expect to take advantage of a living benefit, they would not be advantageous for contract owners who expect to use the more generous living benefits of existing contracts.  She has urged close scrutiny of exchange transactions from the investor’s viewpoint:“ what precisely is being givenup and are the forgone features of the old contract outweighed by the benefits offered in the new contract?”7   Director Champ has suggested that such exchanges or buy-outs raise suitability questions with respect to both the original variable annuity sale and the exchange“ where the original transaction was perhaps premised on the value and importance ofthe living benefits and the exchange removes or reduces those same benefits.”8

Disclosure

Before pursuing one of the strategies, a company should consider the potential impact of the presence or absence in its current prospectus of disclosures regarding the risk that it might, under future market or other conditions, cease accepting purchase payments or offer contract holders incentives to surrender certain benefits.

Recent specificdisclosures in 1933 Act filings regarding the strategies have included:

  • why an offer to terminate a guaranteed benefit rider is being made (e.g., “high market volatility, declines in the equity markets and the low interest rate environments make continuing to provide the [guarantee] costly to us”);
  • the manner in which an incentive amount will be calculated (includingexamples);
  • how a contract holder should evaluate an offer and thefactors to be considered (including circumstances under which the offer should not be accepted); and
  • how an offer may benefit both the insurer and the contract holder (e.g., the insurer would benefit financially because it would no longer incur the cost of maintaining expensive reservesfor the guarantees, and the contract holder would benefit by receiving an increase in the surrender value of the contract and by reduced fees under the contract).

Exchange Offers

An offer to exchange a registered variable annuity contract for another such contract issued by the same or an affiliated insurance company is subject to Section 11 ofthe 1940 Act.  Under Section 11, which is intended to prevent “switching” of investment company securities for purposes of generating additional charges, the exchange offer must either be approved by the SEC or qualify for the exemption from this requirement provided by Rule 11a-2.  The Rule 11a-2 exemption requires that the exchange be made on the basis of relative net asset values and imposes certain limits and conditions on associated administrative fees and sales charges.  To avoid having to obtain an SEC exemptive order, an insurer making an exchange should carefully comply with Rule 11a-2 requirements, including considering under what circumstances offering incentive payments could be viewed as making an offer on a basis other than relative net asset values.

Conclusion

An insurer that wishes to take steps to reduce the risks of the lifetime income guarantees under its outstanding variable annuity contracts should consider whether its proposed course of action is permissible under the terms of the contracts, the impact of disclosures in its existing prospectuses, the new disclosures that will be required and the suitability and other compliance issues that may arise under the federal securities laws. 


1   See Prudential Annuities Life Assurance Corporation Variable Account B, Prospectus Supplement dated Aug. 23, 2012 (“Restrictions on Additional Purchase Payments”) (File No. 333-152411).

2   See Separate Account VA B ofTransAmerica Life

Insurance Company, Post-Effective Amendment No.

41 (filedFeb. 24, 2012) (File No. 33-56908).

3  See Hartford Life Insurance Company Separate Account Three, Prospectus Supplement dated Dec. 28, 2012, (“Enhanced Surrender Value Offer for Eligible Contracts with the Lifetime Income

Builder II Rider” (filedNov. 1. 2012) (File No. 333-119414).

4   Norm Champ, Director, Division ofInvestment Management, SEC, “Remarks to the ALI-CLE Conference on Life Insurance Products” (Nov. 1, 2012).  The Director also indicated SEC staff concernwhether particularactions,suchasrefusingadditional purchasepayments, are permitted under the terms ofthe applicable contract.

5   See note 1 above.

6   See notes 2 and 3 above.

7   Susan Nash, Associate Director, Division ofInvestment Management, SEC, “Remarks to the IRI 2012 Government and Regulatory Affairs Conference” (Jun. 26, 2012).

8    See note 4 above.

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