SEC Proposes Rule That Would Require Equity Index Annuities to Be Registered Securities
What This Means
The Securities and Exchange Commission (SEC) has proposed a rule which, if adopted, is expected to require all insurance companies issuing equity index annuities (EIAs) to register them as securities under the Securities Act of 1933 and sell them pursuant to a prospectus. An EIA is an annuity that provides annual interest equal to some or all of the return of a specified securities index, such as the S&P 500, or a minimum percentage rate specified in the annuity contract, whichever is greater. Insurance agents who currently can sell EIAs with a state insurance license would have to pass FINRA tests and become registered representatives associated with a broker-dealer. EIA sales practices would become subject to the antifraud provisions of the securities laws, including Rule 10b-5. Given the current uncertainty as to how the law applies to EIAs, the proposed rule would not apply retroactively, but only to EIA sales after a rule is adopted. The proposed rule does not address the status of general account life insurance products whose return is index-based.
Prompted by apparently abusive sales practices, including free lunch seminars used to sell EIAs to senior citizens for whom the purchase is unsuitable, on June 25 the SEC unanimously approved Proposed Rule 151A, which would define which EIAs are securities. The key element of the test is whether the return that the annuity owner receives, based on the index return, is more likely than not to exceed the minimum percentage rate specified in the contract. Based on initial discussions with insurance companies, it appears that, in almost all EIAs currently offered, the index return is the one the annuity owner is expected to receive. Accordingly, EIAs would need to be registered under the Securities Act.
Discussion and Analysis
At the time an annuity owner purchases an EIA, the purchaser assumes the risk of an uncertain financial instrument in exchange for a future securities-linked return. The value of such an EIA fluctuates based on the volatility of the securities market. While EIA contracts provide some protection against the risk of loss, they do not eliminate an annuity owner’s exposure to investment risk. Therefore, the protections provided for by EIAs may not adequately transfer investment risk, and the amounts paid by the annuity owner are more likely than not to exceed the amount guaranteed under the contract. Thus, a purchaser’s investment is more likely than not to depend on the volatility of the underlying securities index, thereby exposing the annuity owner to risks and benefits similar to what other securities investors are confronted with.
“More Likely Than Not” Test
- Proposed Rule 151A provides that a determination of the “more likely than not” test be made by the insurer at or prior to issuance of a contract, provided that (i) both the insurer’s methodology and the insurer’s economic, actuarial, and other assumptions are reasonable; (ii) the insurer’s computations are materially accurate; and (iii) an initial determination is made not earlier than six months prior to the date on which the form of contract is first offered, with periodic redeterminations not more than three years prior to the date on which a particular contract is sold to a purchaser.
- If an insurer believes an indexed annuity is entitled to the exemption under Section 3(a)(8), the insurer bears the burden of proving that the exemption applies.
Exemption from Exchange Act Reporting
The Commission is also proposing a new rule, Rule 12h-7, which would provide insurance companies with an exemption from Exchange Act reporting, e.g., 10-Ks and 10-Qs, regarding indexed annuities and other securities that are registered under the Securities Act and regulated as insurance under state law. This rule is being proposed because these assets are regulated under state insurance law, and there is an absence of trading interest in these securities. Applying both state insurance law and Exchange Act reporting could result in unnecessarily costly duplicative regulation.
Effect on Broker-Dealers
Under proposed Rule 151A, persons effecting transactions in indexed annuities that fall outside the scope of the insurance exemption would be required to be registered broker-dealers, or become associated persons of a broker-dealer through a networking arrangement. Thus, the selling broker-dealer and its registered representatives would be subject to the oversight of FINRA.
To view the SEC’s proposal, please visit http://www.sec.gov/rules/proposed/2008/33-8933.pdf.
How Morgan Lewis Can Help
If you have any questions concerning these important legal developments, please contact either of the following Morgan Lewis attorneys:
Washington, D.C.
Michael Berenson
202.739.5654
mberenson@morganlewis.com
Chris Menconi
202.739.5896
cmenconi@morganlewis.com