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Are Index Annuities Securities?

The sentiment seems to be to exempt index annuities from being treated as registerable securities.

Judith A. Hasenauer, 07/01/2010

We have written in the past about the issue of whether index annuities are or aren't registerable securities. This controversy has been raging ever since the product first struck the market. Index annuities typically pay a return that is pegged to an index--usually an index that tracks publicly traded securities. Unlike variable annuities, however, index annuities use a formula that provides the contract owner with all or some portion of the index's results, but with a guaranteed floor that is provided by the issuing insurer. SEC and FINRA expressed concerns that index annuities bore such a resemblance to securities that they should be treated as such for purposes of federal securities laws.

This concern resulted in the promulgation of a rule (Rule 151A) that would clarify the status of index annuities and would determine the majority to be registerable securities. Insurers and others involved in the index annuity business forcefully resisted the proposed rule both in court and by initiation of political action to rescind any determination that index annuities should be treated as registerable securities. The court actions produced an equivocal result whereby the court determined that it would defer to the expertise of the SEC in its determination that index annuities are securities, but required the SEC to giver greater attention of the economic impact of implementation of the rule.

Those involved in the index annuity business have always taken the position that the product did not meet the definition of a registerable security because of the guarantees provided in the products. Annuities have long been exempt from the registration provisions of federal securities laws under the provisions of Section 3(a)(8) of the Securities Act of 1933. This section exempts insurance, endowment and annuity contracts from the registration provisions that apply to other forms of investment. For more than 50 years, variable annuities have been required to be registered as securities despite the Section 3(a)(8) exemption because of the decision of the United States Supreme Court in SEC v. VALIC. This case determined that variable annuities were not eligible for the exemption from registration afforded annuities in general because variable annuities were not the type of annuities that Congress intended to exempt when the exemption was first implemented. The Court reasoned that, since a variable annuity did not guarantee principal and interest by the issuing insurer, the entire investment risk was transferred from the insurer to the contract owner and that such a transfer of risk negated the basic purpose behind the annuity exemption. Insurers issuing index annuities held to the belief that since index annuities guaranteed both stated principal and a minimum rate of interest, there was no shift of investment risk as enunciated in VALIC. The SEC disagreed, and this resulted in the publication of Rule 151A that would require most index annuities to be treated as registerable securities and would also subject sales personnel to the licensing requirements imposed on sellers of securities.

In the intervening years since the VALIC decision, there have been many innovations in the annuity business involving both variable annuities and new forms of nonvariable products. The index annuity is but one of these innovations. With each wave of product innovations there has come the question as to the status of the products under federal securities laws. Many variable annuities now include a number of elements of guarantees that it is sometimes argued that the criteria set forth in VALIC no longer apply. It is doubtful if the SEC would agree and no one in the industry seems willing to test the question in the courts.

Recent developments on the political front may well settle the question whether index annuities will be treated as securities for purposes of federal securities laws. The Financial Regulatory Reform Conference approved an amendment that would, in effect, prevent the SEC from implementing the rule that would require index annuities to be treated as registerable securities. At the present time, it looks likely that this provision will be a part of the current bill under consideration. However, it also appears that there are serious problems facing the enactment of the Financial Regulatory Reform bill in its present format. Thus, whether the prohibition on the SEC to keep it from adopting Rule 151A is still up in the air.

Despite the fact that it is still unclear what legislation, if any, will be enacted affecting index annuities, it is useful to look at the provisions of the Conference amendment to understand the thinking of the Congress with respect to this issue. The amendment approved by the Conference provides that the SEC must treat as "exempt" securities under the provisions of Section 3(a)(8) of the Securities Act an insurance or endowment policy or annuity contract where the value of the contract does not vary according to the performance of a separate account and that satisfies the standard non-forfeiture laws of the applicable state or, if the applicable state does not have standard non-forfeiture laws, that satisfies the Model Laws published by the National Association of Insurance Commissioners. In addition, in order for the annuities to be exempted, there must also be in place suitability standards applicable to the sale of the product. These suitability standards must meet or exceed the suitability standards published by the NAIC.

Regardless of what happens to financial regulatory reform in Congress over the next few days, the sentiment seems to be to exempt index annuities from being treated as registerable securities. There is always the possibility that the exemption could be lost in the political compromises that are likely to take place in the immediate future. However, the mere fact that Congress has gotten as far as it has with respect to this issue should give some idea to the SEC as to the state of the issue.

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