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California Joins the Suitability Group for Annuities

It is only a matter of time before suitability screening will be in place in all jurisdictions in this country.

Judith Hasenauer, 09/01/2011

Have a comment, insight, or burning opinion on this article? Make your feelings known in the comments section at the end of the article.

The California Legislature has passed a form of the NAIC's model annuity suitability law that will probably be signed by Governor Jerry Brown in the next few days. With the nation's most populous (and the largest market for financial products) state joining the group of states that have enacted suitability requirements for the sale of annuities, all sellers of these products need to be sure they have effective suitability screening procedures in place.

It is only a matter of time before suitability screening will be in place in all jurisdictions in this country. The Dodd-Frank financial industry reform law passed last year effectively mandated that the states implement some form of suitability screening requirement for annuities if they were to retain jurisdiction over the product.

There are no profound changes from the NAIC model to the California version of the law. The law applies to all annuities--variable and fixed--but carves out suitability screening for variable annuities where FINRA member broker-dealers have suitability procedures that comply with FINRA suitability rules. Although the new law permits FINRA broker-dealers to take care of suitability screening, it is not totally clear whether this exemption applies only to variable annuities or also applies to fixed annuities that are sold through a FINRA broker-dealer. We have noted that in the past few years more and more broker-dealers require that all annuity transactions undertaken by their registered representatives be placed through the broker-dealer and be subject to the training, supervision, and suitability requirements put in place by the broker-dealers in conformity with FINRA rules.

We have also noted that many individuals who are significant sellers of fixed annuities--particularly indexed annuities--have been reluctant to place their fixed annuity sales through their broker-dealers. We do not believe that this reluctance has as much to do with broker-dealer suitability requirements as it is a reluctance to share commissions on a product that is not a security otherwise subject to sale by a broker-dealer.

Despite this reluctance by individual registered representatives to place fixed annuity sales through their broker-dealers, we have advised our broker-dealer clients that it is prudent to require all such sales to be placed through the broker-dealer and that such sales be subject to the training, supervision, and suitability requirements of the broker-dealer. We have written in the past about the overlap in litigation (including FINRA arbitrations) that has included sales of fixed annuities (particularly indexed annuities) as the subject matter of such disputes. Prudence should dictate that a broker-dealer oversee all financial dealings of its registered representatives in order to avoid vicarious liability.  

Sellers of annuities in California (as well as in most other jurisdictions that have adopted some form of the NAIC model act) will not only be subject to suitability screening requirements, but must also undergo special training in annuities. The law mandates an eight-hour training course approved by the Commissioner of Insurance. The training industry will undoubtedly provide approved courses that will satisfy this requirement. Many insurers will also provide such training courses.

Traditionally, state insurance regulators have imposed compliance requirements under state insurance law primarily on insurers licensed to do business in the state. This is because of the traditional concept that insurance sales people are "agents" of the insurer and that the insurer can therefore impose its will on such "agents." It has been many years since "captive" insurance agents were beholden solely to a specific insurer. The modern trend has been the development of independent marketing organizations that do business with a number of different insurers offering a variety of different products. Thus, the marketing organization "tail" is wagging the insurer "dog," rather than the other way around. The primary competition among insurers these days is for the producer, and insurers must be amenable to the demands of the marketing organization if they want to continue to receive the marketing organization's business. Nevertheless, insurers will need to implement procedures to support individual producers and marketing organizations in order to comply with the requirements of the law.

The California suitability requirements follow the long-standing FINRA model in that it applies only where a "recommendation" is made for the purchase of an annuity. Thus, where there are direct purchases of annuities without a recommendation, such as with direct-response sales programs, no such suitability requirement applies. The law requires an annuity salesperson to make inquiry of the customer about the customer's financial situation in order to make an intelligent suitability determination. However, the law permits a consumer to refuse to provide such information and to purchase an annuity without review of relevant information. Obviously, if a pattern exists where all customers "refuse" to provide personal information, it will clearly indicate that the suitability requirements are being subverted. Likewise, if provision of financial information is refused, there can be no basis for a recommendation to purchase an annuity.

The California law requires that the seller of annuities obtain information regarding the purchasers age, annual income, financial situation and needs (including the financial resources used for the purchase of the annuity), financial experience, financial objectives, intended use of the annuity, financial time horizon, existing assets, liquidity needs, liquid net worth, risk tolerance, tax status, and whether the purchaser has a reverse mortgage. In this connection, the California legislature also passed a new law to limit producers from implementing reverse mortgages to fund purchases of annuities.
 Annuities sold for structured settlements, for qualified pension and profit-sharing plans that are subject to ERISA, and for formal prepaid funeral contracts are also exempted from the law.

Suitability screening and supervision requirements are a fact of life. Insurers, broker-dealers and marketing organizations all have a stake in ensuring that proper procedures are in place. The California law gives the insurance regulator great latitude in enforcement of the new requirements. There will be regulations and interpretations that will evolve during the next few years. Everyone involved should stay informed about these developments and be prepared to modify programs accordingly.

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Judith A. Hasenauer, JD, CLU, is an attorney with the law firm of Blazzard & Hasenauer, P.C. She devotes her practice exclusively to the financial services industry, providing consulting on the development and regulatory clearance of products, compliance issues, distribution issues and related matters, such as advisory activities and industry initiatives.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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