Variable Insurance Products:Sales Practice Regulation

Todd Cipperman, Esq.Cipperman & Company

November 11, 2008

Overview Suitability Switching Firms State Regulation Sales Literature and Advertising Indexed Annuities Non-Cash Compensation Sales Contests Recordkeeping Compliance

Suitability: Rule 2310 “reasonable grounds” Security holdings; financial situation “reasonable efforts” to obtain

information– Financial/tax– Investment objectives– Other information

See also SEC Rule 10b-5; 17(a)(2); 10b-10

State securities statutes

Suitability: What to Consider

Investment Objectives– Disclosure of risks– Investor’s ability to understand– Influence exerted by broker– Suitability ≠ Prudence

Risk Tolerance– Wealthy ≠ More aggressive– The case of the poor, risk-seeking customer i.e. what are the

consequences– Potholes: age, concentration, margin, penny stocks

Investment Costs– See reverse churning cases– Class B shares

Solicited vs. Unsolicited orders Compensation and conflicts of interest Susan Merrill (FINRA Chief of Enforcement): target audience

is people preparing for retirement without sufficient retirement plans

Variable Annuities: Rule 2821

Rule applies to purchase/exchange of deferred variable annuities and subaccount allocations– Note NTM 97-27: Conduct Rules apply to

group variable contracts Rule does not apply

– Reallocations of subaccounts– Follow-on investments– Employer-sponsored benefit plans

No recommendation unless reasonable basis to believe transaction is suitable

Rule 2821: Suitability Customer has been informed of product features

– Surrender period and charges– Tax penalties– Fees and expenses– Insurance and investment components– Market risk– Note: Rep must understand the product

Customer would benefit from tax deferral, annuitization, death/living benefits– Note: Customer need not benefit from all features

Deferred variable annuity as a whole (including subaccounts and riders) are suitable

Rule 2821: Exchanges Consider negatives:

– Surrender charges– Loss of existing benefits– Increased fees/charges

Customer would benefit from product enhancements and improvements

Previous exchange within 36 months– Must make effort to review exchanges at

third party firms

Rule 2821: Suitability Due Diligence Age Annual Income Financial

situation Investment

experience Investment

objectives Intended use

Time horizon Existing assets Liquidity needs Risk tolerance Tax status Other information

Rule 2821: Principal Review

Before submission; within 7 days Reasonable basis that transaction is

suitable Can follow customer’s express

instructions after informed consent Documentation Modified Proposal

– Only recommended transactions– 7 days runs from date OSJ receives application– Allows firms to forward money to insurance

companies during review

Rule 2821: Procedure

Document review for Principal Written Supervisory Procedures Surveillance procedures to detect

high rates or exchanges Polices/procedures to punish reps

engaged in high rates of exchanges Training programs Effective May 5

Variable Life: NTM 00-44 Suitability

– Need for life insurance– Ability to assume investment risk– Can afford premiums

• Establish target ratios– Older customers

Document customer information Familiarity with product features/clearly explained

– Use case studies– Product brochures

Replacements– Fees, taxes– Get written consent

Financing with cash value Marketing Materials: don’t over-emphasize investments

vs. insurance

Switching Firms: NTM 07-06

Surrender charges and loads without benefit

– See also “churning” Assess suitability

– Surrender charges– Comparative fees/expenses

May be the right thing: – Client Service

• Notify customer that new firm can’t service– Better product– Not motivated by compensation

Bonus variable annuity may not be enough Privacy: See In re Next Financial (using

customer data without consent)

State Regulation E.g. Regulation 60 of NYS Insurance

Department– Replacement sales of annuity contracts– Document 2 separate interactions– Pru fined $9.5 Million in 2004

National Assn of Insurance Commissioners model regulation to protect seniors (July 2003)

Suitability: See In re Cantella (MA suit re structured products)

Do-Not-Call Statutes: See In re Morgan Stanley (using CareerBuilder list)

What you say can be used against you.– See Betz vs. Trainer Wortham: tolling statute

of limitations for re-assuring clients

Sales Literature & Advertising(IM-2210-2 and NtM 08-39) NtM 08-39: Aggregate and clear guidance summarizing past

interpretations Can’t imply that VA is a mutual fund or is a short-term, liquid

investment Full disclosure on Riders and Guarantees

– Can’t exaggerate ins. co.’s financial strength– Explain costs and features– Note that Rider is optional

Performance rules same as mutual funds– 1, 5, and 10 year performance– Compare to index– Impact of fees, expenses, etc.– “Past performance is no guarantee of future results.”

Can show predecessor and combined historical performance so long as limits on performance are fully described

– When investment option became available– No significant changes to investment objectives

Illustrations– Must show 0% and no more than 10%– Must use real tax rates when showing benefits of tax deferral and compounding– Show deduction of charges

Indexed Annuities

SEC proposal to treat Indexed Annuities as securities– Primary risk of return on the

purchaser Effect

– Licensing of Reps.– Disclosure, antifraud, sales practices

Comments pending

Non-Cash Compensation: Rule 2820

No paying or receiving gifts > $100 Occasional Meals/sporting events/entertainment: can’t

raise question of “propriety”– But see IM 3060 requiring specific policies and

procedures to include dollar limits, prohibitions on quid pro quos

Business development tools permitted– Lead lists– Software

Reimbursement of travel expenses for sales Training and education meetings Logo gifts ok Personal gifts (e.g. wedding gifts) ok Recordkeeping requirements Sales Contests

Non-Cash Compensation: Training and Education Meetings

Paid by “Offeror” Home office permission No sales targets

– Can recognize performance in selecting attendees

Appropriate location: no golf resorts No payment for spouse expenses,

unless within firm Can play golf; just can’t pay for it

Sales Contests: Total Production and Equal Weighting

Total production of all variable contracts distributed– Can include non-insurance products– Can’t separate out variable products into

multiple contests– Can’t have single product contests– Can limit to a division or department– Can apply to proprietary funds or one

contract, if that’s all firm sells Equal weighting of credit No limits on award Can contribute to third party’s sales

program

Recordkeeping Numerous Rules (e.g., NASD Rule 2210 (Sales Materials), 3010

(Supervisory Records), 3060 (Non-cash compensation), 3110 (General Books and Records)– SEC Rules 17a-3 and 17a-4– Electronic storage must be non-rewriteable, non-erasable

format, aka WORM ("Write Once, Read Many”)– All communications related to your securities business, “even

those cute little instant messages” Financial records, shareholder account ledgers, agreements,

board meeting minutes, brokerage reports May be different time requirements for each type of record SEC access upon request Third party service providers may hold records Advisers Act requirements (generally 5 years) Compound Effect: Most other violations are accompanied by (and possibly sparked by) one or more recordkeeping violations!

Compliance

Firm must adopt and implement policies and procedures reasonably designed to prevent violations of the securities lawsConsult your policies and procedures manual–Written supervisory procedures–Desk procedures–Compliance manualConsult your legal and compliance department(s)

Final Thoughts Regulatory attention to variable insurance

products Treating Reps as fiduciaries Exam priority Higher standard of care with

unsophisticated clients– Seniors– Military personnel

Clear Rules More certainty Fewer problems

Cipperman & Company is a unique law firm devoted exclusively to the investment management industry. Our lawyers have spent their careers in the investment management industry, including significant experience at major industry players. Our shared heritage and experience make our lawyers unique and creative industry partners who can give you practical, real-world advice for making informed business decisions and controlling your legal risk. We have worked on a wide range of transactional and regulatory matters, but we concentrate on three core areas - Distribution, Technology and Fund Formation:

Distribution: Broker-Dealer Regulatory Matters, Dealer, Solicitation, and Referral Agreements, Asset-Gathering Strategies and Structures, Wrap Programs, Marketing Materials

Technology: Licensors and Licensees, Installed and ASP, Portfolio Management Systems, Trading Utilities and Platforms, Compliance Tools

Fund Formation: Hedge Funds, Fund-of-Funds, Institutional Products, ETFs, Variable Insurance Products, Cash Sweep Vehicles

150 S. Warner Road, Suite 140, King of Prussia, PA 19406, 610.687.5320, tcipperman@cipperman.com, www.cipperman.com