Annuity patrol: regulators want new rules to protect investors from predatory sales of variable annuities. But insurers say the new rules are unnecessary and the approach is neither efficient nor sensible.

Regulators have nightmares about advertisements with messages like this: "Sell Annuities to Seniors Who Don't Have Money! Most Have Equity in Their Homes--Help Your Agents Tap Into It!"

Silver-tongued salespeople luring senior citizens into mortgaging their homes to buy variable annuities that they can't afford and don't fully understand are the reason regulators want to toughen sales standards for variable annuities, a hybrid product that's basically mutual funds wrapped in an insurance policy.

Both variable annuities and variable life insurance are sold as securities, and must be sold by financial representatives registered with the NASD. The NASD, formerly known as the National Association of Securities Dealers, has proposed new rules to govern the sale of variable annuities. While it's rare for the organization--the self-regulatory arm of the broker/dealer industry--to set regulations geared to specific products, it's not the first time NASD has been compelled to do so, said Mary Schapiro, vice chairman and president, regulatory policy and oversight.

"We don't normally write rules for [individual] products. It's not unheard of, but maybe not typical. But there's a tremendous amount of investor confusion about this product, and we decided it was time to do something to help investors by making sure brokers take more care in selling them" Schapiro said.

Insurance companies, trade groups and industry watchers generally applaud the NASD's efforts in cracking down on unethical sales practices, but say the proposed rules aren't necessary.

"Is the way to go about this to develop special rules for special products? Or would it be better to constantly and uniformly enforce the rules out there now?" said Fred Jacoby, an attorney with the Philadelphia law firm of Cozen O'Connor.

The life insurance industry "condemns any unsuitable sales, and we support the enforcement of federal security laws against any wrong-doers" said Carl Wilkerson, chief counsel of securities and litigation for the American Council of Life Insurers, an industry trade group. "But we aren't in agreement with the approach the NASD has staked out. It's neither efficient, nor sensible."

Booming Business

Variable annuity sales have been strong. Total premium flow, or total sales, of variable annuities for 2003 was $126.4 billion, a 9.9% increase from the prior year's sales of $115 billion, according to the National Association of Variable Annuities.

First quarter 2004 variable annuities had new sales of $34.4 billion, a 16.3% increase over the first quarter of 2003 and a 9.7% increase over the fourth quarter of 2003, according to AnnuityNet/VARDS. Variable annuity premium flow, or total sales, for the second quarter was $33.4 billion, a 1.5% increase from a year earlier.

With such strong sales comes increased regulatory scrutiny. Regulators, such as the NASD, are monitoring the sales of the product. The National Association of Insurance Commissioners, which promulgates rules governing insurer solvency, is considering what capital requirements are necessary to support the product. And the Securities and Exchange Commission is investigating a number of companies for possible "market timing" issues related to the mutual-fund subaccounts in annuities.

Several insurers declined to comment for this article, asking that trade groups speak on their behalf. In a statement, Hartford Life Insurance, the top writer of variable annuities, said it already follows the NASD guidelines in the sale of variable annuities and it "supports initiatives to help inform and educate consumers on bow variable annuities can be used as an effective vehicle for accumulating and managing assets during retirement."

The NASD's proposed rules deal mostly with increasing disclosure requirements and making sure variable annuities are a suitable investment for the buyers. (See "New Sales Rules for Variable Annuities," page 42.)

The NASD, which regulates 5,682 member firms and more than 664,000 registered representatives, has received more than 1,000 letters in response to its proposed rules. Most of the letters offer criticism, and one of the biggest complaints is that the proposed rules are redundant.

Authority Not Questioned

Wilkerson said the NASD already has the authority under existing regulations to take action against broker/dealers or brokerages that sell "unsuitable" products to consumers. Under NASD rules, financial representatives are barred from selling products that aren't appropriate for specific consumers.

By the NASD's own count, it has taken some 80 enforcement actions in the past two years related to variable annuities. For instance, the NASD fined Prudential Equity Group and Prudential Investment Management Services $2 million and ordered the firms to pay customers $9.5 million for the sales of annuities, including variable annuities. The NASD filed a complaint against Waddell & Reed in January, charging the firm with recommending 6,700 annuity exchanges to its customers--which generated $37 million in new commissions and cost the customers $9.5 million in surrender fees--without determining whether the transactions were suitable.

And the NASD has fined and even barred individual brokers for failing to meet suitability guidelines. For instance, one broker was suspended for six months and freed $28,000 for the sale of three unsuitable variable annuities. The first sale was to a couple, both 76, who were about to move into an assisted living facility and needed liquidity. Their primary investment objective was income, and they wished to preserve the principal for their heir.

"Investment in the variable annuity accomplished none of these goals:' the NASD said in a statement. The variable annuity did not allow the customers full access to their funds for seven years without incurring a surrender charge. The variable annuity purchase did not produce income, because the broker recommended investment in capital appreciation and growth sub-accounts. In addition, the investment failed to preserve principal for their heir because the death benefit applied only if the customers died before the 10th contract year. Finally, the broker sold the customers a retirement income guarantee rider that was supposed to be available only to people 75 and younger. At age 76, the customers were ineligible for this rider, the NASD said.

While the NASD touts the 80 enforcement actions as a sign of trouble in the variable annuity market, the ACLI said not all 80 actions are related specifically to the suitability of variable annuities. Over the past five years, less than a quarter of 1% of enforcement actions related to suitability issues with variable annuities, Wilkerson said.

"It begs the question, if in the larger picture, variable contracts are not a significant contribution to NASD suitability actions ... why are they creating a new rule for this product?" be said.

Regardless, the NASD already has "all the enforcement power," Wilkerson said. "If they spot a regulatory problem, it's better to go after the wrongdoers than create new administrative rules."

But Schapiro of the NASD said the proposed rules are based on best practices guidelines that the NASD issued in 1999.

"We developed those best practices guidelines with tremendous assistance from the insurance industry. The problem with leaving it just with best practices is not everyone adopted them," Schapiro said. "There's no question that there's a problem with sales practices. There are clearly disclosure obligations in place, suitability obligations that already exist. But the level of concern that we've had with this product, both from an enforcement perspective as well as an investor confusion prospective, has led us to believe something more needed to be done."

Buried in Details

The new rules call for additional disclosure at the time of sale, to ensure the buyers are aware of special fees, such as penalties for early withdrawals, as well as the risks involved.

But the SEC already requires such disclosure in a prospectus given with every sale, Wilkerson said. Giving an additional disclosure "undermines the SEC prospectus simplification endeavors," Wilkerson said. The SEC's required prospectus must include disclosures of all risks, fees and charges associated with the product, he said.

"By requiring another piece of paper, which is completely redundant, it reduces the likelihood that consumers will read the important information that the SEC just redesigned," Wilkerson said.

Variable annuities already are heavily regulated by federal and state regulators. The SEC regulates the issuer of the variable annuities and the prospectus disclosure. The NASD regulates the sales person, brokers and dealers. And state insurance commissioners oversee insurance companies and the sales people.

The insurance industry also fears that requiring additional disclosures and paperwork may ultimately discourage sales of variable annuities.

"It is a product that people need to understand and make comparative choices on. But if you throw too much material at them, some of them might just throw up their hands and say, 'this is too difficult,' "Wilkerson said.

That additional disclosure also has caused concern for the National Association for Variable Annuities. "We are supportive of the rule. We want to work with the NASD in that regard to make sure variable annuities are sold appropriately in all instances, but we have concern over several of the specific proposals" including the additional disclosure requirement, said Michael DeGeorge, general counsel for NAVA.

In addition to the SEC prospectus, many states also require a disclosure statement.

"We think there needs to be coordination of these various proposals," DeGeorge said, noting that NAVA is also troubled by the NASD's requirement that a principal of a brokerage be required to sign off on any proposed variable annuity sale within one business day.

"That's an impractical time period," he said. "Frequently, the principal isn't at the same location as the selling representative. We have no disagreement that there should be principal review, but think a more reasonable period of time should be provided [or] it could significantly disadvantage variable annuity sales."

Schapiro said the NASD is concerned "not with making it easy to sell a product, but making sure that sales practices are proper. We believe these rules are necessary to ensure that."

She said, however, the NASD is reviewing comments on the proposal, and will consider all requested changes, including a longer review period. After the NASD finalizes the rules, the SEC will consider them, and publish them for additional comment before deciding whether to adopt them.

Self-Policing

New York Attorney General Eliot Spitzer may be credited with launching the investigation into the sale of variable annuity products when he began to investigate mutual funds, said Hubert Mueller, principal of Towers Perrin. "Variable annuities got dragged into it because variable annuities are mutual funds wrapped in an insurance product. But I don't see it as a large industry issue," Mueller said.

Variable annuities are a much "cleaner product" than equity-indexed products, which might be the next to fall under the NASD's scrutiny, Mueller said. "To sell variable annuities, you need to be both an insurance agent and a securities (NASD) salesman. For equity-indexed annuities, you don't have to pass an NASD test. Product limitations and a lack of market performance on many of the current policies in force could have some market conduct issues down the road; it's less transparent."

The NASD must maintain strict regulations and enforcement, or consumers will doubt the effectiveness of the self-regulated industry, Jacoby said.

"Perceptions are just as bad as reality. The insurance industry has to do a better job of regulating their own people," Jacoby said. "Regretfully, what happens is insurance agents make money when a product is sold, and so does the carrier. That may be a disincentive to look at it. This is a wake-up call to carriers. If you don't police yourself, the NASDs, and the [New York Attorney General] Eliot Spitzers of the world are going to come after you. If you don't police yourself, someone else will."

Key Points

* The NASD, which regulates the sales of variable annuities, is concerned with a rash of inappropriate sales.

* The NASD has proposed rules to govern variable annuity sales practices, based on guidelines it adopted in 1999.

* Insurers are concerned that the proposed rules are redundant, and will make it more difficult to sell an already complicated product.

New Sales Rules for Variable Annuities

The NASD, which regulates the sales of all securities, including variable annuities, is considering strengthening current selling guidelines. The proposed changes include the following:

Suitability: Before recommending a deferred variable annuity to a client, a registered representative must ensure that the customer has been informed of the unique features of the variable annuity and has a long-term investment objective, and that the deferred variable annuity and its underlying subaccounts are suitable for the customer with regard to risk and liquidity.

Disclosure: The firm or its representative would be required to provide the customer with a current prospectus and a separate, brief, "plain English" risk disclosure statement highlighting the main features of the variable annuity contact, including:

* Liquidity issues, such as potential surrender charges penalties;

* Sales charges;

* Fees (including mortality and administrative investment advisory fees, and charges for riders or special features);

* Federal tax treatment for variable annuities;

* Any applicable state and local government premium taxes; and

* Market risk.

Principal Review: Before a registered representative could finalize any variable annuity transaction, a registered principal would be required to review and approve the transaction.

Supervision and Training: Registered firms would have to establish and maintain specific supervisory and training procedures to make sure registered representatives comply with the NASD's rules on variable annuities.

Learn More

Hartford Life Insurance Co. (member of Hartford Life Group)

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Top Variable Annuity Writers

Variable annuity sales have been Strong, and total
premium flow, or total sales, of variable annuities
for the full year of 2003 was $126.4 billion, a
9.9% increase from the prior year's 12-month
sales of $115.0 billion. Here are the top writers for
year-end 2003:

Rank by                                                      12/31/03
Total Flow    ISSUER                                     ($ Millions)

    1         Hartford Life Insurance Co.                   $15,773.0
    2         TIAA-CREF                                     $12,814.9
    3         Equitable Life Assurance Society of the
                U.S.                                        $10,330.6
    4         MetLife/NEF/Gen Am/MLI                         $9,856.0
    5         AIG/SunAmerica/VALIC                           $8,197.3
    6         Pacific Life Insurance Co.                     $6,253.5
    7         ING Group of Cos.                              $6,009.2
    8         Prudential/American Skandia                    $5,318.6
    9         Nationwide Life Insurance Co.                  $4,846.3
    10        IDS Life Insurance Cos.                        $4,386.8
    11        Lincoln National Life Insurance Co.            $4,223.8
    12        Manulife Financial                             $4,145.6

              Top 10 Total                                  $92,155.6
              Total Industry                               $126,368.0

Source: National Association of Variable Annuities