Vigilance rewarded: with better technology and more attention to suitability issues, the writers of life insurance and annuities appear less likely to face new class-action lawsuits. (Market Conduct: Life/Health).

Insurers and regulators have made great strides in policing the sale of life insurance and annuities since the class-action lawsuits of the mid 1990s tarnished the industry. The improvements have been so good, in fact, that some industry observers do not see any new litigation in the pipeline.

Some older class-action suits are still wending their way through the courts. Mostly filed several years ago, they argue that sales of variable annuities inside tax-qualified plans are inappropriate since qualified plans already provide tax deferral, and less-expensive products can be used instead. But beyond that potential liability, the industry appears to have done a remarkable job putting itself into a more-defensible position given the scope and complexity of its products and distribution systems.

"Is the industry better now at monitoring sales practices, both internally and externally, than it was in the past? The answer is an unqualified yes," said Scott Harrison, managing director of KPMG LLP's Risk and Advisory Services practice in Washington, D.C., and a former state regulator. "Programs such as IMSA [Insurance Marketplace Standards Association] have increased the awareness of company management on the need to pay attention to how products are being sold and by whom, as well as improve the tools companies have to monitor those sales." The American Council of Life Insurers formed IMSA more than six years ago to become an independent organization helping insurers address market-conduct concerns and regain the confidence of the public.

Insurers also have tapped into electronic technologies, including the World Wide Web, to improve application and underwriting processes and to better manage their sales representatives. "There will never come a time when any insurer will be able to claim immunity from litigation related to sales practices or other market-conduct issues," said Ann Buffie, a compliance consultant and owner/president of Ann Buffie & Associates, Minneapolis. "But firms that leverage technology to support and educate their agents-and that use the IMSA principles as a guide to their product design and go-to-market strategies-are doing what they can to mitigate their risks."

Many of the nation's largest life insurers faced litigation in the early 1990s over the quality of their representatives' sales pitches. With on-site monitoring by companies absent, agents could tell clients over the kitchen table almost whatever they wanted in order to make the sale--and some apparently did so often. The lawsuits, which cost the industry multiple billions of dollars, said agents told clients they were selling retirement products when they were actually selling life insurance. Motivated by large first-year commissions, they replaced existing life contracts with new ones. And when insurers created universal life insurance to help people take advantage of the high prevailing interest rates of the 1980s, agents told prospects their annual premiums would "vanish" after only a few years. That, of course, was only true if interest rates stayed high.

Harrison played a role in helping companies to understand how to fix those problems when he was deputy superintendent at the New York State Insurance Department. At that time, insurers complained they had little or no control over what representations an agent made while meeting with prospects. "Our response was that we agreed in principle, but we emphasized there were things companies could do and do better," he said.

That kind of thinking led to better training of agents, clearer policy-performance illustrations, more and better disclosure (particularly about policy replacements), and improved sales and marketing materials that had to be approved by new internal compliance officers. "We found the insurance industry was willing to embrace most or all of these suggestions," Harrison said. "And most agents wanted to do a good job by their policyholders."

Since then, improved technology has, given insurers a better ability to monitor the sales activity of individual agents and to track sales that didn't fit a prospect's needs analysis or "seemed a little out of sync," said Harrison. "Companies now are much more sensitive than they were 15 or 20 years ago to the need to identify and root out problem agents."

Insurers also have cut back on the number of agents with whom they do business in order to get better control of market-conduct problems, said Ken Kalis, head of Kenneth J. Kalis Co. and IMSA's only full-time independent assessor. Kalis said companies have heeded the 80/20 rule--that 20% of agents produce 80% of premium--and have focused on working with those producers, whom they label as "premier partners" or members of an "elite" group.

The 1990s also brought a surge in sales of variable life policies and variable annuities as insurers and their customers sought to join in the hot equity markets. This surge resulted in increased federal oversight since variable products are securities registered with the Securities and Exchange Commission. This oversight imposes disclosure requirements on the insurer that allow investors to make an informed buying decision and provides them with remedies if they can prove insurers provided incomplete or inaccurate information.

Disclosure Rules

Distributors must have special licenses to sell variable products, and they are subject to rules issued by the SEC and the National Association of Securities Dealers. Among them are NASD Rule 3010, the "supervision" rule, which Buffie said requires every broker-dealer to establish and maintain supervisory systems to cover the activities of each registered representative and ensure each compiles with securities laws, regulations and NASD rules. Another is Rule 2310, the "suitability" rule, which requires a broker-dealer to have reasonable grounds to believe a sales recommendation is suitable based on facts disclosed by the customer.

"The burden is on the broker-dealer to make reasonable efforts to obtain pertinent information from the customer in order to make an appropriate recommendation," said Buffie. "Some examples of the general types of information to be obtained include the customer's financial and tax status and investment objectives. In a nutshell, the product recommended should fit the customer's needs, including their tolerance for risk and time frame for investment."

Buffie said the NASD believes that because of the complexity and many features available in variable products, the inherent long-term nature of the investment and the penalties for early surrender along with greater fees and expenses than some other securities, the suitability analysis required under Rule 2310 is even more complex. Accordingly, it issued notices to members in 1999 and 2000 reminding broker-dealers of their responsibilities in the sale of variable annuities (99-35) and variable life (0044). These provide more specific guidance.

In Notice to Members 99-35, the NASD states members should make efforts to gather "comprehensive" customer information, including occupation, marital status, age, number of dependents, investment objectives, risk tolerance, previous investment experience, liquid net worth, other investments and savings, and annual income. The notice also discusses the importance of full disclosure of liquidity issues, surrender charges, potential IRS penalties, fees (including mortality and expense charges, administrative charges and investment advisory fees), any applicable premium taxes (charged by states), and market risk, said Buffie.

"The notice makes it clear that the variable annuity contract as a whole, not just the underlying subaccounts selected, should be suitable for the customer, given their individual circumstances' she said. "It also suggests that firms develop monitoring tools to identify representatives who have a high rate of replacement transactions or rollovers. Lastly, the Notice to Members advises that firms should develop other measures to ensure replacement sales comply with NASD rules, and that firms who 'wholesale' variable annuities are also subject to NASD rules and should avoid marketing strategies designed primarily to encourage inappropriate replacements." Wholesalers help insurers to develop business with distributors.

On the variable life side, Notice to Members 00-44 requires all of the above and provides guidance on avoiding violations of Rule 2110 (Standards of Commercial Honor and Principles of Trade) and Rule 2210 (Communications with the Public) regarding misleading advertising and sales literature. Buffie said it also discusses the firm's obligation to provide suitable recommendations regarding the financing of variable life policies with loans or the cash value of another policy, considerations in replacement situations, and the requirement that all variable life insurance advertisements and sales literature be filed with NASD Regulation's Advertising/Investment Companies Regulation Department within 10 days of the first use or publication. This includes the format for hypothetical illustrations, since these formats are considered sales literature, she said.

While regulation of securities is uniform throughout the country, the same cannot be said for fixed insurance and annuity products. These are not considered securities and thus are regulated by each state and the District of Columbia. As a result, suitability rules vary.

Divergent Opinions

The National Association of Insurance Commissioners in December terminated its effort to adopt a model law that sought to achieve uniformity in suitability rules. At the NAIC winter meeting, the Life Insurance and Annuities Committee voted, after several closed-door executive sessions, to table its suitability model act and regulation developed by its Suitability Working Group. "There is a desire still to develop some form of suitability standards, but there does not appear to be a consensus among the states on the key committee as to what direction that should take," said Harrison in December. "I suspect early next year, a decision will be made whether to reconstitute a new working group or reconvene the old one." Harrison said there were many objections to the recent proposal from a variety of groups, including the American Council of Life Insurers.

In a June letter to the committee, the ACLI argued that existing model laws and regulations would provide regulators with "sufficient authority" if they were adopted uniformly and enforced consistently. The ACLI also argued that IMSA membership ought to provide a safe harbor as a "presumption of compliance with suitability requirements," a position the NAIC has not endorsed. In addition, ACLI expressed concern about how complex and detailed uniform suitability regulation might affect direct marketing and group plans.

"The problem with detailed suitability models is that their very complexity challenges uniform adoption on one hand, and likely requires the construction of expensive operational compliance systems on the other," which could then lead to "pervasive and invasive supervision," said the ACLI.

As of December, only Wisconsin, Iowa, Vermont, Kansas, Minnesota and Utah had suitability rules for fixed products, and Arkansas, South Dakota and Ohio had authorized the promulgation of regulations, according to Buffie. So suitability in most states depends upon a patchwork of regulations and upon the ability of insurers to monitor their distribution outlets.

It's Complicated

Fixed annuities, of course, pose virtually no risk to principal compared with variables. Kalis said the major misunderstanding about annuities is that they don't have the liquidity of certificates of deposit or mutual funds. "People just don't understand that their money will be tied up for at least five years when they buy an annuity," he said. "I read that 95% of the complaints about annuities were undisclosed surrender charges." Add in a tax penalty for those younger than 59 and one half years, and the first-year charges could approach 20%, he later said.

Otherwise, fixed annuities are simple to understand, except for one: the equity-indexed annuity. And it is this product that some people believe may become the next target of class-action lawyers. The reason is that the incredible complexity and variety of this class of products--and the fact they are sold by distributors without securities licenses--may leave people with greater performance expectations than many equity-indexed annuities produce.

"There is not much ground for people to complain their variable products didn't perform," said Edward E. Graves, associate professor of insurance at the American College in Bryn Mawr, Pa. "They had a prospectus, and they understood there was investment risk. A much bigger potential market for disgruntled consumers is the EIA."

If held to term, equity-indexed annuities guarantee return of principal or even a slight gain, but hold out the chance of bigger gains linked to a stock market index. Insurers achieve those results by investing the vast majority of premium in, government bonds and a small amount in stock index derivatives that can be exercised only at designated times, usually an annual anniversary. Product designs vary greatly, with some stipulating a percentage of the index' gain and others averaging gains periodically.

Agents sold the product, especially when it was first introduced in the United States in 1995, with a simple mantra about the product being the "best of both worlds," said Graves. The upshot, according to Graves, is that investors may not end up with a return anywhere near that of the index. "That's where the disgruntlement comes from," he said. "If the market had an 18% return, but the EIA was credited with only 1.6%, that wasn't what customers understood the best of both worlds to mean."

Investors in equity-indexed annuities may actually be thrilled with results in 2000, 2001 and 2002 in that they didn't lose money while the S&P 500 index was down sharply. But Graves said class-action suits take a long time to put together and may not take into account the last three years.

Both Graves and Buffie said they were not aware of any equity-indexed-annuity litigation, but Buffie said sales volumes have become large enough to attract plaintiff attorneys' attention. The industry sold almost $6.5 billion in 2001, according to The Advantage Group, St. Louis which tracks it.

Grounds for other kinds of litigation are still certainly possible. "Insurers much more careful to have paper trails to prove they've covered the regulations, and they have insulated themselves better overall," said Graves. "But that doesn't prevent disgruntled purchasers and underemployed attorneys from filing suit, and the suits can be costly even if they don't go to court."

Despite the efforts of insurers, there can still be conduct in the marketplace that is potentially dangerous to them. Graves told of one case, for example, in which the insurer "basically hired" a marketing firm to recruit agents and create point-of-sale materials, a move that placed the insurer "one more step removed" from people actually selling its products. Marketing groups are often formed for specific target-market pursuit, he said. "If they're a really topflight group, they're probably doing an overall planning package," he said. "If they're not, then they're just trying to see how they can sell a whole trainload of the product."

Increasing complexity of insurance and annuity products also stands to make the industry more susceptible to lawsuits because they are more difficult for both clients and distributors to understand, said Buffie. Such complexity was highlighted in a June 2002 speech by the SEC's Paul F. Roye, who cited a study by Info-One that discussed the proliferation of unbundled features in variable annuities. Roye, director of the Division of Investment Management, was speaking before the regulatory conference of the National Association for Variable Annuities. The study noted that 140 contracts offered a choice of benefits, up from just over 80 a year earlier. Unbundling allows customization by the client, but Roye said a study found that almost 70% of dealers surveyed believed the contracts to be too complicated. "The complexity of products, combined with what dealers felt was the lack of support and education about these features, caused many distributors to cite the potential for suitability problems," he said. "We w ill certainly be keeping our eye on this issue."

Roye also raised the issue of "personalized illustrations" in variable life insurance and new prospectus disclosure requirements that will require registered advisers to disclose the illustrations to the SEC. He warned the audience to "tread carefully" in constructing a personalized illustration. "Based on Mr. Roye's comments, I'm not sure life will be any easier for issuers, broker-dealers and agents, or clients in understanding these complex products," Buffie said.

Language may be yet another market-conduct risk, according to Buffie. Some insurers provide disclosure documents, sales literature and applications in an applicant's primary language, but many do not, she said.

RELATED ARTICLE: Variable Annuity Class-Action Fire Still Burns

Should insurers sell variable annuities inside of tax-qualified retirement plans? Class-action litigators believe they shouldn't if the companies don't disclose that other, less-expensive investment options can be used, and the litigators have brought a couple of new cases in addition to ones they initiated in the late 1990s.

Qualified plans provide tax deferral, and litigators claim that finding them with variable annuities, which enjoy tax deferral outside of a qualified plan, is redundant. The insurance industry responds that the higher expenses of variable annuities do not pay for tax deferral, but rather to cover the insurance risk of death benefits, other features and administrative costs. (For more information on this topic, see "Can Annuities Pass Muster?" in the July 2000 edition of Best's Review.)

Michael Spencer, a partner in the New York-based law firm Milberg Weiss Bershad Hynes & Lerach, said several cases from 2000 are still active and that he has taken on two new securities-fraud cases. One is against the Variable Annuity Life Insurance Co., which became part of American International Group when AIG bought American General. The other is against the Equitable Life Assurance Society of the U.S., now a part of the Axa Group. "The underlying facts and theories are the same: They failed to disclose to purchasers that the tax benefits from a variable annuity are unnecessary in a qualified plan," said Spencer. VALIC sells primarily to teachers with 403(b) plans. Equitable agents have been rolling over money from qualified plans into individual retirement accounts when clients leave their jobs, said Spencer.

The VALIC case is in federal court in Tucson, Ariz. The court on Oct. 21 ruled against a motion by the company to dismiss the case, and Spencer said parties had begun the discovery process. The Equitable case is in federal court in the Eastern District of New York, where the defendant had a motion to dismiss pending as of December, according to Spencer.

By virtue of Congress' 1998 Securities Litigation Uniform Standards Act, class-action litigation asserting misrepresentations in the sale of securities must be pursued in federal court. However, a Milberg Weiss suit against American United Life Insurance Co., Indianapolis, predates the law and is ongoing in an Indiana state court. Spencer said there is no ruling yet on a motion for summary judgment. A case against Nationwide Financial Services, Columbus, Ohio, was dismissed in November "for reasons specific to the named plaintiff," said Spencer, who added his firm might appeal the ruling. Another Milberg Weiss case that predated SLUSA--against Los Angeles-based SunAmerica Inc--was settled last fall in a California state court. Spencer said the settlement was sealed, however, and that he could not discuss it.

Milberg Weiss reached a $215-million settlement in January 2000 with American Express Financial Corp., Minneapolis, in which the company admitted no wrong-doing. However, the National Association of Securities Dealers in December 2002 censured the financial planning unit of American Express Co. and fined it $350,000 for misleading investors regarding the costs and tax benefits related to some variable annuities and variable-life products sold over a 30-month period ending in 2000.

Spencer said the fine was "a drop in the bucket," but he added that overall, the litigation and increased regulation have had a positive influence on the industry. "That doesn't mean the abuses have stopped," he said. "It's still very tempting for insurers' agents to make the extra commission off of these things. But on paper, there appear to be some improvements...We have seen more disclosures in prospectuses."

Edward Graves, associate professor of insurance at the American College, Bryn Mawr, Pa., suspects that resolution of class-action litigation may increasingly be in the form of settlements in which there will be no public record. "That's one of the problems with almost all insurance litigation," he said. "I know of cases of abuse that are recurrent. I would like to have a landmark case to put into my courses, to put the fear of God into marketers, but they are settled out of court, and there is no court-of-record decision."

Graves said he wouldn't recommend selling variable annuities within qualified plans. "If anybody is doing it, they had better know their products and the entire qualified plan area very well," he said.

But class-action litigators depend on publicity to some extent, said Scott Harrison, managing director of KPMG LLP's Risk and Advisory Services practice. "Publicity helps them identify more cases; that's how trial lawyers develop business," he said. "That's what happened with the life-insurance cases, and that's what you see with tobacco litigation...The trial bar has demonstrated its ability in the past to maximize public attention with respect to activities targeted for litigation."