Fish or Fowl?

Are equity-indexed annuities securities or insurance? Ever since the NASD issued its Notice to Members 05-50 in August 2005, this question has been the subject of much debate. And, until it's resolved, the regulatory status of this emerging-but-popular product is in doubt. The NASD offered only loose recommendations to member firms about how sales of equity-indexed annuities should be conducted and

Are equity-indexed annuities securities or insurance? Ever since the NASD issued its Notice to Members 05-50 in August 2005, this question has been the subject of much debate. And, until it's resolved, the regulatory status of this emerging-but-popular product is in doubt. The NASD offered only loose recommendations to member firms about how sales of equity-indexed annuities should be conducted and supervised, but most broker/dealers are taking the conservative route and implementing them anyway.

Firms like Raymond James and Royal Alliance Associates have decided to ban reps from selling the product through outside insurance b/ds and have created lists of approved products, just in case regulators decide that the products are securities after all. Some b/ds have also limited surrender charges to 10 percent and 10 years, and capped commissions at around 6 percent or 7 percent. Still, restrictions vary widely by firm, say industry experts. “There are tight and loose guidelines,” says Jack Marrion, president of Advantage Compendium, an index-annuity research consulting firm in Maryland Heights, Mo.

Scott Stolz, president of Planning Corporation of America, the insurance-brokerage division of Raymond James Financial, Tampa, Fla, says his firm announced it would no longer sell equity-indexed annuities out of house in July 2005, just a month before the NASD issued its notice to members. “We require that our reps and independent financial advisors do index business through the b/d as if it were a security,” he says. (His firm and others knew the regulatory spotlight was coming.)

“We have eliminated 80 percent of the products in the marketplace,” Stolz continues. The firm only uses products issued by companies rated “A” or better by insurance rating agency A.M. Best. Registered representatives get product training and support. The client's risk profile, net worth, age and appropriateness of a 1035 exchange sale are automatically reviewed when an equity-indexed annuity order is submitted, he says. Commissions are limited to 7 percent upfront, or less if there is a trailing commission attached. And surrender charges must be 10 years or less.

Ralph Parker, assistant vice president and operations manager at Royal Alliance Associates in New York, says that his firm has also gotten more conservative when selecting products and evaluating suitability. The products are consumer friendly, he says, and issued by companies with at least an “A” rating by A.M. Best. Surrender periods are no greater than the industry average of 10 years.

Sales Boom

Not surprisingly, regulatory scrutiny of equity-indexed annuities began just as sales of the products were peaking. Equity-indexed annuity sales surged to $25 billion in 2005 from $14 billion in 2003, according to industry statistics. With an equity-indexed annuity, the insurer typically guarantees a stated interest rate and some protection from loss of principal, yet it provides an opportunity to earn additional interest based on the performance of a market index. The products became very popular as Greenspan whacked away at interest rates, because comparatively conservative fixed-income instruments offered little fixed yield and no hope for any extra return. Plus, in the wake of the bear market, a lot of investors wanted the security of a minimum guarantee.

But sales have begun to slip, dropping to $19.5 billion year-to-date through the third quarter of 2006, down 5 percent versus $20.4 billion for the same period in 2005, according to Beacon Research, Evanston, Ill. Most industry experts attribute the decline in sales this year to better rates on rival bank certificates of deposit — if you can get a guaranteed 5 percent, why risk getting as little as 2 percent? But some also blame NASD Notice to Members 05-50 and increasing regulatory attention to the products.

Citing concerns over “marketing, supervision, disclosure and investor-protection issues,” the NASD issued the guidance in August 2005, saying that because it hasn't been determined whether a particular equity-indexed annuity is an insurance product or a security, firms must take certain precautions: require reps to notify the firm in writing when they intend to sell unregistered equity-indexed annuities; ensure suitability if rep suggests purchase of an unregistered equity-indexed annuity to replace another security; and make sure reps have received the training they need to sell these products. “Regulators feel that the provisions of equity-indexed annuities are so complex that many people selling them may not truly understand them,” says Jeffrey Bogue, president of Bogue Asset Management, Wells, Maine.

The NASD also encouraged firms to keep a list of acceptable unregistered equity-indexed annuities and to prohibit reps from selling any equity-indexed annuities not on that list unless the firm approves it in writing. The regulator also suggested that firms bring the sale of all equity-indexed annuities in house and supervise these sales as though they were a private security transaction (which comes with a lot more disclosure and suitability requirements attached).

What sparked all this concern? In particular, sales of equity-indexed annuities to replace other products, like variable annuities. The commissions on equity-indexed annuities can be as high as 9 percent. By contrast, variable annuity front-end commissions run an already high 6 percent. On the back end, equity-indexed annuities may have surrender periods that are two to three years longer than variable annuities — for which surrender periods are sometimes already considered long.

The SEC is getting in on the act and is expected to decide in the first half of 2007 whether equity-indexed annuities should be considered securities. Only about two percent of equity-indexed annuities are registered as securities today, according to Advantage Compendium. The rest are considered insurance products or unregistered securities. Under the Securities Act Rule 151 safe harbor, annuity contracts are exempt from securities regulations if the product is issued by an insurer that is subject to state insurance regulation, the insurer assumes the investment risk and the product is not marketed as an investment.

But in August 2006, the SEC sent letters to a number of insurers requesting equity-indexed annuities sales material and contract information. Industry experts say that based on the contracted payout rates, the SEC is concerned that the equity-indexed annuity buyer may be assuming investment risk instead of the insurer, making them subject to securities regulations.

Looking Ahead

An SEC ruling that equity-indexed annuities are securities, some fear, could open a can of worms. Advantage Compendium's Marrion says it would create a regulatory mess because state securities regulators might clash or overlap with state insurance departments. Currently, equity-indexed annuities are primarily regulated by state departments of insurance, which don't usually require the same disclosure standards and licensing requirements for equity-index annuities as they require for securities and variable annuities.

The regulation of equity-indexed annuities is already a sticky issue with state insurance and securities regulators. At a May 2006 forum sponsored by the NASD and the Minnesota Department of Commerce, participants discussed ways to deal with annuity sales, suitability, disclosure, supervision and training. James Poolman, North Dakota insurance commissioner, believes that equity-indexed annuities should be regulated as insurance products and that insurance regulators can work more closely with securities regulators to improve standards and compliance. But Joseph Borg, Alabama Securities Commission director, believes that equity-indexed annuities should be registered as securities.

Borg says he sees a lot of unsuitable sales of equity-indexed annuities in his state. Brokers and/or agents, he says, see equity-indexed annuities as an easy sell — a way to offer a return on the stock market without the risk — rather than considering whether the product is appropriate for the client. But there is still risk associated with the product: Policyholders can lose money on an indexed annuity if they cancel the annuity early. And, in many cases, it will take several years for an equity-indexed annuity's minimum guarantee to break even.

Raymond James' Stolz expects the SEC will require some specific types of equity-indexed annuities to be registered as securities. Products that pay, for example, a 3 percent minimum guaranteed rate on 75 percent of the investment return might be considered securities.

But he fears SEC action could put a real damper on sales, because it would increase costs to the b/d and cause client confusion over equity-indexed annuity products.

Royal Alliance's Parker disagrees. He says that because his firm's unregistered products are already sold as though they were securities — with the requisite disclosures and suitability requirements — there wouldn't be any additional cost.

Plus, a greater standardization of equity-indexed annuity product specifications might make it easier for b/ds, insurers and consumers, says Mark Casady, chairman, president and CEO of LPL Financial Services, a San Diego-based b/d. It would lead to more consistent product training and disclosure.

Alan Lavine is co-author of Quick Steps to Financial Stability (Que/Penguin Group).

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