Almost a year after the Dodd-Frank Wall Street Reform and Consumer Protection Act (“the Act”) was signed, advisors are still unclear about how the provisions in it will affect the financial industry. Many advisors agree that, while some previously overlooked areas of the industry are now rightly being scrutinized, certain consumer protection provisions within the Act would unnecessarily allow government agencies to overreach their authority and over-regulate parts of the industry.
One area that the Act addresses is the insurance industry, already one of the most heavily regulated sectors in the financial world. Even without the Act, insurers and insurance professionals must comply with strict state regulations, annual accreditation requirements and multi-level supervision. Thus while the Dodd-Frank will impose additional restrictions on previously unregulated areas in the financial industry, it may also set additional limitations in place on the insurance industry, which some advisors view as unnecessary and others beneficial.
“I think any time additional measures are imposed that ensures that the general public who are the end users of these products, and we as professionals, fully understand these products, we are better off in the long run,” says Dino Verrelli, founder and CEO of Applegate Brokerage in Beacon Falls, CT. “It just adds credibility to what we do.”
A New Director In Town
Over the years, the insurance industry has consistently won the battle over regulation, maintaining that states are in a better position than federal agencies to supervise insurance companies. The Act introduced a “middleman” by creating the Federal Insurance Office (FIO), whose director will serve as a liaison between the insurance industry and federal agencies, and will observe and monitor the industry, although it has no authority to create and enforce new rules.
Although he will hold a non-voting position with the Financial Stability Oversight Council (FSOC), the director may recommend that a particular insurance company is “systemically important” enough to require oversight by the Federal Reserve Board, which could result in additional standards imposed upon the insurer. While the standard for “systemically important” companies has not yet been defined, experts predict that many large insurance companies with a significant presence in the domestic and international market would likely be affected.
In addition, the FIO director must conduct a study, to be completed within 18 months of the Act’s signing, which will include his observations on consumer protection, capital standards for companies, and national uniformity of insurance regulation, and will offer recommendations on how to improve and modernize the insurance industry in the U.S. In March, The Treasury appointed Illinois Insurance Director Michael T. McRaith, a veteran of the insurance industry who has firsthand experience with the challenges of enforcement.
A ‘Suitable’ Standard Of Care
In January, the SEC released a study recommending that the fiduciary standard of care apply to all financial professionals who provide advice and sell securities to the public. Currently, financial professionals must comply with one of two standards. Registered investment (fee-based) advisors are held to the fiduciary standard, which requires that an advisor provide advice that is in the best interest of his client, and ensures transparency and disclosure of conflicts of interest, fees and other relevant affiliations of the advisor.
On the other hand, commission-based insurance producers and agents of broker-dealers are subject to the suitability standard, which requires that the advisor make recommendations that are suitable to the needs and goals of the client. Many broker-dealers argue that enforcing the higher standard of care could drastically change the way they do business.
Insurers and agents responded with a barrage of letters to the SEC, arguing that as the insurance industry is already heavily regulated, they should be exempt from this higher standard of care. After all, in order to sell insurance and annuities, registered representatives and broker-dealers must obtain and maintain certain registrations, are subject to various state regulations, and must submit to rules and audits required by FINRA.
“Many advisors already follow a ‘put the clients’ interests first’ model, and I am not sure that we can legislate behavior,” says Raymer Malone, CFP®, President, AMP Strategies, LLC (based in Brooklyn, NY), and a veteran of the insurance and annuity industry. “The standard that the advisor is held to is certainly important, however an educated consumer is what is necessary. Consumers need to take ownership of their finances and ask critical questions of their current or potential advisors. If they are educated on the standards and practices of the various models, they will be better equipped to make an informed decision and take responsibility for that decision.”
In addition, many states have already adopted the rules promulgated by the National Association of Insurance Commissioners in 2010. The Annuity Transactions Model Regulations provides guidance to insurers on managing their agents and in the sale and marketing of their products. The insurer must review recommended annuities for each transaction, provide additional producer training on annuities, and document that all annuity recommendations are based on 12 areas of “suitability information” disclosed by the client. Thus, even without the Act, the annuity industry is already headed towards more disclosure, transparency and better customer suitability standards.
Mr. Malone maintains that the existing NAIC rules along with new rules imposed on the insurance industry may not affect most insurance producers’ business, although in certain cases the rules could serve as a deterrent. “Financial advisors are already subject to a suitability or fiduciary standard when dealing with clients’ securities transactions, so many already practice under that model. Forcing advisors to complete training on each product that they use could potentially limit the number of products that an advisor is willing to offer, ultimately hurting the consumer,” he notes. “So while I don’t believe that advisors will refocus their insurance/annuity efforts to other options, there is certainly the potential for those advisors to focus on fewer offerings from a limited number of companies.”
Enforcing the new standard of care remains a murky endeavor. The SEC must first define how the fiduciary standard would apply to the industry, and if and when they get around to it, this will be a lengthy, involved process. Furthermore, budget cuts and staff shortages at federal agencies means that there will be inadequate supervision of the thousands of advisors that would be subject to federal enforcement. Finally, as a practice area that must already conform to certain company, state and regulatory provisions, would the imposition of a strict fiduciary standard make any difference or would it create an unnecessary burden on insurers? As time passes and budget cuts continue, the SEC may be better off leaving good enough alone.
It is well known that lax regulation of derivatives and credit default swaps played a major role in the market downturn. To avoid future abusive practices, the Act aims to regulate and rein in the $600-trillion-a-year derivatives market by enforcing restrictions on derivatives clearing. It would also increase margin requirements and capitalization levels for companies that issue derivatives, and develop less complex, more transparent products. However, these new restrictions may result in negative consequences for annuity companies since most engage in sophisticated hedging programs and utilize derivatives in order to strategically minimize risk. If the new restrictions and capital requirements on derivatives are enforced, this could make hedging programs more expensive, and annuity companies likely to pass these costs on to customers.
According to Mr. Verrelli, “If there are greater restrictions on hedging, then I would imagine the field would be leveled for many insurance companies as far as what strategies they may or may not utilize, thus effecting benefits and costs.”
The Act’s definition of a swap may also change the game for annuity and insurance companies that allow contract exchanges. The Act defines a swap as any contract that “provides for any purchase, sale, payment, or delivery…that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence.” Insurers fear that the SEC and Commodity Futures Trading Commission will enforce this definition on insurance companies, which would be, in their view, unnecessarily restrictive. By including insurance exchanges in the broader definition of swaps, this could conflict with the state’s ability to regulate these exchanges, create confusion within the industry and could be another unnecessary layer of regulation in an already regulated sector.
Looking To The Future
It’s not all bad news for insurance, however. The Act settled a long-standing battle between the SEC and state regulators in exempting fixed annuities from registering with the SEC. And it was silent on a recent hot topic: whether to tax the annual income build-up within annuities and insurance policies. Although the dust surrounding the Act has yet to settle, it’s clear that the future will bring further regulation of the insurance industry. The question is would more regulation ensure a higher standard of responsibility on practitioners and a better care of the clients than already exists?