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Investment Management Institute

2017

Volume One

CORPORATE LAW AND PRACTICECourse Handbook Series

Number B-2309

Co-ChairsBarry P. Barbash

Paul F. Roye


39

Variable Insurance Products— Recent Product Trends and Regulatory Developments (January 20, 2017)

Stephen E. Roth

Sutherland Asbill & Brennan LLP

The author expresses his appreciation to his colleagues Dodie Kent and Patrice M. Pitts for their assistance in preparing this outline.

If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.

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OVERVIEW

In recent years, a number of macroeconomic factors have challenged insurers and their business strategies. The search, by an aging demographic, for yield on investments in an environment characterized by persistent low interest rates and equity market volatility has led retirees and near retirees to look for financial products that provide guaranteed income throughout retirement. Insurance companies have responded by devoting substantial resources to offering products that are both attractive to inves-tors and effectively manage the risks assumed by the insurance company in connection with the guarantees offered as a part of, or as an option under, such products.

Over the past year, however, issuers of SEC registered insurance products, have been focused on the challenges imposed by the implemen-tation of the U.S. Department of Labor’s (“DOL”) final fiduciary rule (“DOLFR”).2 DOLFR expands the definition of an “investment advice fiduciary” under the Employee Retirement Income Security Act of 1974 (“ERISA”), amends existing prohibited transaction exemptions, and cre-ates new prohibited transaction exemptions. Together, these changes have called for a reevaluation of many existing business models. In addition to grappling with a myriad of implementation issues stemming from DOLFR, insurers are also facing the challenge of determining what their menu of SEC registered annuity contracts should look like after DOLFR’s effective date.3 Although the results of the 2016 presidential election have placed the fate of DOLFR in question, most insurance companies and other firms have been moving forward to comply with DOLFR as we now know it, even though it is unlikely that DOLFR will be implemented on time and without changes.

At the same time, insurance companies have continued to monitor and, as needed, react to the steady stream of post Dodd-Frank Act rulemak-ing initiatives, along with other guidance and precedent, flowing from the U.S. Securities and Exchange Commission (“SEC”).

2. See 81 Fed. Reg. 20,946 et seq. (Apr. 8, 2016). An in-depth discussion of DOLFR

is beyond the scope of this outline. 3. As adopted by DOL, the compliance date for most of DOLFR is April 10, 2017,

with the compliance date for certain requirements in two of the prohibited trans-action exemptions—the Best Interest Contract Exemption and the Principal Transac-tions Exemption—being January 1, 2018.

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This outline provides a summary overview of the following topics:

innovation in product design and shift in product sales in aftermath of 2008 financial crisis

product design trends and innovations for variable annuity contracts recently filed with the SEC that appear to be responsive to DOLFR;

certain regulatory issues for insurers that are modifying and design-ing such products;

several recent SEC rulemaking initiatives and related developments, no-action letters and other guidance relevant to insurance companies issuing SEC-registered insurance products; and

recent exemptive application activity, focusing particularly on appli-cations seeking approval of underlying fund substitution transactions.

I. DE-RISKING INITIATIVES AND PRODUCT INNOVATION IN SHIFTING PRODUCT LANDSCAPE

Variable annuity sales have not regained the momentum last experienced before the 2008 financial crisis. Most years, annual sales have declined or remained flat. To address the challenges posed by the significant “headwinds” experienced in the years since the financial crisis, variable annuity issuers have taken steps to “de-risk” product guarantees they undertook—particularly, guaranteed minimum accumulation and with-drawal benefits—to manage their exposure to market risk in the challenging equity markets and persistent low interest rate environment.

Insurers have taken steps to make the riders less “rich.” Guaranteed lifetime income benefits with rate schedules that can be quickly changed have become more prevalent.

Insurers are likely to impose investment requirements or restrictions if a guaranteed lifetime withdrawal benefit is elected—such as limiting the investment options to which a contract owner can allo-cate premium payments or transfer contract value, requiring adher-ence to an asset allocation program, requiring allocation to managed volatility funds or funds with dynamic asset allocation, and/or requir-ing allocation of contract value in designated investment options with automatic transfers back and forth among those designated investment options according to a prescribed mathematical formula.

Rather than make adjustments to their product offerings, some major insurers have:

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○ offered incentives to existing contract owners to move out of products with generous guarantees (so-called “buy-back offers”);

○ suspended the offering of particular living benefit riders; ○ shifted their focus to other types of annuities, notably, fixed

indexed annuities; ○ taken the more dramatic step of exiting the variable annuity

marketplace altogether. These “headwinds” also spurred some life insurance actuaries and prod-

uct developers to package risk exposure and risk protection into “new” kinds of variable annuity and rider combinations. Among the main types of variable annuity innovations that have appeared are:

“investment only” variable annuities (also referred to as “investment-oriented” variable annuities) that offer a broad array of diverse invest-ment choices that allow contract owners to grow their retirement assets until or unless guarantees need to be purchased, and typically do not offer living benefits.4

registered index-linked annuities—general account products with values tied to one or more specified indexes that stabilize volatility through combination of upside “caps” and downside protection

4. Some industry observers have commented that until the late 1990s, all variable

annuities were “investment only” and so these “new” investment only variable annui-ties (referred to as “IOVAs”) call to mind the idiom “everything old is new again.” Unlike their predecessors, these “new” IOVAs offer dozens of subaccount options—including “alternative” investments (e.g., real estate, hedge funds, emerging market debt, arbitrage and commodities), and may even offer a limited number of optional death benefits and/or optional living benefits. They can also provide an implicit form of downside protection through the use of hedging strategies in managed volatility funds, and through diversification provided by alternative investments. See, e.g., Kerry Pechter, “Recent Variable Annuity Innovations Provide Growth,” ANNUITYFYI, http://www.annuityfyi.com/variable-annuities/recent-variable-annuity-innovations- provide-growth-safety/.

Insurers also have developed products designed to deliver retirement income without living benefit features and without the loss of liquidity. E.g., AXA Invest-ment Edge (SEC File No. 333-190033) and Lincoln Investor Advantage (SEC File No. 333-193276)—variable payout options (Income Edge and i4Life, respectively) that allow contract owners who purchased the variable annuity on a non-qualified basis to convert their assets to what resembles a “period-certain” annuity, but with some liquidity; Guardian Investor ProFreedom (SEC File No. 333-187762)—offers the option to gradually move all or part of your account balance to a deferred income annuity.

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○ Products with choice of different downside “buffers”—contract owner assumes “tail risk.”5

○ Products offering specified “floor” protection—insurance com-pany assumes “tail risk.”6

II. SEC PRODUCT FILINGS RELATED TO DOLFR AND RELEVANT REGULATORY ISSUES

In anticipation of the implementation of DOLFR, the elephant in the room for many insurance companies has been whether and how best to change their variable annuity contracts (“VA Contracts”) offered in the retirement plan and IRA markets to facilitate their distribution partners’ compliance with DOLFR’s so-called Best Interest Contract Exemption (BICE)7 requirements. Compliance with the applicable BICE provisions has driven third parties offering VA Contracts to review and reevaluate the source, form, and amount of compensation they receive in connection with the VA Contract recommendations they make, as well as the fees, costs, and benefits associated with those VA Contracts themselves. How-ever, because these determinations must be made in the first instance by third-party distribution partners, it has been uncertain precisely what VA Contract changes would emerge, and how extensive such changes would be. A sampling of SEC VA Contract filings that post-date the adoption of

5. E.g., AXA Structured Capital Strategies (SEC File No. 333-165395); MetLife

Shield Level Selector (SEC File No. 333-185333); Allianz Index Advantage (SEC File No. 333-185864); Voya PotentialPlus Annuity (SEC File No. 333-196391 (no longer available for new sales). In each of these products, the insurer absorbs losses up to a prescribed limit (typically 10-30%) over a specified period of time, for a given investment option.

6. E.g., Members® Zone Annuity, SEC File No. 333-186477; Allstate RightFitSM Annuity, SEC File No. 333-178570. Purchasers of either of these single premium deferred annuities can allocate purchase payments to one or more accounts, each linked with the S&P 500, and with its own “risk/return” profile (i.e., “cap” and “floor”).

7. To satisfy BICE, investment advisors and the financial institutions that engage them must: (1) acknowledge their fiduciary status to investors; (2) adhere to impartial conduct standards, including giving advice in the investor’s best interests, charg-ing only reasonable compensation, and making no false or misleading statements; (3) implement policies and procedures to ensure impartial conduct; (4) refrain from using incentives for advisors to act contrary to investors’ best interests; and (5) dis-close fees, compensation, and material conflicts of interest associated with advisor recommendations. See 81 Fed. Reg. at 21,007.

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DOLFR provides a glimpse into the type and scope of changes insurers are considering.

A. Summary of Product Design Trends

As of the date of this outline, a number of insurers appear to have filed new or modified VA Contracts in response to DOLFR’s require-ments that went effective by December 31, 2016: 1. An analysis of these new VA Contracts shows the following trends.

a. The base contract charges are relatively low-cost. b. The contracts do not assess a front-end sales load. c. Most of the contracts have no surrender charges,8 and those

with surrender charges have relatively short surrender charge schedules (3 to 6 years) and lower early surrender changes (2% to less than 7%) than has been characteristic of VA Contracts in the recent past.9

d. The contracts tend to have low mortality and expense risk charges (e.g., 0.15%, 0.45%) coupled with low administrative charges (e.g., 0.05%, 0.15%).10

8. See, e.g., Lincoln ChoicePlusSM Advisory (SEC File No. 333-212680); Lincoln

Core Income (SEC File No. 333-214235); Lincoln Investment SolutionsSM (RIA) (SEC File No. 333-214143); Lincoln Investor Advantage® Advisory (SEC File No. 333-212682); Lincoln Investor Advantage® RIA Class (SEC File No. 333- 214144); American Legacy® Advisory (SEC File No. 333-212681). Each of these filings went effective December 28, 2016.

9. See, e.g., American General Life Insurance Company’s Polaris Advisory Income Variable Annuity (SEC File No. 333-213338) (4-year surrender charge period, maximum charge 3%; effective Dec. 19, 2016); Jackson National Life Insurance Company’s Elite Access AdvisorySM (SEC File No. 333-212424; effective Dec. 20, 2016) and Perspective AdvisorySM (SEC File No. 333-210504; effective Sept. 19, 2016) (3-year surrender charge period, maximum charge 2%); Allianz Index Advantage ADV (SEC File No. 333-213127) (a combination variable annuity/ indexed-linked contract with a related Form S-1 registration statement filing; 6-year surrender charge period and 6% maximum charge; effective Dec. 28, 2016).

10. See, e.g., Great-West Life & Annuity Insurance Company’s Smart Track Advisor (SEC File No. 333-212090; 811-05817; effective December 23, 2016) (maximum annual mortality and expense risk charge of 0.20% or 0.40%, depending on death benefit option selected); Pacific Odyssey® (SEC File No. 333-185326) (reducing administrative charge by 10 bps on no-load variable product, resulting in lower combined annual mortality and expense risk charge and administrative charge of

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e. Some contracts have a “separate account charge” rather than separate mortality and expenses risk fees and/or administra-tive fees.11

f. At least one contract has no separate account charges, and instead assesses a considerable monthly contract maintenance fee.12

g. Riders: The number, type and cost of riders available vary widely. There are contracts with no riders and contracts with several different death benefit and living benefit riders to choose from.

h. Fund line-ups: Most contracts include a wide variety of under-lying funds (ranging from approximately 30-100 funds),13 including proprietary funds and funds with 12b-1 share classes.

i. Distribution: The registration statements for the contracts generally do not yet include any material changes to dis-tribution disclosures. However, the following is notable:

Most of the new contracts are fee-based (i.e., designed for the advisor channel), and expressly state that no com-missions are paid.14

Disclosures include the possibility of non-cash com-pensation, marketing allowances, overrides, revenue-sharing arrangements, and other forms of payment.

0.30% annually on base contract; 485(b) post-effective amendment filing, effective November 8, 2016).

11. See, e.g., Allianz Index Advantage ADV (0.25% “product fee” assessed during accumulation phase if certain death benefit payout options are selected); American General’s Polaris Advisory Income Variable Annuity (0.40% “separate account fee”).

12. Jackson National’s Elite Access AdvisorySM ($120 maximum annual contract charge).

13. The new Allianz contract (SEC File No. 333-213127), which offers only 3 affili-ated funds and 3 index-linked investment options, appears to be the outlier here.

14. See, e.g., Minnesota Life Insurance Company’s MultiOption Advantage (SEC File No. 333-212515) (effective November 9, 2016). (“Minnesota Life does not pay a sales commission, either a front-end commission or an asset-based (“trail”) com-mission, for sales of the contract.”); Allianz Index Advantage ADV (SEC File No. 333-213127) (“We do not pay sales commissions in connection with sales of the Contracts. Rather, the Contract Owner pays an investment advisory fee to his or her Financial Professional.”).

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j. Disclosure about DOLFR: A few of the filings contain specific new disclosures in their distribution or tax sections addressing compliance with DOLFR.15

Insurers are still digesting industry trends and are seeking defin-itive direction from their third party distribution partners. It would not be surprising, therefore, to see additional changes to prospectus disclosure as well as changes in the underlying fund share classes being offered, especially removal of underlying funds with 12b-1 fees. In addition, while these product filings generally do not seem to reflect significant simplification of VA Contracts (a rather widely- predicted consequence of DOLFR), it is possible that future filings will do so. What is clear, however, is that insurance companies have been proactively re-designing and changing their VA Contracts in response to DOLFR, and actively listening to their distribution part-ners’ guidance and input. As predicted, the BICE requirements, at a minimum, appear to be impacting the structure of broker compen-sation and driving down VA Contract fees and charges. Of course, it

15. E.g.—

Disclosure from the “Taxes” section of the prospectus for American General Polaris Advisory Income Variable Annuity (SEC File No. 333-213338):

On April 8, 2016 the United States Department of Labor published its final regulation defining fiduciary advice, along with related revi-sions to certain existing guidance, as well as a new exemption from specific ERISA prohibitions. The requirements under the regulation and related guidance apply primarily to ERISA plans and IRAs. The new requirements generally will not impact your rights under the Contract, they may, however, affect recommendations made by your financial representative and your financial representative’s ability to make those recommendations. More specifically, the regulation and related guidance generally will apply to recommendations to buy, sell or hold interests in the Contract, as well as recommendations for dis-tributions and rollovers to/from the Contract where the Contract is in an ERISA plan or IRA. The initial compliance date for portions of the new regulation is April 10, 2017, while compliance with other portions of the regulation and guidance is required by January 1, 2018.

Disclosure from the “Distribution of Contracts” section of the prospectus for Jackson National’s Perspective AdvisorySM (SEC File No. 333-210504): “[C]ompensation is subject to applicable state insurance law and regulation, FINRA rules of conduct and Department of Labor (“DOL”) rules and regulations.”

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will take several years to fully appreciate DOLFR’s ultimate impact on the VA Contract marketplace, even if DOLFR’s compliance dates are delayed or DOLFR’s requirements are modified by the Trump administration.

B. Certain 1940 Act Issues to Consider

In making VA Contract changes in reaction to DOLFR, insurance companies have been mindful of certain additional regulatory issues that are implicated under the Investment Company Act of 1940 (the “1940 Act”). 1. Section 26(f) (“Reasonableness Standard”): Section 26(f) of the

1940 Act requires that the aggregate fees and charges under a VA Contract be reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company sponsoring the contract (the “Reasonableness Standard”). In determining if the Reasonableness Standard is satisfied, insurers generally employ a reasonableness analysis for overall charges. This can include an analysis of numerous factors, including, but not limited to: (i) whether the aggregate charges and fees are within the range of industry practice; (ii) whether profits earned are reasonable; (iii) the degree to which the VA Contract and or the services being offered are innovative and entail addi-tional expense; (iv) pricing limitations that were in place under the 1940 Act, prior to the adoption of the Reasonableness Stand-ard; (v) general economic factors; and (vi) state specific regulations.

In connection with any reduction or change in the amount of com-pensation paid for the sale of a VA Contract in response to DOLFR, VA Contract charges (including underlying fund fees and expenses, to the extent considered) should be analyzed in the aggregate to determine whether they continue to meet the Reasonableness Stand-ard under Section 26(f). Similarly, if insurers opt to offer lower cost VA Contracts in the IRA and retirement plan markets than the VA Contracts they sell in the non-qualified market, the disparity in the level of fees and charges assessed for the two markets gen-erally should be analyzed to determine whether that disparity is supported by differences in the services, expenses and risks for the respective VA Contracts.

2. Redeemability and Rule 6c-8 (Permitting Contingent Deferred Sales and Administrative Charges): Section 27(i)(2) of the 1940

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Act requires that VA Contracts be redeemable securities. Section 2(a)(32) of the 1940 Act, in turn, defines a redeemable security as a security that entitles its holder to receive its current net asset value. In practical terms, this means that VA Contract owners may request a partial or full withdrawal from their VA Contract at any time during the accumulation phase, and the request generally must be processed at the next computed daily net asset value.

The SEC interprets this to mean that a VA Contract must be fully and partially redeemable without any restrictions, including any charges imposed at the time of redemption, that would result in the VA Contract owner receiving less than the current net asset value of the VA Contract. Rule 6c-8, however, provides an exemp-tion from the net asset value requirement by allowing an insurer to deduct a deferred sales load and certain annual administrative charges on surrenders and withdrawals. A “sales load” is defined in Section 2(a)(35) and a “deferred sales load” is defined for mutual funds in Rule 6c-10. Taken together, a deferred sales load as used in Rule 6c-8 is any amount properly chargeable to sales or promotional expenses that is payable by the contract owner after purchase, but before or upon redemption. In general, issuers of VA Contracts that impose restrictions on surrenders and with-drawals during the accumulation phase that do not fit under Rule 6c-8 must apply for individual exemptive relief. As insurers continue to assess their product offerings in the wake of DOLFR, any modifications to the amount of sales compensation paid, any charge restructuring, as well as any introductions of new with-drawal charge structures, should be evaluated in conjunction with Rule 6c-8. For example, if a withdrawal charge is no longer being used to pay for sales or promotional activities, it may no longer fit the exemption afforded by Rule 6c-8.

3. Rule 22d-1 and 22d-2 (variations in charges): Rule 22d-1 permits insurers to vary or eliminate sales loads, provided that: (i) any variation is applied uniformly to all offerees in the identified class; (ii) adequate information is provided concerning any scheduled variation, as provided in Form N-4 registration statement require-ments; (iii) before making any new sales load variation available, the company revises its prospectus and statement of additional information to describe the new variation; and (iv) the insurer advises existing Contract owners of any new sales load variation

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within one year of the date when that variation is first made avail-able to purchasers.

Rule 22d-2 permits insurers to vary charges that are deducted from purchase payments, provided that: (i) the prospectus discloses as precisely as possible the amount of the variations and the cir-cumstances, if any, in which such variations shall be available or describes the basis for such variations and the manner in which entitlement for the variation will be determined; and (ii) any such variations reflect differences in costs or services and are not unfairly discriminatory against any person.

As insurers consider varying VA Contract charges by market and/or distribution partner, they should be mindful of the terms and conditions set forth in Rules 22d-1 and 22d-2. Insurers should undertake an analysis of any charge variations, particularly where variations in charges for a single VA Contract are presented in the same prospectus (vs. multiple prospectuses) filed as part of a sin-gle registration statement. In doing so, they also can and should take into account the guidance provided in the recent Capital Group no-action letter discussed below.16

III. RECENT SEC RULEMAKING INITIATIVES AND GUIDANCE

A. Update on Proposed Rule 30e-3:

In October 2016, the SEC held an open meeting to consider whether to adopt certain rules aimed at modernizing investment com-pany disclosure and reporting information.17 One aspect of the initial rule package of particular interest to the variable insurance industry was proposed Rule 30e-3, which would facilitate electronic, website based transmission of annual and semi-annual reports for mutual funds under-lying variable annuities.18 Indeed, many supporters of Rule 30e-3 view

16. See infra note 26 and accompanying text. 17. Investment Company Modernization, Release No. IC-32314 (Oct. 13, 2016) (“Adopt-

ing Release”), and Release No. IC-31610 (May 20, 2015) (“Proposing Release”). 18. The industry has generally been vocal in its support of bringing e-delivery advance-

ments to the variable insurance product and fund space. Variable insurance industry trade associations have advocated persistently for the adoption of Rule 30e-3 since the time of its proposal, noting in particular that:

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adoption of Rule 30e-3 as a long overdue step forward in the world of e-delivery for the variable insurance industry that could also be a stepping stone toward the adoption of a variable annuity summary prospectus.

The SEC did not adopt Rule 30e-3 as part of the final modern-ization rule package. Chair White directed the SEC staff to further study the comments received on proposed Rule 30e-3, and to prepare a recom-mendation for SEC consideration before the end of the year (2016).19

The SEC did not consider Rule 30e-3 again before the close of 2016. Even with the change in Administration and in leadership at the SEC, it seems likely that the proposal will continue to be on the SEC’s 2017 regulatory agenda. Supporters of Rule 30e-3 anticipate that if the SEC does advance Rule 30e-3, it hopefully will include changes to the notice and opt in procedures to make them less burdensome.

B. Variable Annuity Summary Prospectus Update:

For the variable annuity industry, hope springs eternal for the adop-tion of a modernized variable annuity disclosure framework, which would be based, in part, on the model and success of the mutual fund summary prospectus. The Fall 2016 “Reg Flex” agenda has an enhanced disclosure rule for variable annuity contracts in the “proposed rule” phase, slated for consideration in October 2017.20 Consideration of the initiative has been postponed numerous times in the past, leading

“Notice and Access” delivery of shareholder reports will provide contract own-ers with relevant fund information in a manner that is more readily accessible and investor-friendly.

Insurers print and mail voluminous amounts of paper each year in connection with sending shareholder reports to variable contract owners, and the costs in con-nection with printing and mailing shareholder reports to variable contract owners are significant.

Contract owners will always retain the unfettered right to paper shareholder reports and will be reminded twice per year, as well as via an initial notifica-tion, that they can opt in to paper reports at any time.

19. See Adopting Release, supra note 17, at 309-11. Over 900 commenters expressed views on the proposed rule.

20. See https://www.reginfo.gov/public/do/eAgendaMain?operation= OPERATION_GET_AGENCY_RULE_LIST&currentPub=true&agencyCode=&showStage=active&agencyCd=3235&Image58.x=28&Image58. y=17&Image58=Submit.

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some variable annuity industry observers to view these agendas as aspirational.

For many years, the industry has been proactively advancing the dual concepts of a variable annuity summary prospectus and an annual update document. Both documents would be part of a layered dis-closure regime, with the corresponding statutory prospectus available online or in paper. While the SEC staff, individual Commissioners, and the former Chair have voiced their support of the initiative, it does not appear that rule and form amendments permitting variable annuity issuers to utilize a summary offering prospectus at the point of sale and a summary update prospectus/document for in-force business is imminent. As noted earlier in this outline, perhaps the adoption of a “notice and access” delivery regime for mutual fund shareholder reports will blaze a trail, and the staff will turn its attention to bring-ing both content and delivery advancement to the VA Contract space, as well.21

C. IM Guidance Update No. 2016-06:22

Recent SEC guidance (“Guidance Update”) permits mutual funds offering variations in sales loads to list the sales loads (also referred to as “scheduled variations”) for different distributors in an appendix to the statutory prospectus for the fund, and prescribes the conditions for using such an appendix—either as a part of the statutory prospec-tus or as a stand-alone document that is incorporated by reference into the statutory prospectus. The disclosure should specifically identify each broker-dealer or intermediary whose investors receive a sales load variation. Alternatively, for those mutual funds that provide fee structure variations by launching new share classes,23 the Guidance Update requires that each of the available share classes be listed in the prospectus fee table. It is notable that a mutual fund can have a separate prospectus for each available share class, as long as each such

21. Indeed, several commenters in connection with proposed Rule 30e-3 took the oppor-

tunity to advocate for the development of electronic delivery options for variable insurance product disclosure documents, which would include implied consent pro-cedures similar to those in proposed Rule 30e-3.

22. “Mutual Fund Fee Structures,” IM Guidance Update No. 2016-06 (Dec. 2016), available at https://www.sec.gov/investment/im-guidance-2016-06.pdf.

23. See, e.g., Grace Jennings-Edquist, “Wave of New ‘T Shares’ Puts Post-DOL Loads at 2.5%,” IGNITES (Jan. 3, 2017) (emergence of new “T Shares” with a maximum 2.5% load).

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prospectus discloses that other share classes are available. While the Guidance Update is mutual fund specific, it also has relevance for Variable Contract issuers that, in the context of DOLFR, are consid-ering variable annuity fee and charge variations in connection with requests from their distribution partners.

The guidance regarding use of an appendix is premised on the mutual fund prospectus disclosure required by Item 12(a)(2) of Form N-1A. The substantive disclosure requirements for mutual funds set forth in Item 12(a)(2) of Form N-1A, are nearly the same as those for variable annuities (set forth in Item 6(c) of Form N-4).24 However, because Form N-4 does not have prescribed ordering requirements like Form N-1A, the Guidance Update’s discussion permitting funds to use an attached appendix is a change to existing Form N-1A require-ments, but Form N-4 already allows variable annuity issuers to place disclosures regarding sales load variations for different intermediaries in an appendix that is attached to the statutory prospectus.

Without further guidance from the SEC staff, whether variable annuity issuers can utilize a stand-alone appendix remains an open issue. At the moment, alternative approaches available to variable annu-ities may include: filing multiple prospectuses—each describing a differ-ent variation (including sales charge variations) of the same contract sold through different distribution channels—in a single registration

24. For example, both mutual fund and variable annuity prospectuses must “identify

each class of individuals or transactions to which” special plans or arrangements apply. The Guidance Update explains that investors who purchase through a des-ignated intermediary would be a “class” for purposes of Item 12(a)(2) of Form N-1A. The Guidance Update also explains that the prospectus disclosure should spe-cifically identify each intermediary whose investors receive a sales load variation, and provides that if the appendix approach is followed, the appendix must specif-ically identify the name of the intermediary. Variable annuity issuers should antic-ipate that the SEC staff will apply the same interpretation of “class” disclosure to annuity prospectuses, and, if applicable, to the use of an appendix disclosure approach.

In addition to Item 12(a)(2) of Form N-1A, the Guidance update briefly notes that rule 22d-1 under the 1940 Act—which is applies variable annuities as well as to mutual funds—also requires that each variation be applied uniformly to particular “classes” of investors and transactions, and be disclosed in the prospectus with spec-ificity. In this regard, in instituting variations in any charges, variable annuity issuers should be mindful of any discrimination issues under applicable state insurance laws and regulations.

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statement; and presenting broker-dealer by broker-dealer variations in an appendix attached to a single prospectus.

The filing procedure guidance provided in the Guidance Update should be equally applicable to variable annuity separate accounts. To improve the efficiency of SEC staff review, the Guidance encourages mutual funds to utilize, when appropriate, the “selective review” pro-cess25 and the “template review” process available pursuant to Rule 485 (b)(1)(vii) under the Securities Act of 1933, as amended, when making post-effective amendment filings to disclose fee structure variations or adding new share classes.

D. The Capital Group No-Action Letter:26

The SEC staff recently issued a no-action letter, interpreting Section 22(d) of the 1940 Act, that effectively permits a selling broker to charge its customers a commission, set by the broker, on the purchase of no-load mutual fund shares, subject to certain conditions.

In considering the application of the no-action letter to registered variable annuities, two distinctions between mutual funds and variable annuities are noteworthy. First, the no-action letter applies to “clean shares” that are “no-load” and without any other asset-based fee for sales or distribution. By contrast, virtually all variable annuities have a mortality and expense risk charge, and prospectus disclosure typically states that proceeds from this charge may be used for any purpose, including distribution expenses. That said, the focus of the no-action letter is on whether payment from an underwriter or issuer would be consistent with the selling firm being deemed a “dealer.” In this regard, mortality and expense risk charges that are retained by the insurance company depositor should not present an issue if neither the insurer nor the principal underwriter make payments to the broker.

A second issue arises from the no-action letter condition that the broker must be “acting solely on an agency basis,” i.e., as agent for the customer. Under state insurance laws, individual registered repre-sentatives ordinarily act as “agents” of the insurance company, are appointed as such, and are paid by insurance company. Accordingly, state insurance law issues may arise if the intermediaries appointed as

25. See Revised Procedures for Processing Registration Statements, Post-Effective

Amendments and Preliminary Proxy materials Filed by Registered Investment Com-panies, Investment Co. Act. Rel. No. 13768 (Feb. 15, 1984).

26. Capital Group (pub. avail. Jan. 11, 2017).

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agents of the insurance company are paid by purchasers, rather than by the insurance company.

Of course, there are no-load variable annuities designed for sale to clients of investment advisers that charge their clients an ongoing advisory or management fee (typically a percentage of assets under management). Provided that the two issues noted above can be worked through, from a 1940 Act perspective, no-load variable annuities could be distributed through broker-determined commission-based accounts as well.

IV. SUBSTITUTION APPLICATIONS

Virtually every variable life policy or variable annuity contract (each a “variable contract”) supported by a separate account structured as a unit investment trust contains a provision reserving the right of the insurance company depositor to replace shares of one or more underlying funds held by the separate account for shares of one or more other funds (a “substi-tution”). (The separate account may or may not already own shares of such other funds.) Typically, a substitution can occur without the approval of contract owners. Moreover, the prospectus for these variable contracts dis-closes the insurer company depositor’s right to substitute.

Despite insurers’ reservations of rights, substitution transactions involv-ing variable contracts that are supported by registered separate accounts gen-erally require regulatory relief from the SEC.27 An insurer typically obtains such relief from through the SEC’s approval of a “substitution application.” More specifically, the SEC will issue an order granting the requested relief unless it orders a hearing on the application.28

27. Section 26(c) of the Investment Company Act of 1940, as amended (the “1940

Act”), prohibits the depositor of a registered unit investment trust from performing a “substitution” without obtaining SEC approval. Specifically, Section 26(c) of the 1940 Act provides: “It shall be unlawful for any depositor or trustee of a registered unit investment trust holding the security of a single issuer to substitute another security for such security unless the Commission shall have approved such sub-stitution.”

28. In some circumstances, instead of filing a formal application, insurers may rely upon no-action relief or published guidance from the SEC staff to perform sub-stitution transactions. See, e.g., The Prudential Insurance Company of America (pub. avail. July 18, 1986) (merger of affiliated underlying funds); Bankers Security Life Insurance Society (pub. avail. July 11, 1991)( separate account reorganization); AIG Life Insurance Company (pub. avail. Aug. 16, 2001) (permitting allocation of monies received upon liquidation of an unaffiliated underlying fund to a subaccount

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Much of the substitution activity over the past year appears to be attributable to: (i) the on-going trend of insurers filing substitution appli-cations to simplify their variable contract fund line-ups and improve their operational efficiencies;29 and (ii) the recent amendments to the SEC’s rules regulating money market funds.30

A. Simplifying Fund Line-Ups and Improving Operational Efficiencies:

In the aftermath of the recent financial crisis, insurance company issuers of variable contracts have devoted substantial resources to refin-ing their products in ways that are attractive to both contract owners and the insurers. As part of this trend, a number of insurers have sought

investing in an unaffiliated money market fund); The American Enterprise Life Insurance Company (pub. avail. Apr. 30, 2002) (permitting allocation of monies upon liquidation of an unaffiliated underlying fund to a subaccount investing in an affiliated money market fund with a 12b-1 fee).

29. See, e.g., Allianz Life Insurance Company of North America, et al., Release No. IC-32207 (Aug. 3, 2016) (Notice), Release No. IC-32242 (Aug. 29, 2016) (Order) (File No. 812-14580); New York Life Insurance and Annuity Corporation, et al., Release No. IC-32193 (July 26, 2016) (Notice), Release No. IC-32227 (Order) (Aug. 23, 2016) (File No. 812-14589); The Guardian Insurance & Annuity Company, Inc., et al., Release No. IC-31958 (Jan. 15, 2016) (Notice), Release No. IC-31993 (Feb. 10, 2016) (Order) (File No. 812-14449). See also, currently pending applications: Hartford Life Insurance Company, et al., (File Nos. 812-14446; 812-14447); The Prudential Insurance Company of America, et al., (File No. 812-14562); Transamerica Life Insurance Company, et al., (File Nos. 812-14488; 812-14490); Transamerica Advisors Life Insurance Company, et al., (File Nos. 812-14487; 812 14489); Commonwealth Annuity and Life Insurance Company, et al., (File No. 812-14646).

30. In advance of the compliance deadline for the SEC’s money market fund reforms, several insurance company issuers of variable contracts filed applications to substitute their existing prime money market fund options with government money market funds. See Money Market Reform: Amendments to Form PF, Inv. Co. Rel. No. IC- 31166 (Jul. 23, 2014).

After issuing several orders permitting insurance company issuers of variable contracts to replace their money market fund options, the SEC staff ultimately pub-lished guidance, in the form of FAQs, stating that insurers may replace their existing money market fund options without obtaining an order of approval pursuant to Section 26(c) of the 1940 Act, provided that certain conditions were met. See 2014 Money Market Fund Reform Frequently Asked Questions, available at https:// www.sec.gov/divisions/investment/guidance/2014-money-market-fund-reform-frequently-asked-questions.shtml. Following the publication of the SEC staff’s guid-ance, each insurer with a pending money market fund substitution application withdrew its application.

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to simplify their fund lineups and improve operational efficiencies by consolidating the number of fund options under their contracts that have duplicative investment strategies. Many insurers have also sought to further improve their operational efficiencies by reducing the number of funds in their fund lineups that are not managed by an affiliate of the insurer. Importantly, substantially all of the insurers that have sought to simplify their fund line-ups and improve their operational efficien-cies through substitution applications have simultaneously sought to reduce costs for contract owners by proposing replacement funds with relatively low expense ratios.

The specific facts and circumstances associated with these sub-stitution applications, including those filed in 2016 and in prior years, vary widely. Insurers have sought to substitute:

existing funds with replacement funds with lower expense ratios;

existing funds with replacement funds that are managed by an affil-iate of the insurer;

several existing funds with a smaller number of replacement funds, each replacement fund having a substantially similar investment profile as each existing fund it replaces;

actively-managed existing funds with actively-managed and/or passively-managed funds;

existing funds with replacement funds that have no history of oper-ations (i.e., shell funds);

existing fund share classes that do not charge Rule 12b-1 fees with replacement fund share classes that do charge Rule 12b-1 fees, and vice versa; and

existing funds that are eligible investment options under riders or features with investment restrictions, or existing funds that are part of asset allocation models, with replacement portfolios that are also eligible investment options under such riders or features or are also part of such asset allocation models. For an application currently pending before the SEC, one of the

fund firms with portfolios that stand to be replaced as investment options under prescribed variable contracts and a financial services firm with clients who own some of the affected variable annuity contracts

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have requested a hearing in an effort to block certain of the proposed substitutions.31

B. Conditions for Relief and Representations

Over the past two years, under the direction of the Chief Coun-sel’s Office of the Division of Investment Management, the SEC staff has been refining the list of conditions it requires and has requested that those conditions be presented in a discrete section of each substi-tution application. Although the precise conditions in each application reflect the particular facts and circumstances presented, the conditions will (at a minimum) generally provide that:

The proposed substitution(s) will not be effected unless the insurer determines that the proposed substitution(s) are permitted under the variable contract and can be consummated as described in the application under applicable insurance laws and other applicable regulatory requirements.

The proposed substitution(s) will not change the amount or value of contracts held by affected contract owners; create a tax liability for affected contract owners; or alter the obligations of the insurer under the contracts of affected contract owners.

The insurer or its affiliate, and not the contract owners, will bear the expenses and transaction costs reasonably related to the pro-posed substitution(s).

The insurer will impose an expense limitation and/or a revenue cap for a prescribed time period after the date of the substitution(s), if the fees and charges a contract owner currently pays under the contracts will be greater after the proposed substitution(s) than before the proposed substitution(s).

Notice about the proposed substitution(s) and written confirma-tion after a substitution has been effected will, and any prospectuses for the “replacement portfolios” may, be delivered to affected con-tract owners.

31. See Leslie Scism and Sarah Krouse, “The $15 Billion Fight Over What Funds

Hartford Annuities Holders Can Invest In,” Wall St. J.(Jan. 18, 2017, 8:00 a.m. ET), http://www.wsj.com/articles/the15billionfightoverwhatfundshartfordannuitiesholderscaninvestin1484744401; Joe Morris, “American Funds Fighting Hartford Over VA Shakeup,” IGNITES (Jan. 19, 2017).

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Lastly, if the investment adviser of a replacement fund intends to rely on an SEC order that allows the adviser to add or change sub-advisers without shareholder approval (commonly known as manager-of-managers exemptive relief), as a condition of the sub-stitution application, the SEC staff may require (i) the adviser to obtain shareholder approval of the adviser’s ability to rely on the manager-of-managers exemptive relief, (ii) at a vote held after the substitution date. The SEC staff may also require disclosure to that regard in the prospectus of the replacement fund delivered to con-tract owners. In addition to these conditions, the SEC staff has required that

insurance company issuers and other applicants make a variety of representations—particularly, representations about similarities between existing funds and replacement funds, and about the impact the pro-posed substitution(s) would have on the benefits offered by guarantees under the contracts, and on the value of those benefits.32

CONCLUSION

Market shifts and changes in the regulatory environment have forced insurance company issuers of variable insurance products to reinvent strate-gies, processes, and product offerings, while coping with persistent financial, economic and regulatory uncertainty. In 2016, the DOL fiduciary rule loomed large, causing upheaval in distribution channel structures and work-flows, and prompting new product design for variable annuities and mutual funds that are investment options available under those variable annuities. Consumers and variable annuity marketplace observers have seen initial responses to DOLFR, but everyone now is reassessing the situation in light of likely delays in DOLFR compliance dates. Therefore, the ultimate impact of DOLFR on the design and structure of variable annuity con-tracts is uncertain.

32. The other representations that the SEC staff requires, or that applicants often make,

include representations regarding: benefits to contract owners; benefits to insurers; assets involved in substitutions; insurers’ obligations under affected contracts; con-tract owners’ rights under affected contracts; and the process of redeeming and pur-chasing fund shares. Furthermore, if applicants are seeking relief from Section 17(a) of the 1940 Act to purchase replacement fund shares in-kind rather than for cash, the applicants are required to make additional representations regarding the in-kind transactions.

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Separately, if certain current SEC rulemaking initiatives and other guidance ultimately result in investor and insurance company friendly disclosure modifications—not to mention much needed advancements in e-delivery for the industry—such changes could significantly shape the SEC-registered insurance product marketplace. In the meantime, insur-ance companies issuing SEC- registered variable contracts will need to con-tinue to react to, and to adapt and refine their business models to fit, a fluid landscape.

S.E.R. January 20, 2017

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