Since the late 1950s, state exclusivity in the regulation of insurance has significantly eroded. In addition to the increasing overlay of federal antitrust law, as discussed above, the following illustrates the emergence of dual regulation.

If the McCarran antitrust immunity is narrowed by judicial interpretation or congressional action, both the Department of Justice and the FTC would accrue additional authority to challenge insurer and agent conduct, resulting in preemption or dual regulation. Even more ominous from the perspective of state insurance regulation, however, would be congressional action that directly or indirectly removes the bar to FTC regulatory and antitrust jurisdiction over the insurance industry. Various bills introduced in Congress over the past few years would do just that.

The FTC is not only an antitrust enforcement agency but also a major regulatory agency with sweeping authority over both competitive and consumer practices pursuant to Sec. 5 of the FTC Act, which bans unfair methods of competition and unfair or deceptive acts or practices. In addition, the FTC is responsible for enforcing the Clayton Act, which bans activities ranging from price discrimination to anticompetitive mergers.

To define and enforce the broad proscriptions of Sec. 5, the FTC has both adjudicatory and rule-making authority. If it determines in an adjudicatory proceeding that a party is engaged in an unfair trade practice, it may issue a cease-and-desist order even if the conduct was undertaken pursuant to state law. Furthermore, the FTC has the authority to promulgate rules that preempt state law. Thus the introduction of the FTC into the regulation of the insurance business promises not only extensive dual regulation but also very likely dominant federal regulation in those antitrust and trade practice areas embraced by Sec. 5.

By 1940, Congress had enacted a comprehensive statutory framework governing all facets of the securities industry and securities markets. Nevertheless, despite affirmation of Congressional authority over insurance as part of interstate commerce in the South-Eastern Underwriters Association case, since the federal securities laws did not specifically relate to insurance, the McCarran Act was deemed to render them inapplicable to insurance. Furthermore, the Securities Act of 1933 expressly exempted an insurance policy or annuity contract issued by an insurer, and the Investment Company Act of 1940 expressly exempted insurers. Consequently, until the late 1950s, federal securities regulation of life insurance products remained virtually nonexistent.

Judicial Application: Variable Annuity Cases. By the late 1950s, some insurers had developed variable annuity products under which premiums paid to the insurer were allocated to a separate account. Instead of fixed benefits, the amount of benefits varied in accordance with the investment experience of the separate account, which was not subject to the traditional statutory limitations on equity investments. At the commencement of the payout period, benefits might be either fixed or variable. Although the insurer continued to assume the mortality and expense risks, the annuitant assumed the investment risk.

In SEC v. Variable Annuity Life Insurance Company (VALIC), the Supreme Court determined that the concept of insurance involves some assumption of investment risk by the insurer and a guarantee that at least some of the payments will be paid in fixed amounts. Since VALIC�s variable annuity failed to meet these criteria, the Court found the contract to be a security, subject to the registration and prospectus requirements of the Securities Act of 1933. Although other insurers sought to design variable annuity products to avoid the implications of the VALIC decision, the Supreme Court went to some length to sustain the SEC�s assertion of jurisdiction.

Following VALIC, the Prudential Insurance Company expressed willingness to register its variable annuity as a security under the 1933 Act but maintained that it was entitled to be exempt from the Investment Company Act of 1940. That act exempts an insurance company whose primary and predominant business is the writing of insurance. Prudential primarily issued fixed-dollar insurance products, presumably fitting the exemption. Although the SEC concurred that Prudential itself was exempt, it ruled that the separate account containing the assets funding the variable annuity was an investment company that had to be registered. In Prudential Insurance Co. of America v. SEC, the lower court affirmed the SEC�s position, and the Supreme Court refused to review.

As a result of these cases, a variable annuity contract constitutes a security under federal law and is subject to the registration, prospectus, and antifraud requirements of the Securities Act of 1933; the separate account funding the variable annuity is an investment company subject to the 1940 Act. A variable annuity may be a security for federal purposes, however, it can still be insurance for state insurance regulatory purposes. Consequently, variable annuities are subject to dual regulation by the SEC and the state insurance commissioners.

Regulatory Application of Federal Securities Laws to Variable Life Insurance. In the early 1970s some insurers introduced variable life insurance (VLI), which provides cash values and death benefits that vary based on the investment experience of the underlying separate account. Although policyowners assume some of the investment risk, the insurer typically guarantees a minimum below which the death benefit cannot fall. Consequently, with respect to the death benefit, the insurer assumes not only the mortality and expense risk but also investment risk. More recently, insurers introduced a flexible premium policy, commonly referred to as a variable universal life policy, under which the policyowner may vary the amount and/or frequency of policy premiums as well as the level of the death benefit protection.

In an effort to launch VLI, the life insurance industry petitioned the SEC to exempt VLI policies containing specified features, such as the substantial guaranteed minimum death benefit, from the federal securities laws on the bases that the main purpose of the product was to provide protection against death, that the investment element was incidental, and that the policies were pervasively regulated by the states. Initially, the SEC adopted blanket exemptive rules under both the Investment Company and the Investment Adviser Acts since reconciliation with state insurance regulation would be very difficult. At the same time, however, the SEC expressly expected state regulation to provide "material protections to purchasers substantially equivalent to the relevant protections that would be available under the Investment Company Act."

The National Association of Insurance Commissioners (NAIC) responded by developing its Variable Life Insurance Model Regulation, adopted in 1973, which contained significant restraints on product design to ensure that the product would primarily be insurance rather than an investment. Initially, the SEC accepted the model, but in 1975 it rescinded its exemption, concluding that a blanket exemption rule deferring to a state regulatory pattern administered by diverse regulatory authorities would not assure adequate investor protection. Consequently, VLI policies are treated as securities under the 1933 act, and the separate accounts that fund VLI are subject to direct SEC control as investment companies.

Four federal securities laws have become quite relevant to life insurance companies that issue variable annuities and variable life insurance (hereafter in combination referred to as variable insurance).

The Securities Act of 1933. A major function of the securities markets is to enable the distribution of large blocks of new securities to the public through which the issuer of the securities seeks to raise funds by their sale. The fundamental philosophy underlying the 1933 Securities Act is disclosure of accurate information needed by a prudent investor to make an intelligent decision as to whether to buy the security. (The SEC does not pass upon the merits, or lack thereof, of a security.) Disclosure is achieved through (1) filing a registration statement with the SEC containing detailed information on the security, the issuer, the underwriting arrangements, financial statements, the officers, and security holdings, (2) providing a prospectus to potential buyers (containing much of the information in the registration statement), and (3) antifraud provisions that ensure that such disclosure is full and accurate.

Since variable insurance products are deemed to be securities, prospectuses must be delivered in conjunction with their offer and sale. The prospectus must be kept current for as long as payments may be accepted from contract owners. As part of the registration process, financial statements certified by independent public accountants must be filed for the separate account (as the issuer of the security) and the insurer (as the guarantor of the mortality and expense guarantees). In general, compliance with the registration and prospectus requirements of the 1933 act has posed no insurmountable difficulties in the sale of variable insurance contracts.

However, the elusive objective of a highly readable and easily understandable prospectus describing the variable insurance contract being offered has been a source of periodic SEC and industry concern and conflict. The prospectus must include the merits and disadvantages of the investment, and it must disclose the nature of the risk and expense charges incurred. Given the complexity of the products, the requirements of the Securities Act, and the advent of new products, fulfilling this objective promises to engage the SEC and the life insurance industry on an ongoing basis.

The Securities Exchange Act of 1934. A second basic function of the securities markets is to provide a way to trade outstanding securities. The 1934 Securities Exchange Act governs this activity through disclosure requirements, prevention of fraud and manipulation, regulation of the securities exchange markets, regulation of the over-the-counter (OTC) market (trading securities other than on a securities exchange, such as the New York Stock Exchange), and control of credit in securities markets. In the context of regulating life insurance company products, the most relevant provisions are those relating to the OTC market and broker/dealers. A broker is defined as any person engaged in the business of effecting transactions in securities for the account of others. A dealer is any person engaged in the buying and selling of securities for his or her own account as part of a regular business. The broker/dealer is the entity under the 1934 act responsible for supervising the activities of the salespersons. Insurance companies, or their affiliates, which distribute variable insurance contracts are required to register as broker/dealers. In most instances, affiliates have been formed for this purpose.

The 1934 act provides for the creation and registration of qualified associations of brokers and dealers, subject to SEC oversight and control, for self-regulation of their members. A broker/dealer who does not belong to a qualified association may not effect a transaction in the OTC market. Since currently the only such association is the National Association of Securities Dealers (NASD), the sale of variable insurance products necessitates membership in the NASD.

Pursuant to the requirements of the 1934 Securities Exchange Act, no broker/dealer or associated person can become a member of NASD unless qualified under appropriate standards of training and experience. The NASD must promulgate rules designed to prevent fraudulent practices and promote equitable principles of trade; safeguard against unreasonable profits, commissions, or other charges; prevent unfair discrimination between customers, issuers, or broker/dealers; and provide appropriate discipline (censure, suspension, or expulsion) for the violation of its rules. Imposing the act�s informational and examination requirements on a wide range of people spread throughout the insurer�s operations and training, supervising, and licensing agents selling variable insurance products have both posed problems.

Insurer Personnel. As noted above, a broker/dealer and its associated persons must meet standards as to training, experience, and other qualifications. Substantial information must be filed for each person engaged in securities activities, including information about sales, trading, research, investment advice, advertising, public relations, and recruiting and training salespersons. Furthermore, the broker/dealer must certify that on the basis of diligent inquiry and other information, it has reason to believe that the person is of good character and reputation and is qualified to act as an associated person. Associated persons must also successfully complete a securities examination.

Since the definition of an associated person is quite broad, including any partner, officer, director, branch manager, or employee (other than those whose functions are clerical or ministerial), this causes serious practical problems for insurers. Throughout an insurance company that sells variable contracts, there are several departments and people who have at least some contact with the business. Who must take the examinations and for whom must the information be filed? Obviously, agents selling variable contracts and their supervisors are subject to the requirements, but what about the insurer�s board of directors and top executives whose primary activities are in other areas? The time and expense burdens of these informational and examination requirements were somewhat relieved when the SEC took the position that an insurer would not be required to register as a broker/dealer as long as a subsidiary so registers and complies with all requirements.

Agents Selling Variable Insurance. A person selling securities, which includes a life insurance agent selling variable insurance products, must register individually as a broker/dealer unless he or she is an associated person of a broker/dealer. The definition of an associated person includes one who is controlled by the broker/dealer. Thus if an independent agent is under sufficient control of the broker/dealer, he or she need not register as a broker/dealer. If a broker/dealer establishes a relationship with an independent agent, the broker/dealer is responsible for either ensuring that the agent is registered as a broker/dealer or assuming the supervisory responsibilities attendant to the associated person relationship. Thus life insurance agents selling variable insurance (or mutual fund) products are subject to the training, examination, experience, and supervision requirements promulgated by the NASD. These requirements pose significant difficulties for the individual agents who are basically insurance salespersons and for the insurers bearing the expense of educating, training, and supervising those agents.

Consequently, agents entering the variable contracts market are confronted with a different selling environment. Prospectuses must be used, sales loads must be disclosed, and projections of investment results are prohibited. In addition to requirements pertaining to business conduct, agents must comply with NASD standards of commercial honor and equitable principles of trade, and they must recommend only suitable products fitting the customers� circumstances.

The Investment Company Act of 1940. As an issuer of securities, an investment company engages primarily in the business of investing, reinvesting, and trading securities. In essence, an investment company enables an investor to invest in a pool of securities (for example, a mutual fund or a separate account funding a variable annuity). An investment company�s accumulation of liquid and readily negotiable securities has offered a tempting target for exploiters. To counteract actual and potential abuses, Congress enacted the Investment Company Act of 1940, which encompasses six main areas governing investment companies: (1) registration of investment companies, (2) provisions aimed at honest and unbiased management, (3) security owner participation and control through both general and special voting rights, (4) adequate capital structure, (5) financial statements and accounting, and (6) selling activities. Securities issued by investment companies (such as mutual fund shares and variable insurance contracts) are subject to various selling limitations, including the prospectus requirements, rules on permissible commissions to avoid unconscionable or grossly excessive sales loads (maximum sales loads are prescribed in certain situations), and controls of standards for and filing of sales literature.

Some of the most difficult issues pertaining to the viability of variable contracts under federal securities laws have arisen in connection with the 1940 Investment Company Act. The SEC has accommodated the life insurance industry in some areas through exemptive relief or modifying some of its rules or interpretations. In other areas, however, exemptive relief has been denied, leaving the industry to its own devices as to how to cope with the problem.

Confronted with products that did not fit neatly within the act, the SEC in its early administrative decisions determined that variable insurance contracts should be regulated as periodic payment plans that were essentially a means of purchasing investment company securities by installment. Pre-1940 abuses in the marketing and sale of periodic payment plans had prompted enhanced regulation focusing on the types of sales and related charges allowed and the manner in which they may be deducted and, at times, refunded. Defining variable insurance contracts as periodic payment plans, however, has subjected them to controls that may not be suitable to variable insurance. Although the SEC has issued numerous exemptive orders and rules to handle insurer problems, the basic problem�that the provisions were not drafted with variable insurance in mind�remains.

The major area of difficulty in attempting to accommodate the provisions of the 1940 act with the nature of variable insurance products involves the regulation of various charges: sales loads, administrative expense charges, mortality and expense risk charges, investment-related charges such as advisory fees and with respect to VLI, the cost of death protection. The problems posed include the following: (1) The current securities law regulatory emphasis on limiting the individual charges inhibits product design and pricing. (2) Unlike periodic payment plans in which sponsors incur little capital expense, the administration of variable insurance contracts demands substantial administration and capital. SEC application of "at cost" and "reasonable expense" concepts under the 1940 act makes it difficult for an insurer to realize a satisfactory return on the use of its administrative and capital resources. This encourages insurers to emphasize fixed-dollar contracts (even to the exclusion of issuing variable contracts) that are not subject to such pricing limitations. (3) To be motivated to sell complex variable contracts, life insurance agents must be able to generate compensation comparable to that for selling fixed-dollar products. Because of SEC limitations, compensation tends not to be sufficiently comparable, thereby creating a marketing bias against the sale of VLI. (4) The SEC has concentrated its regulatory efforts on the securities elements of the variable insurance products and has avoided regulation of the insurance elements. Unfortunately, securities-related and insurance-related charges cannot be neatly divided for regulatory purposes. Some charges that insurers characterize as insurance charges may have components deemed appropriate for investment regulation under the 1940 act. Furthermore, as long as the SEC regulates only investment-related charges, the potential exists for insurers to evade such charge limits by adjusting insurance charges to the extent permitted by state law. On the other hand, insurers have been strongly against the SEC�s exercising control over insurance elements of the contracts.

For these reasons the SEC Division of Investment Management has concluded that the regulation of specific charges under the 1940 act is inappropriate for variable insurance and has recommended legislative changes that would grant the SEC authority to adopt rules to assure the reasonableness of aggregate contract charges and the manner in which they are deducted. (The SEC would no longer examine individual contract charges or the manner in which they are deducted or refunded.) However, granting such authority is viewed, at least by some in the insurance community, as giving the SEC control over insurance charges and prices, something that not even state insurance regulators have with respect to most types of life insurance products.

Investment Adviser Act of 1940. An investment adviser is any person who for compensation engages in the business of advising others, either directly or indirectly, about the value of securities or the advisability of acquiring or disposing of securities. An investment adviser must register under the Investment Adviser Act, pay a registration fee, maintain certain records, be subject to SEC oversight and examination, comply with antifraud provisions and certain requirements as to investment advisory contracts, and must not be compensated based on a share of the capital gains of the investment company funds.

Advising Separate Accounts. If an insurer wants to serve as an investment adviser to its separate account, the insurer has to register as an investment adviser. The SEC has taken a no-action position on several provisions in the act that would have been difficult, if not impossible, for the entire insurance company to comply with. To avoid these issues, many insurers choose to register a subsidiary, rather than the insurer itself, as the investment adviser.

Advising Prospective Buyers: Financial Planners. During the 1980s, there was a increasing demand for relatively low-cost financial planning services. The number of individuals and organizations offering financial planning services grew dramatically. A financial planner can be defined as a person who offers individualized advice on securities investments, nonsecurities investments such as life insurance, and the management of financial affairs. An insurance agent who offers and sells only insurance products and provides no other financial services is not considered to be a financial planner.

Outside of the Unfair Trade Practices Act provisions dealing with financial planners, states� regulations vary. Generally, life insurance agents may act as financial planners but cannot use that or a similar designation to imply that the agent is generally engaged in an advisory business in which compensation is unrelated to sales unless that is actually the case. States differ as to whether a life insurance agent can collect a fee for financial planning services and, if the agent can, under what conditions.

In addition to state requirements, life insurance agents engaging in financial planning services may find themselves subject to the Investment Adviser Act of 1940. In dealing with the applicability of the act to financial planners, the SEC uses three elements to define who is an investment adviser under the act. An individual is an investment adviser if he or she (1) provides advice or issues reports or analyses regarding securities, (2) is in the business of providing such services, and (3) does so for compensation. The advice need not relate to specific securities but may relate to the advisability of investing in securities generally. The compensation element can be met by receiving compensation in any form from any source, even if it is not a separate fee. Whether a person is "in the business" is determined by an analysis of the facts and circumstances, including the frequency of the activity. Providing advice with some regularity, even when it is not the person�s primary business activity, renders the person subject to the Investment Advisers Act. Furthermore, a person is deemed to be in the business if he or she holds himself or herself out as an investment adviser, receives separate or additional compensation that is a clearly definable charge for providing advice about securities, or offers specific investment advice on other than isolated instances.

A life insurance agent advising on variable insurance products (securities) would appear to fall within the definition of an investment adviser except for the exclusion for a broker/dealer whose performance of investment advisory services is solely incidental to the conduct of its business as a broker/dealer. As a general proposition, this exclusion relieves the broker/dealer and its associated persons (agents) from investment adviser status when they provide investment advice as an essential component of their brokerage business. However, the SEC considers how individuals represent themselves to prospective clients in determining the scope of the exclusion. Even if an insurance agent is a registered representative of a broker/dealer, if he or she holds himself or herself out as a financial planner, the likelihood of being deemed an investment adviser increases. In view of the increasing frequency of insurance agents who engage in financial planning, the SEC�s sensitivity to supervising financial planning activities adequately, and the tendency of private litigants to sue those with the deepest pockets (insurers), both insurers and agents need to be alert to the registration and antifraud responsibilities of agents who engage or appear to engage in financial planning.

Despite the evolvement of SEC regulation, issuing variable insurance still constitutes doing insurance business that is subject to state regulation.

Regulation of Variable Annuities. In the 1970s the NAIC adopted its Model Variable Contract Law, authorizing separate accounts and imposing some limitations thereon, as did most states. The NAIC next adopted a model regulation geared to variable annuities. Approximately half of the states have adopted the model (or similar regulation); most other states have adopted somewhat different controls.

In determining whether an insurer may issue a variable annuity, a commissioner must be satisfied that issuing such contracts will not render the insurer�s operations hazardous to the public or its policyowners. Variable annuity policies must be filed with and approved by the commissioner, as are other life insurance policy and annuity contract forms. The regulation mandates that the policy include a statement that the benefits will vary, a description of the means by which the insurer determines the amount of the variable benefits, the investment factors to be used, and the grace and reinstatement provisions. The reserve liability must be established pursuant to the Standard Valuation Law in accordance with actuarial procedures recognizing the nature of the benefits provided. Annually, an insurer must give its variable annuity contract owners both a statement of the investments held in the separate account and information on the values pertaining to the individual�s policy.

A state�s general proscriptions as to unfair trade practices apply to variable contract situations. States commonly, as does the NAIC model regulation, prohibit illustrations of benefits that include projections of past investment experience into the future or make predictions of future investment experience. However, in permitting the use of hypothetical, assumed rates of returns to illustrate possible benefit levels, the model regulation accepts the argument that illustrations based on certain specified investment return assumptions, as distinguished from projections of an individual company�s experience, can contribute to a meaningful presentation to prospective purchasers.

To sell variable annuities an individual needs to be licensed as a life insurance agent. The examination for an agent�s license includes questions that the commissioner deems appropriate on the history, purpose, regulation, and sale of variable annuities. An agent must also comply with the training, examination, and business conduct requirements of the federal securities laws. The commissioner may deny, suspend, or revoke an agent�s license to sell variable annuity contracts on grounds akin to those applicable in nonvariable annuity situations.

Regulation of Variable Life Insurance. After the SEC decided to resume direct regulation of VLI under the 1940 Investment Adviser Act, the NAIC substantially amended its model regulation in 1982 to eliminate restrictions no longer relevant to avoiding SEC assertion of authority, to bring the model regulation into conformity with the 1980 changes in the Standard Valuation and Nonforfeiture Laws, and to enable the development and sale of flexible-premium variable life plans�that is, variable universal life insurance. Over 30 states have adopted the NAIC model VLI regulation or something similar thereto; more than 10 additional states have related legislation or regulations.

An insurer is authorized to write VLI only if the commissioner finds that the plan of operation to issue VLI is not unsound; the general character, reputation, and experience of management and other relevant persons reasonably ensure competent VLI operations; and the method of operations is not likely to render them hazardous to the public or policyowners.

Mandatory policy benefit and design requirements cover several areas. The insurer must bear the mortality and expense risks, whose charges are subject to maximums stated in the contract. For scheduled premium policies, the insurer must provide a minimum death benefit in an amount at least equal to the initial face amount of the policy. Changes in the variable death benefit must be made at least annually; the cash value must be determined at least monthly. Computation of values must be based on reasonable assumptions acceptable to the commissioner.

A VLI policy must contain statements about the variable and fixed nature of the death benefits, the variable nature of the cash values subject to specified minimum guarantees, and any required minimum death benefit. The policy must also provide for a grace period, reinstatement, and policy loans. VLI policies must be filed with and approved by the commissioner before use. Reserves for VLI must be established under the Standard Valuation Law in accordance with actuarial procedures that recognize the variable nature of the benefits. The insurer must maintain assets in the separate account that have a value at least equal to the valuation of reserves for the variable portion of the VLI policies.

The insurer has to deliver specified information to the applicant for a VLI policy before the execution of the application. Under the Securities Act of 1933, delivery of the prospectus meets this requirement since the prospectus contains the information the regulation requires. The application for a VLI policy must contain prominent statements that the death benefits may be variable or fixed under specified conditions and that cash values may increase or decrease according to the experience of the separate account (subject to minimum specified guarantees). It must also contain questions designed to elicit information about the suitability of VLI for the applicant. Each insurer must establish (and maintain) written standards of suitability and must not recommend VLI to an applicant in the absence of reasonable grounds to believe that the purchaser is not unsuitable after reasonable inquiry about the applicant�s insurance and investment objectives, financial situation, and needs.

The insurer�s sales materials, which are subject to the NAIC life insurance advertising rules, may not be false, misleading, deceptive, or inaccurate. The insurer must disclose in writing, prior, or contemporaneously with the delivery of the policy, all charges that might be made against the account, such as taxes, broker�s fees, insurance costs, and mortality and expense guarantees.

The insurer must give its VLI policyowners annual reports on cash values, death benefits, partial withdrawals, or policy loans, and must also furnish a financial statement summary of the separate account, a list of investments in it and charges against it, the net investment return for the past year, and any changes in investment objectives. Before its use in the state, all information provided to applicants and the form of any reports to policyowners must be submitted to the commissioner. Material will not be approved if found to be false, misleading, deceptive, or inaccurate.

The VLI regulation and the Uniform Agent and Broker Licensing Act now contemplate examining all agents applying for a license on both traditional and variable contracts. The agent must comply with the federal securities law requirements on training, examinations, and business conduct. The commissioner may reject an application for, suspend, or revoke an agent�s license to sell VLI on the same grounds used for other forms of life insurance.

Following the variable annuity cases discussed earlier in this chapter, insurers and agents selling variable insurance contracts have become subject to the broad gamut of regulatory, disclosure, and antifraud requirements of the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940. Although in many situations the SEC has tried to accommodate the federal securities laws to the nature and structure of the life insurance industry, the unique attributes of the contracts, and the role of state insurance regulation, it has not backed away from enforcing the fundamental concerns embodied in these laws to defer to state regulation. Therefore, while SEC regulation of variable contracts is very real and very detailed, the SEC has not tried to achieve exclusive control by preempting state regulatory activity.

The states have continued to view variable contracts as insurance products subject to the full range of insurance regulation. State legislatures and regulators have developed a regulatory framework to deal with the unique nature of these products and to allow for the substantial federal presence. The design of variable insurance contracts, the sales and distribution process, and the administrative mechanisms must satisfy the requirements of both federal and state securities laws. Dual federal and state insurance regulation is a fundamental fact of life for insurers and their agents operating in the variable insurance contract arena.

With respect to the federal securities laws, insurance products can be classified as falling into one of three categories. First, there are the traditional contracts, under which virtually all of the investment risk remains with the insurer, contract values do not vary, and the contracts are funded through an insurer�s general account. Such contracts remain within the domain of state insurance regulation. Second, there are variable insurance contracts, under which the investment risk is transferred to the buyer, and contract values vary frequently with investment performance. These contracts must be registered as a security under the Securities Act of 1933, and their underlying separate account must be registered as investment companies under the Investment Adviser Act of 1940. Third, there are hybrid contracts, which are the focus of the next section of this chapter.

Securities Act of 1933: Applicability of Sec. 3(a)(8) to Hybrid Contracts. Responding to high interest rates, life insurers in the 1970s began to offer a variety of new annuity products, generally referred to as guaranteed investment contracts (GICs). Although GICs had investment guarantees similar to those in a traditional annuity, they also involved the payment of interest in excess of what was guaranteed. Single-premium deferred annuities (SPDAs) particularly interested the SEC. SPDAs were excess interest contracts under which the purchaser typically made a substantial single payment. The insurer guaranteed to pay a minimum interest (typically 4 percent to 6 percent) for the life of the contract, with the possibility that it would periodically declare excess interest. These products were marketed primarily as an investment vehicle with little focus on the traditional annuity features. Similar to other securities, the ability of the contract owners to earn the high anticipated rates of interest depended on the investment portfolios and the investment acumen of the insurer. The products were sold as tax-deferred investment vehicles and as alternatives to certificates of deposit and municipal bonds.

Because marketing the products as investments and paying excess interest at the company�s discretion shifted some of the investment risk to the purchaser, the SEC undertook to determine whether such contracts were securities that should be subject to the registration, prospectus, and antifraud provisions of the Federal Securities Act of 1933. In doing so, the SEC embarked on a road that significantly broadened the scope of its reach to life insurance products funded out of an insurer�s general (as distinguished from its separate) account.

Ever since the VALIC decision in 1959, regulators, courts, and insurers have wrestled with the issue of just how much investment risk an insurer must assume under an annuity or life insurance contract to come within the Sec. 3(a)(8) exclusion, which expressly excludes an insurance policy or annuity contract issued by an insurer from the 1933 act. In reaching their determination, the courts have focused on the extent to which the insurer bears the investment risk, how the contract is marketed, and to a lesser extent, whether the insurer assumes the mortality risk.

After a period of several years, pressured to clarify the status of fixed annuity contracts under the federal securities laws and to effect more objective standards in applying Sec. 3(a)(8), in 1986, the SEC adopted Rule 151. This rule provides that if an insurer�s contract meets the following three basic conditions, the insurer can rely on the Sec. 3(a)(8) exclusion: (1) The insurer is subject to the state insurance commissioner�s supervision, (2) the insurer assumes the investment risk under the contract, and (3) the contract is not marketed primarily as an investment. Investment risk will be deemed to be the insurer�s if the insurer guarantees the principal amount of purchase payments and interest credited for the life of the contract, credits a minimum specified rate of interest, and guarantees that any excess interest above the required minimum will not be reduced within one year. Although Rule 151 applies specifically to annuities, the SEC has indicated that the same principles also apply to life insurance. Furthermore, courts have applied the standards of Rule 151 to a life insurance policy.

As of 1992, the courts and the SEC agreed that the investment risk assumption is the most crucial factor in determining whether a contract falls within the parameters of Sec. 3(a)(8). They concur that purchase payments and minimum interest rates must be guaranteed. However, there is considerable uncertainty as to what extent excess interest rates and credited excess interest must be guaranteed and whether a contract with less than a year-long guarantee of excess rates or a contract not guaranteeing credited excess interest can fall within Sec. 3(a)(8).

How the contract is marketed is also an important factor in determining the availability of the Sec. 3(a)(8) exclusion. For the most part, the courts have found that a contract meets Rule 151�s marketing condition despite references to the "investment" aspects of the insurer�s investment abilities, the excess interest rates, and the tax advantages. Since investment management is the lifeblood of life insurance companies, it is appropriate for the insurer to tout its investment experience in relation to the insurance product. However, although the SEC maintains that a contract will not qualify for the Sec. 3(a)(8) exclusion if it is marketed with primary emphasis on current discretionary interest rather than on the product�s usefulness as a long-term device for retirement or income security purposes, there is some suggestion that this may not be the case for the courts. Both the SEC and the courts agree that mortality risk assumption is less of a factor for falling within Sec. 3(a)(8) than investment risk assumption and the manner of marketing. However, to what extent mortality risk assumption is a factor and how its meaningfulness is to be evaluated remain uncertain.

Even though the life insurance industry has sought to avoid registering general account products under the 1933 Securities Act, doing so does have at least three advantages. First, there is increased flexibility in product design since the insurer no longer has to worry about designing a product to meet SEC exclusion standards. Second, registration eliminates legal uncertainty and potential liability under the 1933 act for illegally selling an unregistered product. Third, a registered product can be marketed as an investment. On the other hand, the disadvantages include registration and prospectus disclosure requirements and costs, periodic reporting requirements, restrictions on advertisements, and requirements that agents have a securities license.

Applicability of the Investment Company Act of 1940 to Life Insurer General Accounts. Sec. 3(c)(3) of the Investment Company Act of 1940 excludes an insurer whose "primary and predominant business activity is the writing of insurance." In the context of hybrid (GIC) contracts, this raises at least two fundamental issues as to the act�s applicability.

First, the Prudential case held that a separate account funding a variable annuity is separable from the insurance company and constitutes an investment company not covered by the exclusion for insurance companies. In contrast, hybrid or GIC contracts are funded out of an insurer�s general account. This poses the question about whether such general accounts are subject to the 1940 act as investment companies. To date the SEC has not sought to regulate general accounts underlying such contracts.

The second question is at what point an insurer loses its ability to rely on the Sec. 3(c)(3) exclusion. This is a problem when an insurer�s registered general account products become a high enough percentage of its business that its primary and predominant business is no longer issuing unregistered products (for example, the situation in the VALIC case). The rapid growth of various types of excess interest and variable insurance contracts during periods of high interest rates (as occurred in the 1980s) demonstrated that such a possibility is not a remote one. If the 1940 Investment Company Act ever does become applicable to a life insurer�s general account, the regulatory complexities and the potential for dual or preemptive regulation would be greatly magnified.

Federal Securities and State Insurance Regulation of Hybrid Contracts. The SEC and the courts have established general principles that determine whether an insurance product is excluded from the 1933 Securities Act. Although the governing principles are easy to understand, their application to a particular situation is often difficult.

SPDAs. In 1991 a lower federal court enjoined persons offering unregistered securities, including SPDAs, from further violations of the antifraud provisions of the 1933 Securities Act and 1934 Securities Exchange Act. The SEC charged that the defendants misrepresented the risks, the returns, and the purported guaranteed nature of the securities. The SEC successfully argued that these SPDA contracts were securities subject to the 1933 act that did not fall within the Sec. 3(a)(8) exclusion because of the investment risk assumption and the marketing factors.

Market Value Adjustment Contracts. A market value adjustment feature (MVA) is generally designed to avoid problems of disintermediation when the current or market interest rate is guaranteed for a specified period and a withdrawal occurs before the end of the guaranteed period. Upon early withdrawal or surrender before the end of the period of guaranteed excess or discretionary interest, the insurer adjusts the proceeds paid to reflect changes in the market value of portfolio securities supporting the contract. If the value of the securities has decreased, the amount payable on surrender decreases. (The opposite also applies.) On occasion, the adjustment could invade previously credited interest or principal. Even though the purchaser can avoid an MVA by holding on to the contract until the end of the term, the MVA feature does shift investment risk to the contract owner who decides to surrender the contract during the guaranteed period. Whether the shift is enough to require registration under the 1933 act depends on the terms of the MVA feature. However, MVA contracts probably cannot obtain the protection of Rule 151, which requires that the insurer guarantee the principal amount of purchase payments (premiums) and all interest credited to them.

Whether or not MVA contracts are subject to the 1933 act, they are subject to state insurance regulation. In the mid-1980s the NAIC adopted the Modified Guaranteed Annuity Model Regulation, defining an MVA contract as a deferred annuity contract whose underlying assets are held in a separate account and whose values are guaranteed for a specified period of time. The contract must contain nonforfeiture values based on a market-adjusted formula if the contract is held for less than the guaranteed period of time. The assets must be held in a separate account during the period in which the contract owner can surrender his or her contract. The regulation mandates contract benefit and design requirements and covers reserve liabilities, separate accounts, and annual reports to contract owners. An agent must hold a variable annuity license to sell such annuity contracts. By 1992, five states had adopted either the model or something similar to it, and two states had adopted related legislation. (In 1986 the NAIC also adopted the Modified Guaranteed Life Insurance (MGLI) Model Regulation.)

Index Policies. Prior to Rule 151, the insurance industry thought that annuity contracts whose accumulation rates were tied to external indexes fell within the Sec. 3(a)(8) exemption. Although the buyer bears the investment risk of the external index�s going up and down, the insurer bears the investment risk of its investments underlying the contract achieving a higher or lower rate than the external index. Nevertheless, the SEC apparently holds the view that Rule 151 does not protect indexed-interest-rate annuity contracts from application of the 1933 Securities Act on the theory that externalization shifts the investment risk to the contract owner. Thus the prospects are substantial that interest-indexed contracts are subject to the act.

In 1988 the NAIC adopted the Interest-Index Annuity Contracts Model Regulation, covering individual annuity contracts whose interest credits are linked to an external reference. However, as of 1992, no state had enacted this legislation, leaving the regulation of such contracts, for the most part, to existing rules and regulations.

Universal Life Insurance. The late 1970s and early 1980s witnessed soaring inflation, spiraling interest rates, growing demands for term (as opposed to permanent) insurance, a flood of policy loans and surrenders to take advantage of higher interest rates available elsewhere, and heightened consumer sophistication. An increasing number of life insurance companies concluded that new products were needed to respond to the changes in the marketplace. These factors contributed to the emergence of universal life insurance (as well as SPDAs, MVA contracts, and indexed annuities, as discussed earlier).

Universal life insurance generally refers to a whole life policy with flexible premiums, adjustable death protection, a cash value credited at current rates of interest, and funding through the insurer�s general account. Through this vehicle insurers seek to satisfy the public�s needs for both protection and savings within the framework of one product.

In essence, the premiums go into a side fund from which the insurer makes two deductions: a charge for insurance protection (in effect, term insurance) no greater than the maximum charge guaranteed in the policy and a charge for insurer expenses and profit. The money remaining in the side fund earns interest for the policyowner. The insurer guarantees that the annual rate of interest credited on the cash value will not be less than a stated percent. (It may not exceed the maximum rate permitted under the Standard Nonforfeiture Law.) In addition, excess interest is provided at a rate determined at either the company�s discretion (the excess rate may be guaranteed for a specified period of time, such as one year) or according to a stipulated external financial index (for example, 90-day Treasury bill or long-term corporate bond indexes). Typically, to qualify for excess interest, the fund must be a minimum size. This fund is referred to as the policy�s cash value, but unlike the traditional whole life policy cash value, its growth is based on a variable, rather than a fixed, rate of interest. Unlike variable contracts utilizing a separate account, the funding vehicle for universal life is the insurer�s general account.

Commonly, a universal life insurance policy grants the policyowner a choice in the manner of determining the death benefit. One option is for the death benefit to equal the face amount of the policy or the cash value plus a pure risk amount (a specified amount or a specified percentage of the cash value), whichever is greater. The second option is for the death benefit to equal the face amount of the policy plus the cash value. Typically, policyowners can, from time to time, change the death benefit option chosen and increase (subject to evidence of insurability) or decrease the face amount of the policy, thereby affording considerable flexibility. Some policies also provide cost-of-living increases in the amount of the death benefit.

Within limits, policyowners can vary the amount of annual premium they pay upward or downward, depending on their personal circumstances and preferences. If they skip a premium payment, the charge will simply be taken out of accumulated cash value.

Under a traditional whole life policy, funds can be withdrawn by either a policy loan (on which interest must be paid) or by surrendering the entire policy for its cash value minus a surrender charge, if any. In contrast, a universal life policy permits partial withdrawals from the cash value investment fund. Thus a universal life policy functions much like a savings account or a money market investment fund.

By unbundling the savings and protection elements of a traditional whole life policy, universal life offers flexibility in the amount of premiums paid, the determination of death benefits, and the withdrawal of cash values. Cash values are accumulated on a variable basis, enabling the policyowner to benefit from high interest rates; disclosure of the company fee portion of the premium is improved. Universal life has been described as being essentially a package of term life insurance coupled with an investment fund with the added benefit that the returns on the investment fund are tax deferred.

SEC Involvement with Universal Life Insurance. SEC concern with a life insurance company�s general account products has extended to universal life. In 1981 the SEC Division of Investment Management sent a letter to several life insurers that were marketing universal life insurance, requesting their views on the status of the product under the 1933 Securities Act. This inquiry suggested possible assertion of SEC jurisdiction even over general account products containing traditional insurance guarantees. Such an expansive application of the federal securities laws would constitute pervasive federal regulation of the core of the life insurance business. However, to date, the SEC has not concluded that universal life falls outside the Sec. 3(a)(8) exclusion from the 1933 act.

State Regulation of Universal Life Insurance. As insurers began to offer universal life insurance policies, various states started issuing guidelines that differed widely in their comprehensiveness and sometimes conflicted with one another. Consequently, the NAIC developed a model regulation to address several areas of regulatory concern, including compliance with the standard valuation and nonforfeiture laws, the matching of assets and liabilities, the need for mandatory or prohibited policy design features, and disclosure and periodic reporting. The purposes in drafting the model were to supplement existing life insurance policy regulations, provide guidance in areas where regulatory gaps existed, and treat universal life as another insurance product, rather than as a form of investment requiring a wholly new regulatory treatment. In 1983, the NAIC adopted the Universal Life Insurance Model Regulation (last amended in 1989). As of mid-1992, over 10 states had adopted the model regulation or similar regulation.

The regulation establishes the minimum valuation standard and minimum reserve requirement for universal life policies, and it governs nonforfeiture values for both flexible and fixed-premium policies. It imposes certain mandatory policy provisions: An insurer must provide periodic disclosure, at least annually, to policyowners. There must be guarantees of minimum interest credits and maximum mortality and expense charges. No figures based on nonguaranteed amounts can be included in the policy. The policy must describe the method of calculating the cash surrender value and must provide a 30-day grace period.

Specific disclosure requirements are imposed on the advertising, solicitation, or negotiation of a universal life insurance policy. At the time of application, the agent must give the applicant a summary statement of the policy substantially in accord with a prescribed form. Policy premiums, death benefits, and cash values must be illustrated for the current interest rate actually being paid on existing policies in force and for the interest rate guaranteed in the policy. The regulation is not intended to conflict with or supersede the Unfair Trade Practices Act or the Model Regulation on Advertising and Solicitation.

As with conventional whole life insurance, the insurer maintains life insurance reserves required by state law for the death benefit payable under the universal life policy. The cash value of a universal life policy is computed in a manner similar to the calculation of cash values for traditional whole life policies, albeit on a monthly rather than an annual basis. The cash value so computed must comply with the minimum requirements of the Standard Nonforfeiture Law.

In addition, the Universal Life Insurance Model Regulation sets forth information that must be furnished to the insurance department to better enable the commissioner to determine that the insurer is adequately matching assets and liabilities. A statement of actuarial opinion, including an assurance of sound investment practices is also required.

Three major bodies of law (antitrust law, state insurance regulation, and securities law) at the state and federal levels, each with its own focus and sense of priorities, have regulatory authority over acquisition and merger activity involving insurance companies. The Department of Justice, the FTC, and the state insurance commissioners seek to prevent changes in control that would adversely affect the competitiveness of the marketplace. In addition, state insurance commissioners approve or disapprove acquisitions and mergers in terms of their actual or potential impact on policyowner and public interest with respect to the insurer�s continued ability to do business, its financial condition, fairness to policyowners, and the competence and integrity of the new owners and management. The same acquisitions and mergers pose different concerns for the SEC, whose focus centers on investor protection through full disclosure in the framework of a balanced treatment between the acquirer and the management of the target company.

With multiple exercise of regulatory authority involving both state and federal government, the prospect for constitutional challenge is quite real. Most likely, however, the Supreme Court will accommodate various regulatory and public policy interests in a way that leaves multiple regulation of acquisitions and mergers substantially intact.

The early and mid-1980s witnessed a small increase in the number of insurance company insolvencies and near insolvencies, especially in (but not limited to) the property and casualty insurance industry. Concern continues over the financial condition of insurers, including some high-profile life insurance companies, as a result of three large life insurer insolvencies in 1991. With the specter of the savings and loan crisis, the pressure for a substantive and direct federal regulatory involvement, as distinguished from the traditional congressional role as overseer, has escalated. After an intensive investigation led by Congressman John Dingell, legislation has been introduced that, if passed, would create direct federal regulation for insurance company solvency. Although support for federal involvement (including support from some segments of the insurance industry) has significantly increased, at this writing the ultimate fate of such legislation is still uncertain.

Since its inception, state insurance regulation has been confronted with the problem of regulating a business that crosses state lines. As discussed in chapter 26, to cope with a regional and national business, the states joined together in 1871 through the NAIC to coordinate their activities and achieve the necessary degree of uniformity to enable a nationwide industry to function as it addressed state regulatory concerns at the same time. For more than 120 years, the NAIC has proven to be resilient and flexible in dealing with insurance regulatory problems. While far from perfect, this voluntary collective state effort has proven to be a remarkable force in the industry.

Although the states continue as the prime regulator of the insurance business, there are competing demands of the other relevant regulatory disciplines, resulting in a considerable amount of dual state and federal regulation of the business. Furthermore, while not new in nature but perhaps new in intensity, there have been recent efforts to supplant large portions of state insurance regulation with direct federal insurance regulation�for example, the proposed legislation for direct federal solvency regulation, mentioned above.

To address defects in solvency regulation, as well as to avert federal intervention, the states have responded with increased activity at the individual state level and voluntary cooperative activity through the NAIC to develop appropriate model laws and regulations. But, unlike the past, when the states could voluntarily select which elements of an NAIC work product to adopt or reject, the NAIC is exerting pressure to gain widespread state compliance with its solvency program through the NAIC accreditation program.

Specific aspects of solvency regulation and guaranty fund legislation were discussed in chapter 26. In addition, in 1989 the NAIC established Financial Regulation Standards to serve as baseline standards to encourage states to upgrade the quality of insurance solvency regulation. Establishing national standards within the flexible framework of state insurance regulation was undertaken, in part, to demonstrate that direct federal solvency regulation is undesirable and unnecessary. It is anticipated that adopting the NAIC standards will achieve greater uniformity and consistency between the states.

The NAIC standards cover three elements of a state regulator�s capability: (1) the laws enacted and the regulations adopted, (2) regulatory practices and procedures with respect to effective financial analysis and financial examinations, and (3) department organizational practices and procedures. Periodically, the NAIC may add to, modify, or eliminate standards in response to new situations and improved regulatory techniques.

In 1990, recognizing that what one state does or does not do can have a dramatic impact on the fate of other states� regulation, the NAIC adopted an accreditation program to provide an incentive for states to improve their solvency regulatory programs to meet NAIC standards. Commencing in January 1994, accredited states will not accept examination reports from nonaccredited states, thereby impairing the ability of insurers from nonaccredited states to do business in the accredited states until they undergo a second examination acceptable to the accredited states. Furthermore, an accredited state may decide not to license an insurer domiciled in a nonaccredited state.

States seeking accreditation must undergo a multiphase accreditation review. Initially, the state conducts a self-examination of how its regulatory capabilities meet the NAIC standards on model laws and regulations in place, sufficient staffing in terms of numbers and expertise, and other technical capabilities. After a preliminary review by the NAIC and after the state has dealt with suggested changes, the insurance department is subjected to an on-site review by an independent audit team. Thereafter, the NAIC Accreditation Committee votes whether to accredit the state. To assure continued compliance, a state faces an annual desk audit and a complete review every 5 years. If the NAIC changes its standards, states are given a specified period of time, such as 3 years, to bring their laws, regulations, and practices into conformity to preserve their accreditation. At the end of 1992, 19 states had been accredited, accounting for at least 70 percent of the total United States premium.

Whatever the criticisms of particular aspects of the NAIC accreditation program for solvency regulation, the approach may herald a new era in state insurance regulation. Although directed at regulation for solvency, the basic approach�standards coupled with a strong incentive to gain individual state compliance�can be applied to other facets of regulation. The NAIC has again demonstrated its flexibility in combining the virtues of regulation at the state level with the necessity of adequately regulating a nationwide business.

Although the NAIC accreditation program has commanded the most attention, the concept of interstate compacts has been advanced as an alternative state response to the need for coordinated and consistent regulation of a nationwide industry. Under the Contract Clause of the United States Constitution, the states may enter into an agreement with one another, subject to the approval of Congress, to institute uniform standards, rules, and enforcement mechanisms deemed necessary and appropriate to regulate certain aspects of the insurance business. As legislatively enacted statutes, compacts take precedence over previously enacted statutes. Since compacts are legally binding contracts with other states, they also take precedence over subsequently enacted conflicting statutes. State actions contrary to the compact impair the contract rights of the other states in violation of the Contract Clause of the United States Constitution. A state may not unilaterally abrogate its compact responsibilities. Thus interstate compacts afford a constitutional, statutory, and contractual basis for uniform legislation.

As an agreement entered into by the states, the states can determine the precise nature and scope of an interstate compact�s authority and mechanisms. An interstate compact could establish a primary compact agency to serve a subordinate agency in each state that is a party to the compact. This primary agency may have rule-making and enforcement powers to establish uniform standards in those areas deemed to require uniform treatment, while leaving the majority of regulatory issues to be handled under the current system of regulation. In the context of insurance regulation, a natural candidate for the primary compact agency would be the NAIC, although other possibilities might also be considered.

Although the ultimate fate of the interstate compact concept for insurance regulation is unclear, it is a viable alternative to direct federal regulation of insurance, and it is a significant evolutionary step beyond the NAIC accreditation approach.

In the 1980s there was a notable movement toward the convergence or closer integration of financial services. Commonly, financial services are defined as including deposit-taking and lending institutions (banks, savings and loans, and other thrifts), securities and investment services, insurance, and real estate services. The convergence (or integration) of financial services refers to a marketplace phenomenon characterized by the movement of various financial institutions across traditional boundaries (legal or otherwise), the development of products designed to compete across traditional boundaries, and the entry of nonfinancial companies into the financial services marketplace.

It is beyond the scope of this chapter to predict the nature of insurance business regulation in the future. It appears safe to assume, however, that the extent to which the economic, technological, and political forces foster or deter further convergence of financial services, they will also have a substantial impact not only on the nature of regulation but also on the locus of regulation at the state and/or federal level. The ultimate locus of regulation, in significant part, will reflect the effectiveness of current regulatory structures in responding to changing circumstances and needs.

In addition to the move toward the convergence of financial services in the United States, financial services in general and insurance in particular are becoming increasingly internationalized. Although international trade in goods and services must confront a host of government-imposed trade barriers, the evolution of bilateral discourse and agreements between nations, regional trading blocks (the European Union, formerly the European Community, and the North American Free Trade Agreement), and worldwide trade negotiations (General Agreement on Tariffs and Trade) pushes for increased free trade.

Negotiating reciprocal agreements with other nations may have a significant impact on the nature and locus of insurance regulation. Even if such agreements only compel comparable treatment between domestic and foreign insurers, thereby leaving current regulatory institutions intact, the increased internationalization of the marketplace will give rise to problems that insurance regulation must confront.