When Congress enacted the basic federal securities laws between 1933 and 1940, it refrained from regulating any aspect of the insurance industry. Insurance contracts and annuities issued by insurance companies were expressly exempted from the 1933 Act. Sec. 3(a)(8) exempts

In doing so, Congress was quite aware of the Supreme Court decision in Paul v. Virginia and its progeny which found insurance not to be commerce, hence not subject to congressional authority founded on the Interstate Commerce Clause. (Note: The original enactment of the federal securities laws occurred prior to the South-Eastern Underwriters Association decision in 1944.) Furthermore, the decision to explicitly exclude insurance was also based upon congressional reluctance to regulate an industry already subject to extensive regulation by the states, thereby rendering the application of federal securities law unnecessary. Because insurance products were outside the scope of federal authority, both the courts and commentators agreed that the explicit insurance exemptions contained in the federal securities law were superfluous, serving only to emphasize that insurance policies and annuity contracts were not securities subject to the Act. Even the SEC early on took the position that insurance and endowment and annuity contracts issued by regularly constituted insurance companies were not intended to be securities and that in effect Sec. 3(a)(8) is supererogation. Every federal securities act that followed either implicitly or explicitly excluded insurance products. It was clear that this exemption was a continuation of the long and historical nonintervention in the area of insurance and annuity regulation by the federal government.

Even though the South-Eastern Underwriters Association decision removed the bar to congressional authority over insurance, with the enactment of the McCarran Act, Congress declared that only those federal laws specifically relating to the business of insurance should so apply. Since the federal securities laws did not specifically relate, the McCarran Act rendered them inapplicable to insurance. Consequently, until the emergence of variable annuities in the late 1950s, federal securities regulation of life insurance products remained virtually nonexistent.

Life insurers have long sold annuity contracts. An annuity may be described as a contract under which an insurer agrees to make a series of payments for a prescribed fixed period or for the life of a designated individual(s). Under an immediate annuity, payments commence shortly after the initial premium is paid. Under the more common deferred annuities, payments do not commence (that is,

are deferred) until some future date. Premium payments may be periodic over time or a single, large lump-sum premium at the outset. Traditionally, benefit payments are fixed; that is, the insurer guarantees that a minimum rate of interest will be credited during the accumulation, or pay in, period and guarantees that once the payout period begins, payments will be a certain guaranteed amount per dollar accumulated. Payments received during the accumulation period are allocated to the insurer’s general account, which is invested in accordance with state law.

During periods of inflation, the traditional fixed dollar annuities tend to lack public appeal. By the late 1950s, some insurers had developed variable annuity products for sale to the general public in an effort to tailor the traditional annuity concept to an inflationary economy. In contrast to the traditional fixed dollar annuities, under the variable annuity concept, premiums paid to the insurer (less charges deducted to cover sales and administrative expenses as well as premium taxes) are allocated to a separate account whose funds were invested according to specified investment objectives. Instead of fixed payments, the amount of annuity payments varies in accordance with the investment experience of the separate account. At the commencement of the payout period, benefits might be either fixed or variable. Although the insurer continues to assume the mortality and expense risk, the annuitant assumes the entire investment risk.

In order for the variable annuity concept to become a reality, insurers needed relief from the traditional investment restrictions on equity investments. To enable insurers to enter into the equity area through such products as variable annuities (and subsequently variable life insurance), while at the same time safeguarding insurer assets backing fixed dollar policies, states began to enact separate account legislation. Except with respect to reserves for guaranteed benefits and funds, the funds allocated to the separate account and accumulations thereon may be invested and reinvested without regard to the statutory limitations such as those generally imposed on common stock investments. With state authorization of separate accounts, a fundamental hurdle was removed to the issuing of life insurance products providing benefits which vary based upon the fluctuating investment performance of equity securities.

Mutual funds, the National Association of Securities Dealers and others in the investment community perceived variable annuities to be direct competitors with their own products and recommended that variable annuities be brought under securities law regulation. The SEC concurred and brought an action against Variable Annuity Life Insurance Company (VALIC) which was a new insurer formed to sell variable annuities out of its general account (rather than a separate account which later became the general pattern of operation). Not only did the benefits during the pay in period vary according to investment experience, the annuity payments during the payout period were also variable. The SEC argued that the individual deferred variable annuity contracts were securities subject to the Securities Act of 1933 and that VALIC was an investment company within the meaning of the Investment Company Act of 1940. VALIC defended on the basis that the McCarran Act vested the states with exclusive jurisdiction over the life insurance industry and that the 1933 Act expressly exempted annuities from the provisions of that Act. A sharply divided Supreme Court disagreed.

In SEC v. Variable Annuity Life Insurance Co., the Supreme Court deter-mined that the concept of insurance involves some assumption of investment risk by the insurer and a guarantee that at least some of the payments would 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 and found VALIC to be an investment company subject to the 1940 Act. (The attempt to quantify guarantees has proven to be a theme often revisited by the courts.) In a concurring opinion, Justice Brennan found that the federal securities laws were adopted to protect people entrusting their money to others to be invested on an equity basis. In contrast state insurance regulation of reserves, solvency and contract terms was irrelevant to matters of investment policy and investment techniques. Consequently, he concluded that variable annuities constituted the type of investment form that Congress intended to be regulated by the 1933 and 1940 Acts.

The VALIC case clearly demonstrated that at least certain types of annuities must be registered under and comply with the requirements of the 1933 Act and that an insurer issuing only variable annuities from its general account must register as an investment company under the 1940 Act. Thus, VALIC established the precedent for dual federal securities and state insurance regulation for variable annuity products. Two subsequent cases further defined the scope of federal authority under the securities laws.

United Benefit Life Insurance Company varied the design of its annuity product in an effort to avoid the implications of the VALIC decision. Premium payments were to be invested primarily in common stocks using the separate account vehicle. However, the annuity payments would be fixed rather than variable, with the amount being based upon the annuitant’s pro rata interest in the separate account at the time the payments commence. Furthermore, minimum cash values would be guaranteed at 50 percent of net premiums at the end of the first year, grading up to 100 percent at the end of 10 years. Unlike the VALIC variable annuity, here there were guarantees in both the premium paying (accumulation) period and the payout period. Thus, the insurer assumed some investment risk. The Court of Appeals found that the guarantees were sufficient under the standards of the VALIC decision to avoid the finding that the annuity constituted a security.

Nevertheless, in SEC v. United Benefit Life Insurance Co., the Supreme Court reversed, holding that the flexible fund annuity did not fall within the exemption and therefore had to be registered as a security under the 1933 Act. In doing so, the Court separated the accumulation and payment phases of the annuity, holding the former to be a nonexempt security. The Court rationalized the decision on two bases. First, the accumulation phase was not insurance under the federal definition of insurance since the guaranteed amounts were substantially less than that guaranteed by the same premiums in a conventional deferred annuity. Second, the primary appeal to the purchaser was not stability and security but rather growth through professional management of securities and, as such, competed against mutual funds. The Court, in United Benefit, modified VALIC in three important ways. (1) In some manner the guarantees had to be substantial. (2) For the first time, the Court indicated that a life insurance product could be split into separate pieces in determining whether a security is involved which must be registered under federal securities law. And (3), the manner in which a product is marketed constitutes an important factor in determining whether or not it is a security for federal securities law purposes.

Following VALIC, the Prudential Insurance Company expressed willingness to register its variable annuity as a security under the Securities Act of 1933 but maintained that it was entitled to be exempt from the Investment Company Act of 1940. That Act exempted an insurance company which was defined as a company organized as an insurance company whose primary and predominant business is the writing of insurance. Prudential, which primarily issued fixed dollar insurance products, presumably fitted the exemption. (In contrast, VALIC primarily issued securities since variable annuities were deemed to be securities for purposes of federal law.) Although the SEC concurred that Prudential itself was exempt, that is, it was not an investment company, the Commission maintained that the insurer created an investment company (that is, the separate account) and the insurer proposed to be its investment adviser and principal underwriter. Thus, the Commission ruled that the separate account which contained the assets backing up the reserves to fund the variable annuity was an investment company which must be registered. In Prudential Insurance Co. of America v. SEC, the Court of Appeals affirmed the SEC’s position and the Supreme Court refused to review.

As a result of the VALIC, United Benefit and Prudential cases, a variable annuity contract constitutes a security under federal law and is subject to the registration and prospectus requirements of the Securities Act of 1933. Secondly, even though an insurer doing primarily a regular insurance business is exempt from the Investment Company Act of 1940, the separate account funding the variable annuity is an investment company which needs to be registered and comply with the other provisions of the Act. Thirdly, although a variable annuity may be a security for federal purposes, it can still be insurance for state insurance regulatory purposes. Variable annuities have become fully subject to the wide range of requirements imposed by the federal securities laws as well as evolving state law to both enable and regulate this new product. Dual regulation by the SEC and the state insurance commissioners has arrived in full force.