Since variable annuities and variable life insurance (hereafter often referred to in combination as variable insurance) are deemed securities under the federal securities laws, they cannot be offered for sale without compliance with these Acts. When the federal securities laws were enacted, little if any consideration was given to their potential applicability to life insurers and their products. If all of the provisions of these Acts were literally enforced, the sale of variable insurance contracts would not have been viable. Relief was required to address the structure and marketing methods of the life insurance industry. Fortunately, the SEC possesses two modes of exemptive relief; exemptive rulemaking power having general applicability and the authority to grant exemptions on an individual company basis.

With respect to group variable annuities issued in the qualified profit sharing and pension plan markets and the separate accounts funding these contracts, the SEC adopted several exemptive rules commencing in 1963. Such exemptions were based on the rationale that employers who provide retirement benefits possess greater sophistication and investment experience than individual investors. Hence, they do not require the same degree of protection. These rules were rescinded after Congress amended the 1933 and 1940 Acts in 1970 to exempt variable contracts and their underlying separate accounts used solely to fund qualified pension or profit-sharing plans.

With respect to individual variable insurance products, within the constraints of effectuating the purposes of the federal securities laws, the SEC sought to accommodate those laws to the nature of such products through a combination of granting exemptions to individual companies and the promulgation of rules for general applicability. The latter sometimes occurred after experience with the former. The result has been an evolving system of dual federal and state regulation of variable contracts rather than wholesale SEC efforts to preempt state control. In the process, four federal securities laws have become quite relevant to life insurers issuing variable contracts.

As discussed earlier, 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 means of their sale. In the context of life insurance equity oriented products, such as variable annuities and variable life insurance, the distribution is the ongoing sale and issuance of such products. The fundamental philosophy underlying the 1933 Act is disclosure of accurate information needed by a prudent investor to make an intelligent decision as whether or not to buy the security. (The SEC does not pass upon the merits, or lack thereof, of a security.) This is to be achieved through (1) the filing of a registration statement with the SEC containing detailed information on the security (for example, a variable annuity or variable life insurance contract), the issuer, the underwriting arrangements, financial statements, the officers, security holdings, etc., (2) providing a prospectus to potential buyers (containing much of the information in the registration statement) and (3) antifraud provisions to assure that such disclosure be full and accurate.

Since variable insurance contracts are deemed securities, prospectuses must be delivered in conjunction with their offer and sale. Although under the 1933 Act, a prospectus need not be provided to a customer after a specified number of days, when a security such as a variable annuity contract or variable life insurance policy is issued by an open-end investment company, there is no cut off time to relieve the obligation of delivering a prospectus. Furthermore, issuers of variable insurance contracts are obligated to maintain a current prospectus so long as payments may be accepted from contractholders. Since insurers issue variable contracts on an ongoing basis, they must continue to keep their prospectuses up to date.

The prospectus is a lengthy, detailed and complex document. Among other things, it must cover contractual provisions, investment objectives, securities holdings and historical performance; the merits and disadvantages of the investment; benefit provisions; policyholder rights under the contract; and disclosure of the nature of the risk and expense charges incurred.

A variable life insurance prospectus and registration statement must contain a table of hypothetical illustrations showing cash values at assumed interest rate of returns of 0 percent and two other rates not to exceed 12 percent. The prospectus illustrations must be accompanied by adequate disclosure indicating that the purpose of the illustrations is to demonstrate the mechanics of the variable life insurance policy and that the illustrations do not reflect or predict future account values. The registration statement must be signed by officers of the separate account registrant. They are liable for material misstatements and/or material omissions as to anything in the prospectus, including the hypothetical illustrations. Personalized illustrations must be derived from and may not be greater than that derived from the methodology, format and presentation depicted in the prospectus. Abusive manipulations of personalized illustrations may subject the broker-dealer and/or its salesperson to liability for securities fraud.

As part of the registration process, the separate account as the issuer of the security and the insurer as the guarantor of the mortality and expense guarantees must file financial statements certified by independent public accountants. Although initially independent CPA audits were a new experience for some life insurance companies (since at that time states did not generally require such audits), such is no longer the case.

As a general proposition, compliance with the registration and prospectus requirements of the 1933 Act has posed no insurmountable difficulty in the sale of variable insurance contracts. However, a source of periodic SEC and industry concerns and conflicts has been the elusive objective of a highly readable and readily understandable prospectus describing the variable insurance contract being offered. Furthermore, as with state insurance regulators in general, an ongoing SEC objective is to standardize presentations to facilitate comparative shopping as to the contract terms, performance and costs. Given the complexity of the products, the requirements of the Act and the advent of new products, this task promises to continue to engage the SEC and the life insurance industry on an ongoing basis.

And finally, the impaired financial condition of several prominent life insurers in recent years has heightened investor (variable contractholder) sensitivity to the financial solidity of their own insurers. If an insurer is publicly held or has issued variable annuity, variable life or other policies registered as securities under the 1933 Act, any insurer response to or announcement of adverse developments must be prepared and communicated within the framework of the requirements of the federal securities laws. Also, disclosure and compliance issues may arise with respect to amending the registration statement and/or the prospectus to reflect such developments.

As noted earlier, a second basic function of the securities markets is to afford a means of trading outstanding securities. The Securities Exchange Act of 1934 regulates these activities. In the context of regulating life insurance company products, the most relevant provisions are those relating to broker-dealers and the over-the-counter (OTC) market (that is, the trading of securities other than on a securities exchange).

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 own account as part of a regular business. A person can be a broker and dealer at the same time. The distinction between a broker and a dealer was predicated on technical differences in legal obligations of each category under the common law in the early 1930s. However, such distinction has long since been blurred by the courts in a multitude of securities law cases. Consequently, today, for registration and most other purposes, such distinction no longer remains significant. It is now common to use the general term broker-dealer to refer to legal entities engaged in the securities brokerage business and to refer to the broker-dealer sales personnel as registered representatives.

The broker-dealer is the linchpin through which the SEC regulates the OTC market, of which equity oriented insurance products are a part. (For example, the broker-dealer is the entity under the 1934 Act responsible for supervising the activities of the sales persons.) As is true with respect to the licensing of insurance companies and insurance agents by state insurance departments, registration requirements for broker-dealers are the foundation of regulatory control exercised by the SEC in the OTC market.

Sec. 15(a)(1) of the 1934 Act requires that a broker-dealer effecting transactions in or inducing or attempting to induce the purchase or sale of a security (including variable annuities and variable life insurance) must register as a broker-dealer with the SEC. Registration requires disclosing specified information and filing financial statements. The basic application for registration as a broker-dealer calls for information on a variety of matters relating to the proposed manner of doing business and prior activities in the securities field. Considerable information is sought with respect to the past history and background of the persons who are to be the principals, directors, officers and controlling shareholders of the applicant. Registration can be denied by the SEC if the applicant makes false or misleading statements in the application for registration or other required reports, has been convicted of a felony or misdemeanor arising out of securities violations or has been involved in prior activity adversely reflecting upon his or her moral character. Furthermore, intentional misstatements or omissions of facts may be grounds for criminal prosecution. In addition, a statement as to financial condition is required to better enable a determination as to whether the applicant can meet its customers’ claims for cash and securities.

Unless there are problems with the application, it typically will become effective 45 days after its receipt. Once registration has become effective, the registered broker-dealer may engage in all the activities which require registration as a broker-dealer, subject to the bounds of the antifraud provisions of the Exchange Act. Within a specified period (6 months or one year) after the granting of registration to a broker-dealer, the SEC or, upon direction of the SEC, a registered securities association shall inspect the broker-dealer to determine whether it is operating in conformity with the statutes and the rules and regulations thereunder. If a broker-dealer effects a transaction in securities without being so registered, such person is subject to severe civil and criminal discipline.

Prior to 1975, virtually any person who managed to avoid a securities violation was entitled to be registered as a broker-dealer or to be an associated person with a registered broker-dealer. However, today, Sec. 15(b)(7) also imposes "operational capability" standards on registered broker-dealers; requires broker-dealers and their natural associated persons to meet SEC imposed standards as to training, experience, competence and other qualifications which the SEC finds appropriate for the protection of investors and the public; and authorizes the SEC to administer such tests. Although initially the Commission proposed a minimum set of qualifications, subsequently it decided to rely upon a registered securities association and the securities exchanges to develop and administer examinations for their respective members and associated persons.

The 1934 Act also contains a number of provisions in the nature of substantive regulation, which are intended to protect customers’ funds and securities in the possession of the broker-dealer. These include requirements as to broker-dealer record-keeping, financial reports and net capital standards designed to protect customers against the risk of a broker-dealer insolvency. The SEC routinely conducts inspections of broker-dealer records using accountants from its regional offices. There are also rules governing short sales and the ex-tension of credit to customers by broker-dealers, banks and other persons for the purchase of securities.

In short, under the Securities Exchange Act of 1934, the regulation of the OTC market, through the exercise of control over broker-dealers, consists of a registration and inspection system of broker-dealers coupled with the application of antifraud provisions. Such regulatory elements, imposed by statute and enforced by the SEC, serve as the foundation of a system for control. However, it was not long before a major dose of self-regulation under SEC oversight was introduced.

The introduction of the philosophy of self-regulation under SEC oversight was accomplished in 1938 by virtue of the Maloney Act, which amended the Securities Exchange Act of 1934 to provide for the creation and registration of qualified associations of brokers and dealers. Subject to SEC oversight and control, such associations are to perform self-regulatory functions over their members.

To qualify as a registered securities association, an association must meet several standards, including the capacity to carry out the purposes of the 1934 Act, the capacity to enforce compliance by its members and associated persons, and the adoption of rules meeting statutory standards, including appropriate discipline for members and associated person violations. More specifically, an association of broker-dealers shall not be registered unless the SEC finds, among other things, that (1) by reason of the number and geographical distribution of its members and the scope of their transactions, the association possesses the capacity to carry out the purposes of the Act; (2) such association is so organized and possesses the capacity to (a) carry out the purposes of the Act and (b) enforce compliance by its members and their associated persons with the Act and the rules and regulations thereunder; (3) the association’s rules provide that any registered broker-dealer may become a member and any person may become an associated person with a member; (4) the rules of the association assure fair representation of its members in terms of governance; (5) the rules of the association are designed to prevent fraudulent and manipulative acts, to promote just and equitable principles of trade and, in general, to protect investors and the public interest; (6) the rules of the association are not designed to permit unfair discrimination between customers, issuers, brokers and dealers or to fix minimum profits or to fix rates of commissions; (7) the rules of the association provide (subject to Commission rule or order) that its members and associated persons thereof shall be disciplined for violations of the Act (and the rules and regulations promulgated thereunder) by expulsion, suspension, fines, censure, and/or by limitation of activities, functions and/or operations; and (8) the rules of the association provide a fair procedure for disciplining members and associated persons thereof and for barring persons from membership. Upon compliance with these qualification standards, an association of broker-dealers can become a registered securities association entitled and obligated to carry out the self-regulation of its members.

Congress did not impose such regulation upon the securities business. But rather, the securities dealers sought such self-regulation, presumably as being preferable to the imposition of direct federal enforcement.

A broker-dealer may not effectuate a transaction in nonexempt securities in the OTC market unless it belongs to a registered securities association. Consequently, since currently the only such association is the National Association of Securities Dealers (NASD), unless and until an alternative association is created, the sale of securities, including variable insurance products, necessitates membership in the NASD and compliance with its rules. Thus, even though broker-dealers remain subject to SEC’s overall jurisdiction, the NASD assumes primary and direct authority for monitoring and regulating the activities of its member firms.

As a general proposition, the NASD must accept any broker-dealer as a member. However, denial of membership can be based upon any one of several grounds. To assure that broker-dealers register with the SEC, Sec. 15(g) of the 1934 Act provides that the NASD shall deny membership to any broker-dealer which is not registered as a broker-dealer with the SEC. Furthermore, the NASD may deny membership to a registered broker-dealer, or bar a person from becoming an associated person, who is subject to statutory disqualification. The NASD may deny membership if (1) such broker-dealer or associated person does not meet standards as to financial or operational capacity or does not meet standards of training, experience or competence as prescribed by the association or (2) such broker-dealer or associated persons has engaged and there is reasonably likelihood that he or she will again engage in acts inconsistent with just and equitable principles of trade. The NASD may also deny membership to a registered broker-dealer which is not engaged in the type of business which the rules of the association require members to be engaged in.

To register with and become a member of the NASD, the applying broker-dealer must agree to abide by all applicable NASD rules and regulations, of which there are generally two categories. First, there are those rules seeking to protect the investing public from fraudulent conduct and seeking to ensure the integrity of the securities markets through high ethical conduct and standards. Second, there are those rules designed to regulate the technical aspects of the broker-dealer’s day-to-day business. Failure of a broker-dealer to abide by these rules affords an additional basis upon which to deny membership in the NASD.

In addition to federal law, states have also enacted securities legislation, most of which is patterned after the Uniform Securities Act which, in turn, draws significantly upon the federal securities laws. Such laws make it unlawful for any person to transact business within the state as a broker-dealer, or as an agent of a broker-dealer, unless such person is registered as such. It also should be noted that not only do states require a life insurance agent to obtain a variable contract insurance license under state insurance law in order to sell variable insurance products, but state securities laws also impose their own registration requirements relating to broker-dealers.

In the absence of some additional statutory language, a life insurance agent and insurer management personnel involved in effecting or selling variable insurance contracts (securities) would be required to register as a broker-dealer and comply with all of the provisions of the 1934 Act applicable to broker-dealers. However, one need not register as a broker-dealer if he or she falls within the definition of an associated person of a broker-dealer. An associated person includes a partner, officer, director, branch manager, or other person who either controls or is controlled by the broker-dealer. Thus, a salesperson controlled by a broker-dealer and a management person controlled by or controlling a broker-dealer fall within the ambit of associated persons. While not having to comply with all of the requirements which are imposed on broker-dealers, as discussed below, associated persons are subject to substantial training, examination, experience and/or supervision requirements.

One of the most important rules of the NASD is that no member broker-dealer may permit any other person to manage, supervise, solicit, or handle any securities on behalf of the member broker-dealer unless such person registers as a representative with the NASD. Thus, agents and management personnel are typically regulated as registered representatives.

Regulation of Registered Representatives. Registration of a broker-dealer has no effect on the registration of its management and sales personnel who are associated persons. But rather, such persons must individually qualify to become registered representatives. Becoming a registered representative can only be  accomplished by means of a formal submission made by a broker-dealer who is a member of the NASD. An individual cannot apply for and obtain a securities registration in any other manner.

Pursuant to the requirements of the 1934 Act, the NASD must provide that no broker-dealer or associated person can become a member unless qualified under appropriate standards as to training and experience. Following the submission of the application, the individual must take the NASD securities examination appropriate to the type of business he or she intends to conduct. The NASD has established two levels of qualification: one for registered principals (management personnel) and one for registered representatives (sales personnel). Furthermore, there are various categories for registration as a principal and for registration as a representative, with separate examinations for each category. The appropriate category depends upon the functions the person will perform.

With respect to management personnel, other than in a situation involving a sole proprietorship, new applicants for broker-dealer membership in the NASD must have at least two officers or partners who qualify as registered General Securities Principals (requiring successful completion of the examination appropriate to such responsibilities) and one who is qualified to register as a Limited Principal–Financial Operations and Investments (requiring successful completion of a different examination). Any person required to be registered as a principal whose supervisory responsibilities are to be limited to securities sales activities and training of the sales personnel may register as a Limited Principal–General Sales Supervisor. This category of registration lessens the burdens on principals of broker-dealers, who would otherwise have to meet the more stringent qualifications. Those persons seeking to be a member of the super-visory personnel of a broker-dealer must pass an examination demonstrating that they can manage persons they supervise to function within the framework of the established standards.

With respect to sales personnel, such as life insurance agents selling variable insurance contracts, they must file an application for membership with the NASD and pass NASD securities examinations, different examinations depending upon the business which the agent intends to sell. A Series 6 registration and examination permits the agent to sell mutual funds, variable annuities and variable life insurance policies. A Series 7 registration and examination, if successfully passed, qualifies the individual to become a general securities representative, which authorizes him or her to sell a broad range of securities (although not commodities or certain types of options). Once the person is registered with the NASD as a registered representative (salesman or agent) of a particular broker-dealer, he or she may represent only that broker-dealer. If a registered representative subsequently desires to become more active in the management of the broker-dealer’s securities business or wants to establish a branch office in which he or she assumes the responsibility for supervising other registered representatives, he or she must apply for registration as a general securities principal and successfully complete the examination therefor.

Application of the Registered Representative/Broker-Dealer Standards in the Insurance Context. Since variable insurance contracts are deemed to be securities under the federal securities laws, life insurers and life insurance agents must come to grips with the application of the broker-dealer controls imposed under the 1934 Act. There have been two particular problem areas: (a) the imposition of informational and examination requirements on a wide range of people spread throughout an insurance company and (b) the training, supervision and licensing of agents selling variable insurance contracts.

Insurance Company Personnel. A broker-dealer and its associated persons must meet standards as to training and experience and other qualifications. Substantial information must be filed for each associated person engaged in securities activities including sales, trading, research, investment advice, advertising, public relations, recruiting and training salesmen. The filing of such information is more than just a perfunctory task. It calls for information on educational background, business connections, reasons for leaving prior employment, record of disciplinary actions, etc. Furthermore, the sponsoring 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. Also associated persons must successfully complete a securities examination covering such subjects as corporate and government securities, investment companies, provisions relating to broker-dealers, methods of distributing securities, and regulation of stock exchanges.

Since the definition of associated person is quite broad, including any partner, officer, director, branch manager, or employee (other than those whose functions are clerical or ministerial), serious practical problems are posed for insurers. Throughout an insurance company which sells variable contracts are several departments and persons having at least some contact with such business. Who must take the examinations and for whom must the information be filed? Clearly, agents selling variable contracts and their supervisors are subject to such requirements, but what about other insurer personnel such as the board of directors and top executives whose primary activities involve other areas?

The time and expense burdens of these informational and examination requirements were somewhat relieved when the SEC took the position that if a life insurer which establishes a separate account to fund variable contracts, forms a wholly owned subsidiary to engage in the offer and sale of those securities, and registers such subsidiary as a broker-dealer, and if that subsidiary supervises all persons directly or indirectly involved in the sale of those securities, the life insurer itself need not register as a broker-dealer. Consequently, insurers have commonly formed affiliates for this specific purpose.

Furthermore, while an insurer may also provide certain clerical and ministerial functions for its affiliated broker-dealer without having to register, a caution flag should be raised. Even though an affiliate is created or acquired to serve as a broker-dealer, an insurer must continue to be alert to performing activities or functions within the insurer itself which might trigger broker-dealer status for the insurer. For example, an insurer issuing variable contracts frequently remits commission payments to an insurance agency, broker-dealer or agent. This practice reflects the traditional mode of distributing fixed insurance products. But, in the context of variable contracts, it raises the issue as to whether the insurer is "effecting" securities transactions, thereby acting as a broker-dealer under the 1934 Act. Importantly and fortunately, the SEC does not require registration of a person as a broker-dealer, such as an insurer, if the services performed by that person are of a clerical or ministerial nature. Activities such as accounting, data processing, recordkeeping, custodial transfer and commission payments may be found to fall within the clerical-ministerial exemption. However, it is important for insurers issuing variable contracts to be sure, perhaps through obtaining a no action letter from the SEC, that the activities it engages in consist only of the clerical and ministerial functions so as not to give rise to broker-dealer status for the insurer.

Agents Selling Variable Insurance and/or Other Securities. As noted above, a life insurance agent selling securities need not register as a broker-dealer if he or she is an associated person licensed as a registered representative of a broker-dealer. But how does a life insurance agent who is deemed an independent contractor within the insurance environment fare under the federal securities law framework?

If an independent agent is under sufficient control of the broker-dealer, he or she need not register as a broker-dealer. Instead, he or she is an "associated person" and may register as a registered representative of the broker-dealer. The critical issue is whether his or her activities are subject to control by the broker-dealer within the statutory definition of control. If not, the individual independent contractor agent must register as a broker-dealer and comply with all of the requirements which attach to broker-dealers. Whether the requisite control exists depends upon the factual circumstances of the situation. However, regardless of the outcome, if a broker-dealer establishes a relationship with an independent agent, the broker-dealer is responsible for either (1) ensuring that the agent is registered as a broker-dealer or (2) assuming the supervisory responsibilities attendant to the associated person relationship.

Either as a broker-dealer (the less likely situation) or as a registered representative of a broker-dealer (the more likely situation), life insurance agents selling variable insurance (and/or mutual fund or other securities) products are subject to the federal securities laws, including the substantial training, examination, experience and supervision requirements promulgated by the NASD. These requirements can pose significant difficulties for individual agents who are basically insurance salesmen and for the insurers bearing the expense of educating, training and supervising such agents. Obtaining these licenses requires significant background checks to ascertain if the agent has violated any federal or state criminal law or any NASD or exchange rule that would bar entry into the securities business. In addition, the agent must comply with requirements pertaining to business conduct, which are elaborated upon in the immediately following discussion.

Under the 1934 Act, the NASD must promulgate rules designed to (1) prevent fraudulent practices and promote equitable principles of trade, (2) safeguard against unreasonable profits, commissions or other charges, (3) prevent unfair discrimination between customers, issuers or broker-dealers, and (4) provide for appropriate discipline for the violation of its rules (for example, censure, suspension and expulsion). As a consequence, when a life insurance company becomes involved in the distribution of equity products, it triggers a host of regulatory requirements in addition to those imposed by insurance regulation.

The NASD Rules of Fair Practice implement that organization’s fundamental requirement that member broker-dealers and associated persons of broker-dealers observe high standards of commercial honor and just and equitable principles of trade. To achieve this objective, the NASD has promulgated rules regulating a wide range of activity relating to such areas as the sale of securities, suitability of such sales, confirmations of transactions, and supervision. The NASD regulatory requirements are enforced by the Association through a system of periodic compliance inspections of its member broker-dealers at both their main and branch offices.

As a consequence, in addition to insurance regulation, life insurers, their affiliated broker-dealers and their agent registered representatives confront a unique regulatory environment when they sell products falling within the parameters of the federal securities laws. This environment includes rules of fair practice governing (1) the supervision of the salespersons, (2) private securities transactions, (3) outside business activities of associated persons, (4) suitability and fair dealing with customers, (5) influencing or rewarding employees of other broker-dealers and finders fees, and (6) sales literature, advertising and communications with the public. Some of these rules are considered in the immediately following paragraphs.

Supervision. The exercise of meaningful supervision over persons to assure their compliance with all applicable provisions of the securities laws is a most difficult, time consuming and important responsibility of a broker-dealer. Article III, Sec. 27(a) of the NASD rules provides the foundation for broker-dealer compliance and supervision. A broker-dealer must establish and maintain a system to supervise the activities of each registered representative. Such system shall be reasonably designed to achieve compliance with applicable securities laws, regulations and NASD rules. Each broker-dealer is to establish and maintain specified written oversight and review procedures, including the identification, the locations and the responsibilities of supervisory personnel. Each broker-dealer is to designate appropriately registered principals to comply with the supervisory responsibilities for each type of business in which the broker-dealer engages. The broker-dealer must assign each registered representative to a "supervisor" and make reasonable efforts that all supervisors are properly qualified as to regulatory requirements, the firm’s product line, experience and capabilities. And broker-dealers must meet periodically with each registered representative as to compliance matters relevant to the activities of that representative. The broker-dealer must periodically conduct an examination of each of its branch offices. Also each broker-dealer is to identify for the NASD one or more principals having the responsibility of reviewing the firm’s supervisory practices and making recommendations to senior management. In brief, the NASD licenses are intended to reassure customers that the agents selling variable products are properly trained, supervised and audited.

The broker-dealer must never allow a person to buy or sell securities as an agent for the broker-dealer unless such person is duly licensed as a registered representative with respect to those securities bought or sold. Failure of a broker-dealer to register a person who should be registered is basis for swift disciplinary action. Furthermore, a broker-dealer is accountable for all violations of the federal securities laws committed by any person employed by the firm.

Private Securities Transactions. This area involves any securities transactions beyond the regular scope of an associated person’s relationship with a broker-dealer such as new offerings of securities which are not registered with the SEC. That is, these are transactions in which the broker-dealer does not participate (sometimes referred to as "selling away" or engaging in "off book transactions"). Typically such activity involves private placements, sale of limited partnerships, investment management services or investment clubs. Not uncommonly, the registered representative erroneously deems such a product sold not to be a security for the purpose of the federal securities laws.

The problem presented in the private securities situation is that securities are sold without the benefit of supervision or oversight by the broker-dealer even though the investor commonly believes otherwise. As a consequence, under the NASD rules, registered representatives of insurance broker-dealers may find themselves engaged in illegal private securities transactions which can expose not only the representatives but also their broker-dealers to liability and enforcement actions. The fact that the broker-dealer did not exercise supervision over a private securities transaction does not absolve it of liability to an investor who later sues to recover losses suffered because of the absence of due diligence in analyzing securities recommended or because the investment was not suitable in his or her circumstances.

Article III, Sec. 40 of the NASD Rules requires that a registered representative, prior to participating in any private securities transaction, provide to its broker-dealer written notice describing the proposed transaction in detail (including compensation to be received) for the broker-dealer’s approval or disapproval. If the broker-dealer approves, it must exercise supervision and record keeping with respect to such transaction. If it disapproves, the registered representative may not participate in the transaction. This rule seeks to protect broker-dealers against investor claims as well as to protect customers by ensuring proper supervision of registered representatives’ sales activities. Thus, it is incumbent upon the broker-dealer to train and continuously remind its registered representatives (including its life insurance agents) that the definition of a security is very broad and any activity even remotely resembling a securities transaction should be brought to the broker-dealer’s attention for approval.

Outside Business Activities of Associated Persons. Article III, Sec. 43 of the NASD Rules prohibits an associated person of a broker-dealer from accepting employment or compensation concerning any business activity outside the scope of the broker-dealer employment relationship unless the person provides the broker-dealer with prompt written notice. This affords the broker-dealer an opportunity to raise timely objections, if any, and to exercise supervision when appropriate. This rule was adopted over strong life insurance industry objection, which among other things pointed out that life insurance agents often engage in a wide variety of noninsurance and nonsecurities enterprises.

Suitability and Fair Dealing with Customers. Article III, Sec. 2 of the NASD Rules provides that

In recommending products, a registered representative must have reasonable grounds to believe that the product being recommended is suitable for his or her customer. Such determination should be based upon customer disclosures as to income, net worth, securities holdings, life insurance, real estate holdings, customer financial sophistication, investment objectives and financial needs. Registered principals of the broker-dealer make the final determination as to suitability and the acceptance of the transaction.

It should be noted that, in a variation on the suitability theme, the SEC recognizes a broker-dealer obligation of fair dealing under the general antifraud provisions of the federal securities laws. The Commission maintains that a violation of the suitability doctrine may constitute a violation of Rule 10b-5 under the Securities Exchange Act of 1934, which is the SEC’s general antifraud rule under the Act. This position is predicated on the theory that when a broker-dealer holds itself out as a broker-dealer (that is, "hangs out its shingle"), it implicitly represents that it will deal fairly with customers in accord with the standards and practices of the profession. Under this "shingle" theory, the broker-dealer impliedly represents that it will recommend securities only when it has a reasonable basis that such are suited to the customer’s needs.

Judicial decisions have contributed to the development of suitability as a fraud concept outside the antifraud provisions of the federal securities laws. In Anderson v. Knox, for example, a federal Court of Appeals held that an insurance agent who had induced a client to buy excessive amounts of bank financed insurance was liable for damages for common law fraud since the policies were unsuitable to the policyholder’s needs. Judicial thinking, scholarly works and regulatory attitudes suggest that criminal and civil liabilities attendant

to the suitability and fair dealing concepts set forth in the NASD rules have yet to reach their full potential.

Sales Literature, Advertising and Communications with the Public. A series of SEC and NASD rules and guidelines has evolved to govern advertising, sales literature and communications with the public concerning the distribution of equity products.

Communications with the Public. Article III, Sec. 35 of the NASD Rules of Fair Practice mandates that every item of advertising and sales literature (the definition of which is quite broad) be approved by a registered principal of the broker-dealer prior to its use. Furthermore, such material must contain a broker-dealer’s name, the identity of the preparer of the material and the date first published. Advertisements and sales literature must also be filed with the NASD within 10 days of their first use. Such materials can be disapproved for failure to meet NASD guidelines.

Variable Contract Guides. The NASD has established a Variable Life Insurance Marketing Guide. Prior to 1990, NASD policy emphasized that the primary attribute of a variable life insurance (VLI) policy is its death benefit even though VLI also contains an important investment aspect in its cash value. The NASD opined, however, that VLI should not be described as an investment. With the advent of single premium VLI policies, the NASD revised its position to permit broker-dealers to give more weight to the investment element of policies or contracts. By 1990, the NASD further relaxed its position and moved to imposing no absolute requirement that broker-dealers maintain a "balance" in describing the insurance and investment elements of a VLI policy. However, communications should describe both elements.

By early 1994 the NASD had in place SEC approved guidelines covering variable products to govern the preparation of and communication with the public through advertising and sales literature. The primary thrust of such guidelines is to prohibit referring to variable products as mutual funds. The guidelines require that communications concerning variable products, among other things, clearly identify the product as either a variable life insurance policy or a variable annuity contract; avoid implying that the underlying product is a mutual fund (since there are significant differences between mutual funds and variable contracts); avoid presenting variable products as short-term liquid investments; in references to liquidity, disclose the impact of early withdrawal such as sales loads, tax penalties and potential loss of principal; and avoid suggestion that guarantees apply to investment returns. Also by mid-1994, the SEC approved a new set of NASD guidelines limiting the use of rankings by mutual funds and other investment companies (including separate accounts underlying variable insurance products) in advertising and marketing materials.

With respect to illustrations, the methodology and format of hypothetical illustrations must be patterned after the required illustrations used in the variable life insurance prospectus approved by the SEC. Illustrations must reflect the maximum guaranteed mortality and expense charges associated with the policy for each assumed rate of return. Current charges may also be illustrated in addition to the maximum charges. Also, an illustration may utilize any combination of investment returns up to and including a gross rate of 12 percent if one of the returns illustrated is a 0 percent gross rate. However, even though the maximum rate of 12 percent may be acceptable, the NASD does require that the broker-dealer confirm that such maximum rate illustrated is reasonable in light of market conditions and available investment options. Mandating the illustration of a 0 percent rate of return serves to demonstrate how the absence of growth in the underlying investment account can affect policy values and to reinforce the hypothetical nature of the illustration. NASD guidelines also permit comparisons between variable life insurance contracts and other financial instruments based upon actual experience, not assumed hypothetical performance. Performance comparisons must be fair, balanced and complete and must comply with NASD rules governing communications with the public. In addition, the SEC has imposed performance comparison advertising rules, including standardized computation of performance data in advertising and sales literature for mutual funds and variable annuities.

As indicated previously, the format of any personalized variable life insurance illustration must be filed with and approved in advance of use by the Advertising Department of the NASD. The sale of variable life insurance and the use of personalized illustrations can be conducted only by sales persons registered with the NASD, and NASD rules mandate that each broker-dealer review, supervise and store all sales materials including illustrations.

Nature of Insurance Broker-Dealer Transgressions. The most common disciplinary actions against insurance broker-dealers and their registered representatives have involved the conversion or theft of insurance customer funds related to traditional insurance and annuity products rather than securities. There have been instances of discipline of registered representatives associated with insurance broker-dealers in connection with various schemes to generate additional commission income (for example, falsified applications). And there have been a few instances of NASD actions against unauthorized trading by an insurance broker-dealer or its registered representatives involving redemptions of a security, such as a mutual fund, followed by using the proceeds to purchase an insurance policy or annuity contract. On occasion, associated persons of insurance broker-dealers have engaged in private securities transactions. Disciplinary actions against insurance broker-dealers for failure to supervise have been relatively uncommon.

The scope and structure of insurance broker-dealers reflect the diversity of life insurance companies with which they are affiliated. The range of products marketed by the broker-dealer varies according to the affiliated insurer’s product mix and target market. Typically, the structure of the broker-dealer parallels that of its parent insurance company since the brokerage activities constitute an element of the insurer’s larger insurance business.

Registered representatives of an insurance broker-dealer commonly operate principally as life insurance agents with securities sales often constituting a relatively small amount of the total business sold. Perhaps one-third of insurance company broker-dealers limit their activities to the sale of investment company shares (for example, mutual funds) and variable insurance contracts issued by the insurer. While the other insurance broker-dealers sell other securities as well, the volume of their general securities activities tends to be quite limited, especially in comparison to the products and services offered by full service securities firms. Consequently, supervision and compliance are commonly conducted through the insurer’s traditional distribution systems, whether the general agency system, regional branch offices or direct reporting to the insurer.

There are a host of securities services and activities typically offered by full service securities firms which most insurance broker-dealers do not offer. For example, insurance broker-dealers usually do not maintain discretionary accounts which would enable registered representatives to buy and sell securities for clients without their specific approval of each transaction. This avoids a host of potential conflict of interest problems.

The structure and operations of most insurance broker-dealers tend to be quite different from those of the full service broker-dealers. Several of the rules under the federal securities laws and the NASD Rules of Fair Practices recognize the unique status of insurance oriented broker-dealers. For example, an SEC rule provides a special $2,500 minimum net capital requirement for broker-dealers who engage in no securities activities other than the purchase and sale of registered investment company securities (such as mutual fund shares) or variable contracts funded by insurance company separate accounts. Broker-dealers confining their activities to the sale and redemption of registered investment company securities or interests in insurer separate accounts are exempt from custody and reserving requirements. The Securities Investors Protection Act excuses from membership in the Securities Investor Protection Corporation those broker-dealers whose activities are limited to the distribution of insurance, variable annuities and registered investment companies since such broker-dealers are unlikely to become insolvent or unable to reimburse amounts owed to their customers. Fingerprinting requirements are typically not applied to personnel of insurance company broker-dealers because their limited brokerage activities do not lend themselves to misappropriation or fraud in the handling of

securities. Similarly, the NASD Rules of Fair Practice afford special regulatory treatment to insurance company variable contracts concerning such matters as sales charges, transmittals, selling agreements and redemptions, and exempt variable contracts from the rules relating to the sale of investment company shares.

Since the federal securities law requires that sellers of securities (registered representatives) must enter into a selling agreement with a broker-dealer, life insurance producers must assess what they want and need in the broker-dealer relationship in order to best select which broker-dealer they should affiliate with. In doing so it is important to understand that broker-dealers possess varied orientations, for example, a general securities orientation, a life insurance orientation, a life insurance producer orientation, or a financial planner orientation. In assessing broker-dealers, a life insurance agent needs to consider several facets of a life insurance producer/broker-dealer relationship.

Broker-Dealer Life Insurance Orientation. For life insurance agents generating most of their own business, it is important that they work with a life insurance oriented broker-dealer. Life insurance producers commonly develop sales over a period of time, with such activity often requiring sophisticated technical backup such as illustrations, studies and analysis. This is particularly true when working with business clients. Although national and regional securities firms recognize life insurance has its place, such broker-dealers tend to be more oriented to providing the support services which a securities representative needs rather than the technical assistance required by a life insurance professional. Furthermore, securities oriented broker-dealers tend to focus on fast sales and high turnover. Broker-dealers with life insurance orientation are more likely to provide the life producer with better training and the assistance necessary to become a registered representative and to sell variable insurance products.

Multiple Representation. Being flexible and responsive to client needs may require that the life insurance agent/registered representative have access to several life insurance companies so as to be able to select from a variety of products, to obtain substandard insurance, and to select a high performing company. Securities oriented, financial planner oriented and producer oriented broker-dealers generally encourage and facilitate access to products from different insurers. In contrast, most insurance company oriented broker-dealers will not enter into variable product selling agreements involving variable products other than those issued by their insurer owner. For example, it is unlikely that Insurer A would permit its field force to sell Insurer B’s variable products through the broker-dealer owned by Insurer A.

Peer Quality. Because of the opportunity of beneficial cooperative activity with other persons associated with the broker-dealer, the quality of other producer/representatives of the broker-dealer can be quite important.

Compliance Excellence. Although insurance orientation is quite important, the ability of the broker-dealer to carry out the compliance function is essential. Most life insurance agents are not knowledgeable about, tolerant of, or sensitive to the highly regulated nature of the securities industry. Both the SEC in enforcing the federal securities laws and the NASD in enforcing the standards of fair practice aggressively search out fraud. Surprise audits of both broker-dealers and their registered representatives are not uncommon. Common sales techniques used by life insurance agents may be illegal when used by registered representatives, for example, use of past performance as an indicator of future performance. Violations of securities laws can be severely punished, licenses revoked, heavy fines imposed. Aggrieved investors can bring civil actions under the antifraud provisions of the federal securities laws. And occasionally either the Department of Justice or a state attorney general’s office will prosecute a registered representative in criminal actions. Because of the severe consequences for violations, the broker-dealer’s supervision and compliance program are critical. Registered representatives need to rely on competent compliance officers to assist them in what they can and cannot do and can and cannot say. When a life producer elects to affiliate with a broker-dealer having a slack compliance program, he or she will have made a hazardous choice.

Due Diligence. To avoid legal liability for fraudulent or misleading statements, a registered representative of a broker-dealer must be able to demonstrate that he or she did not know of a misstatement or omission of fact about the security and that he or she used reasonable care or due diligence in researching the security. A due diligence team for a broker-dealer can aid the representative in avoiding legal problems by fully evaluating a security before it is offered to potential clients.

Nationwide Service. For life insurance producers having a corporate client base extending beyond state lines, it may be critical to affiliate with a broker-dealer which is licensed in all states and which will obtain the necessary state licenses required for the producer representatives. Federal securities law prohibits producer representatives and broker-dealers from selling outside the jurisdictions in which they are licensed.

Adequate Compensation. Not surprisingly, life insurance producers entering into a broker-dealer relationship seek to obtain as much compensation as possible consistent with other important factors. The higher the cost of providing the various services of a broker-dealer (for example, quality compliance and due diligence efforts), the greater the likelihood that the broker-dealer will require a higher proportion of the commission income, thereby leaving the agent with less. Thus, some life insurance producers may decide to form their own broker-dealer in order to retain a greater proportion of their commission income. However, this approach is both expensive and fraught with hazards, including an enormous amount of compliance paperwork, the very substantial responsibility of handling due diligence on new and existing products, and the very large potential legal liability exposure of a broker-dealer.

With the Supreme Court decision in the Prudential case that a life insur-ance company separate account funding a variable contract constitutes an investment company, the Investment Company Act of 1940 was brought into play. Some of the most difficult issues pertaining to the viability of variable contracts under the federal securities law arise in connection with this Act. Although the SEC sought to accommodate the life insurance industry in some areas through exemptive relief or modification of some of its rules or interpretations, in other areas exemptive relief was denied, leaving the life insurance industry to its own devices as how to cope with the problem. The basic problem is that the 1940 Act was not drafted with variable insurance in mind. This problem persists.

As an investment company, the separate account must register with the SEC, which involves disclosure of considerable information. Periodic reporting, including financial statements, is required on an ongoing basis. Prospectus requirements, proxy rules and insider trading rules apply. Limitations on capital structure may also apply. However, the SEC came to grant exemptions from certain requirements in several areas, such as minimum net worth of the separate account prior to a public offering, the right of redemption, current offering price, deposit of payments with trustees, and custody of assets. Subsequently, the SEC adopted several rules codifying certain exemptions.

However, early on, exemptions were denied in certain areas of SEC concern such as securityholder voting and control and regulation of various charges (see discussion below as to charges). Fundamental to the Act’s efforts to promote honest and unbiased management and securityholder participation in management are provisions pertaining to independent management and securityholder control. In these areas, the SEC would not budge from imposing 1940 Act requirements regardless of the problems posed to insurers.

Insurers have registered a considerable number of separate accounts as investment companies. For various reasons, an insurer will commonly organize a wholly owned subsidiary, which, in turn, creates a separate account. The sub-sidiary acts as the investment adviser and underwriter to the separate account. Some type of committee is created to serve as the investment company’s (separate account’s) board of directors. The members of such board, rather than being the directors of the insurer itself, are elected by the variable contractholders so as to meet the requirements of the 1940 Act. The SEC was adamant that the provisions for securityholder voting and control as to electing directors, reviewing principal underwriting and investment advisory contracts, approving changes in investment policy and ratifying selection of independent auditors are fundamental to achieving the protections intended by the Act.

Insurers argued that these were impossible to comply with under those state insurance and/or corporate laws mandating that an insurance company’s affairs (which includes separate account assets) be managed by the insurer’s board of directors. It is difficult to reconcile the SEC concept of a mandated autonomous management of the separate account with the common requirement of the insurance law that a corporation’s (insurer’s) board of directors is responsible for the conduct of its affairs. The SEC refused to budge. These provisions, which assure that those persons having an investment risk possess the ultimate voice in policy, were said to constitute the essence of the Act. Finally, to avoid an impasse, the NAIC adopted in its Model Variable Contract Law (and many states enacted) legislation permitting securityholder (variable contractholder) control in compliance with the federal securities laws.

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, that is, sales loads, administrative expense charges, mortality and expense risk charges, investment related charges such as advisory fees and, with respect to variable life insurance, the cost of death protection. The Act provides a statutory framework designed for products and services which existed in 1940. Variable insurance products did not exist and Congress did not anticipate their creation. Even the SEC Division of Investment Management has described the Act as "the proverbial ‘round hole’ into which the ‘square peg’ of insurance products is forced."

Variable Insurance Products as Periodic Payment Plans. Confronted with a product that did not fit neatly within the Act, in its early administrative decisions, the SEC determined that variable insurance contracts should be regulated as periodic payment plans. Under the Act, periodic payment plans are essentially a means of purchasing investment company securities by install-ment. The regulation of these plans goes beyond that imposed on ordinary mutual funds due to the abuses engendered by such plans prior to the enactment of the 1940 Act.

An investor buying shares in a mutual fund directly would commonly incur a sales load deducted as a simple percentage of the current investment. In contrast, an investor buying through a periodic payment plan had his or her total sales load computed as a percentage of the total amount to be invested over the life of the plan (for example, 10 years or more). To encourage marketing efforts by salesmen, the plans deducted a proportionately higher amount from the early payments. Consequently, little of the early payments was left for investment. Furthermore, plans often were terminated or lapsed long before their completion. In the absence of requirements to refund excess sales loads, investors paid loads substantially in excess of those for completed plans. That is, an investor who ceased making payments paid a sales load on a larger investment than he actually made.

The structure of the periodic payment plans gave rise to other abuses. Investors paid double sales loads when they first paid a primary sales load in purchasing interests in unit investment trusts and then a secondary load when the trust purchased shares of an underlying mutual fund. Also double loads were paid on dividend reinvestments. To further exacerbate the abuses, sponsors of periodic payment plans often deducted a fee for managing the unit investment trust assets even though these were nondiscretionary accounts and management fees were paid to the adviser of the underlying mutual fund.

Although Sec. 27 of the 1940 Act allows higher initial sales loads necessary to provide incentives for marketing periodic payment plans, it addresses common abuses by establishing a maximum sales load, the manner of deducting sales charges and refund requirements mandating a return of a portion of the load paid by plan holders who terminate early. Sec. 27 also subjects a periodic plan payment certificate issued by a management company to the same charge limits imposed on unit investment trusts under Sec. 26. Sec. 26 bars payments of trust assets to the depositor or principal underwriter for the trust unless such constitute reasonable compensation for certain bookkeeping or other administrative services. Sec. 26 also limits trustee or custodian fees to those set forth in the trust instrument and which are actually incurred. No other charges are permitted.

In short, the pre-1940 abuses in the marketing and sale of periodic payment plans gave rise to enhanced regulation focusing on the types of sales and related charges allowed and the manner in which they may be deducted and refunded. As a consequence of being defined as periodic payment plans, variable insurance contracts have been subject to controls designed for such plans regardless of their suitability, or lack thereof, for the variable insurance situation. For years, the life insurance industry and the SEC have struggled over the issues of whether and to what extent the SEC should regulate the charges associated with variable insurance contracts in accord with the limitations imposed on periodic payment plans.

Current Regulation of Variable Contract Charges. As is true with any insurance product, an insurer needs to derive compensation from variable insurance products through deductions from premiums and/or separate account assets to cover the costs and expenses associated with the product such as the insurance benefits provided, managing the investment portfolio, administering the products and compensating the sales force.

The typical variable annuity contract assesses four types of charges: (1) sales loads which are either front end, deferred and/or contingent deferred, (2) admin-istrative expense charges, (3) mortality and expense risk charges, and (4) invest-ment related charges such as advisory fees. Advisory fees are subject to the Act’s imposed fiduciary obligations which apply to all investment companies. The other charges are subject to Secs. 26 and 27 of the Investment Company Act.

A life insurer is subject to several risks. The distribution risk assumed by an insurer under insurance contracts is the risk that the amounts realized from explicit sales loads imposed on contracts will be inadequate to cover the actual distribution costs. The expense risk assumed by an insurer under insurance contracts is the risk that the actual expenses which the company incurs in issuing and administering the contracts will exceed charges in the contracts for such services. The mortality risk assumed by an insurer under an insurance contract is the risk that insureds will live longer with respect to an annuity contract and shorter with respect to a life insurance contract than the insurer expected in establishing the cost of insurance. The insurer also assumes mortality risk to the extent the contract provides a guaranteed minimum death benefit.

Although the SEC possesses clear authority under the Investment Company Act to regulate sales loads, for over 20 years the Commission and the life insurance industry have debated the regulation of the mortality and expense risk charges imposed pursuant to variable annuity and variable life insurance products. Underlying this debate has been SEC concern over the use of separate account assets to cover distribution costs in excess of those provided for under the sales load limitations of the 1940 Act. The basic issue is whether the SEC has the authority under the Act to regulate mortality and expense risk charges or, in doing so, whether the SEC is engaged in ratemaking of life insurance charges which falls within the jurisdiction of the state insurance regulators. The SEC maintains that Secs. 26 and 27 authorize the Commission to pass upon the reasonableness of any charge deducted from the assets held in a separate account which were derived from the sale of periodic payment plan certificates. The history of this debate reflects a struggle to attain a practical and workable regulatory approach. To date, the SEC has achieved practical regulatory authority with which insurers have chosen to comply.

Charges under Variable Annuity Contracts. The sales load limitations for periodic payment plans, including variable annuities, are quite complex. Issuers may not pay sales loads in excess of 9 percent of total premiums. However, an issuer may deduct more than 9 percent from a particular premium (up to 50 percent of the first 12 monthly premium payments) if certain conditions are met, including a provision for a refund of some portion of excess sales load in the event the owner surrenders and the period over which the life of the contract is measured for compliance with the 9 percent limitation does not exceed twelve years. (The NASD Rules of Fair Practice establish an 8.5 percent sales load limit for annuities with multiple payments and a sliding limit based upon the amount for single premium contracts.)

The charges for administrative expenses for a separate account funding a variable annuity are limited to the cost of services to be provided.

Variable annuity issuers may deduct a mortality and expense risk charge to compensate the insurer for the mortality and expense risks it assumes under the contracts. Such risks are incurred when the insurer provides annuity and/or expense guarantees under the contract. Since risk charges are not compensation for performing authorized functions under the Act, a variable annuity issuer must obtain an exemptive order from the SEC in order to deduct risk charges. Applicants for exemptive relief must show, among other things, the charge is within the range of industry practice for comparable contracts or reasonable in relation to the risks assumed. Since 1986, the SEC staff has adopted a rule of thumb limiting annual mortality and expense risk charges to 1.25 percent of separate account assets annually. The staff has indicated that it will not process exemptions or recommend to the Commission that it grant exemptions to permit a mortality and expense risk charge greater than the 1.25 percent level. When the mortality and expense charges exceed this level, concern is triggered that some of the charge is being used to help finance the distribution costs of the product, thereby getting around the sales load limitations.

Charges under Variable Life Insurance Policies. The primary charges assessed under a typical VLI policy are the four types of charges noted above with respect to variable annuities plus charges for the cost of insurance (that is, the cost of the death benefit protection). As with variable annuities, with the exception of investment advisory fees, the charges are regulated under Secs. 26 and 27 of the Act.

Sales loads may not exceed 9 percent of the total premiums paid or expected to be paid over the lesser of 20 years or the life expectancy of the insured. The insurer may either use a level load and deduct no more than 9 percent from each premium payment or it may utilize an excess load and deduct a percentage that exceeds 9 percent in the early contract years but decreases in later years so as not to exceed the total aggregate limit. In addition, restrictions are imposed on the use of excess loads, such as no sales load deductions in the first 12 months exceeding 50 percent of any one premium and provision for refund of excess loads paid if the contractholder surrenders the contract within the first 24 months.

Whereas the administrative charges for variable annuities must be limited to cost, with respect to VLI, the charges simply must be reasonable in relation to the services provided and the expenses incurred.

The mortality and expense risk charges pursuant to VLI policies compensate the insurer for the risk that actual mortality rates will differ from actuarial projections and that actual expenses will exceed the guaranteed rates. Here, the risk is that the insured will die sooner than anticipated, or before the expected premium payments have been paid. VLI issuers deduct mortality and expense risk charges from separate account assets in accordance with exemptive Rules 6e-2 (for VLI) and 6e-3(T) (for flexible premium or variable universal life insurance). For scheduled premium policies, risk charges must be disclosed in the prospectus and be at least equal to 50 percent of the maximum deductions stated in the prospectus and in the contract. The SEC staff imposes a rule of thumb limiting annual mortality and expense risk charges of .50 percent for scheduled premium policies, .60 percent for single premium products (with 1980 CSO mortality charges) and .90 percent for flexible premium policies.

In short, the Investment Company Act of 1940 created a regulatory scheme to combat the abuses which arose in the 1920s and 1930s in the sale of periodic payment plans. Applying this scheme to variable insurance contracts has resulted in the development of a complicated pricing structure consisting of an array of charges, each associated with a different expense, such as a sales load, investment management charges, administrative charges and insurance risk charges. Each of these charges is subject to a different regulatory standard (with some being able to include an element for profit while others cannot). Each charge must be calculated on a different basis (such as a percentage of premium, percentage of separate account assets, or a flat dollar per policy charge). The resulting multiplicity of charges renders the charge structure difficult to comprehend, complicates comparison shopping by consumers and necessitates a significant amount of explanation in disclosure materials such as the prospectus and insurance sales materials. Furthermore, the mandated pricing structure is complicated for insurers, hence increasing the cost of the policies due to increased product design difficulties and lack of ready ability to use existing administrative processing systems.

Problems with the Current Regulatory Framework. Even though variable insurance contracts fall within the literal definition of periodic payment plan certificates, they constitute significantly different investment products. Variable insurance contracts have not been involved in the types of abuses which gave rise to the regulation of contracts posed by Secs. 26 and 27. As a result, the regulations applicable to periodic payment plans, in a variety of ways, are ill suited to variable insurance. Although the SEC has issued numerous exemptive orders and rules to accommodate insurer problems, the basic problem that such provisions were not drafted with variable insurance in mind persists.

Variable Insurance Contracts vis-à-vis Periodic Payment Plans. The differences between the periodic payment plans which the 1940 Act is designed to address and the variable insurance situation are widespread and fundamental.

First, periodic payment plans are simply a means to purchase securities by installment. In the early stages the investor receives little more than the opportunity to pay excessive sales loads. If payments are not continued, the investor is virtually certain to suffer economic harm. In contrast, VLI offers a combination of investment and insurance. Substantial economic benefit in the form of meaningful insurance protection becomes immediately available with the payment of the first premium. Variable annuities also commonly offer some form of death benefit protection during the pay in phase and rights to select annuity payout options at rates established when the contract is purchased.

Second, a periodic payment plan simply requires a plan trustee or sponsor to perform relatively simple administrative tasks. Charges for illusory services required regulatory limitations. In contrast, the issuer of variable insurance contracts affords a wide array of services in administering the contract. The insurer must commit a significant amount of capital to develop and maintain elaborate systems to handle a variety of contract features and monitor insurance, tax and securities law requirements.

Third, there is a distinction relating to the insurer capital structure. Periodic payment plan sponsors were thinly capitalized. When trusts were liquidated, some investors did not receive the services for which they had already paid. Thus, Congress imposed minimum capital requirements on plan sponsors. In contrast the average insurer possesses a much stronger capital base. Since a separate account is an integral part of an insurance company, a less paternalistic approach to capital requirements for variable insurance seems appropriate.

Fourth, state insurance regulation provides an additional layer of protection not available in the periodic payment plan situation. Variable insurance is subject to minimum capital and surplus requirements, reserves and investment restrictions. As a consequence, an insurer typically is much stronger than a typical periodic payment plan sponsor. Furthermore, state law mandates nonforfeiture benefits and provides important protections through approval of contract forms.

Problems Caused by Current Approach to Regulating Charges. Several major difficulties arise in applying the 1940 Act periodic payment plan provisions to insurers issuing variable insurance.

First, the current securities law regulatory emphasis on limiting the individual charges inhibits product design and pricing. In designing a new contract, an actuary makes assumptions as to such pricing variables as the probable rate of death, anticipated earnings on the investment of premium payments, long-term expenses of administering the policy, the rate of policy persistency, the expected margin of profit consistent with company objectives, and contingencies for unexpected events. In establishing a contract price, the actuary seeks the optimum combination of assumptions which will enable the insurer to recover its expenses on a block of policies within a given number of years with expectation that thereafter the block of policies will become profitable. Whereas state regulation affords insurers the flexibility in adjusting the pricing elements, of a contract, the Investment Company Act limits most of the pricing elements, thereby inhibiting the actuarial process. Thus, the Act inhibits innovation and introduction of new products. And even if an insurer is willing to write variable insurance products, the Act may force the creation of inappropriately priced products.

Second, the stringent limits imposed on specific charges have also caused insurers significant problems. In particular, the requirement that administrative services be provided at cost has drawn major criticism. Unlike periodic payment plans where sponsors incur little capital expense, the administration of variable insurance contracts demands heavy capital outlay, including the design of new and complex products, filings with both the SEC and the several state insurance regulators, audits of separate accounts, developing and purchasing elaborate and expensive administrative systems to handle the complex contracts, monitoring compliance with securities, insurance and tax laws, and registering the field force with the NASD. If an insurer cannot generate adequate income from such administrative activity and the use of its capital due to the SEC limits, the insurer is more likely to emphasize fixed dollar contracts (even to the exclusion of issuing variable contracts), which are not subject to such pricing limitations. Although an insurer can recover development and administrative expenses under Secs. 26 and 27, the regulatory framework renders it difficult to realize a satisfactory return on the substantial capital investment because of the "at cost" and "reasonable expense" concepts as applied under these Sections.

Third, a substantial concern expressed by the insurance industry has been the belief that the refund requirements under the 1940 Act create a marketing bias against the sale of variable life insurance. Insurance agents typically offer a wide array of insurance products for sale. To be motivated to sell complex variable contracts, they 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. For example, these provisions require an insurer to return, or not deduct more than, certain specified sales load amounts if an excess loaded contract is surrendered during the first 24 months. Unless an insurer is willing to draw upon its capital and surplus, such limitations preclude an insurer from paying competitive commissions on variable insurance vis-à-vis fixed dollar insurance. Many insurers are reluctant to establish and/or maintain a variable life operation if they cannot sell such contracts on an equal basis with fixed dollar products.

Fourth, a fundamental concern has been the continuing need to separate "insurance related" charges from "securities related" charges and subject only the latter to the comprehensive periodic payment plan regulation. Because of congressional determination that regulation of the insurance industry should be left to the states, as reflected by the McCarran Act, the SEC has sought to concentrate its regulatory efforts on the securities elements of the variable insurance products and to avoid regulation of the insurance elements. Unfortunately, securities related and insurance related charges are not susceptible to neat divisions for regulatory purposes. Some charges which insurers characterize as insurance charges may have components deemed to be appropriate for 1940 Act concern. Furthermore, so 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. Furthermore, these problems are compounded by significant differences in the degree of insurance protection afforded by variable life insurance vis-à-vis variable annuities.

In short, 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 emphasis on limiting the individual charges inhibits product design and pricing. (2) Unlike periodic payment plans where sponsors incur little capital expenses, the administration of variable insurance contracts demands substantial administration and capital. SEC application of "at cost" and "reasonable expense" concepts under the 1940 Act renders it difficult for an insurer to realize a satisfactory return on the substantial use of its administrative and capital resources. This encourages insurers to emphasize fixed dollar contracts (even to the exclusion of issuing variable contracts), which 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) Securities related and insurance related charges are not susceptible to neat divisions for regulatory purposes. Some charges which insurers characterize as insurance charges may have components deemed to be appropriate for 1940 Act concern. Also, while the SEC regulates only investment related charges, the insurers might seek to evade such charge limitations by adjusting insurance charges to the extent allowed by state law. On the other hand, insurers have been strongly against the SEC exercising control over insurance elements of the contracts.

Recommended Change in Approach. For the reasons discussed, the SEC Division of Investment Management has concluded that the regulation of specific charges under Secs. 26 and 27 of the Investment Company Act is inappropriate for variable insurance. The Division recommends legislative changes which would be more flexible and would grant SEC jurisdiction over all contract charges in the aggregate. The SEC would then no longer examine individual contract charges or the manner in which they are deducted or refunded. Rather, it would possess authority to adopt rules governing the overall level of charges to assure the reasonableness of aggregate contract charges and the manner in which they are deducted. The insurer would be required to represent in its registration statement for a variable insurance product that its charges meet the reasonableness standard. Variable insurance would be exempt from Secs. 26 and 27 and the specific charge limits imposed by those sections. In essence, the recommended changes would treat variable insurance separate accounts more like mutual funds, which are subject to more general prohibitions against excessive fees. These recommendations would not affect other provisions in the federal securities laws.

The most significant difference between proposed changes emanating from the SEC and the recommended changes proposed by the life insurance industry relates to the authority of the Commission to adopt rules and guidelines for determining the reasonableness of the charges in the aggregate. The granting of such authority is viewed, at least by some, as providing SEC control over insurance charges and prices, something which not even state insurance regulators possess with respect to most types of life insurance products. Nevertheless, the staff recommendations have not generated substantial controversy and were favorably received by the life insurance industry. However, there has been some frustration over the slow pace at which the SEC has moved forward with the proposal as a result of personnel turnover. As of late 1994, no legislation has been proposed to implement these recommendations. In the meantime, insurers continue to seek exemptive orders so as to be able deduct a mortality and risk charge for the products the insurer offers.

The history of the mortality and expense risk charge debate is said to offer three options for the future. First, continue the practice of requiring an insurer to file an application for exemption as to each product it offers through investment company separate accounts. Second, adopt an exemptive rule incorporating class relief concepts towards which the SEC staff has recently moved. Third, obtain amendments to the Investment Company Act to exempt variable insurance contracts from the charge restrictions in Secs. 26 and 27 of the Act and, in lieu thereof, require that the aggregate charges under variable contracts be reasonable.

The Investment Advisers Act of 1940 was enacted as a companion to the Investment Company Act. The Advisers Act focuses upon those persons providing investment advice. An investment adviser is defined as any person who for compensation engages in the business of advising others as to the value of securities or as to the advisability of acquiring or disposing of securities. Such person must register under the Act, pay a registration fee, maintain records, and be subject to SEC oversight and examination. Certain provisions are directed against conflicts of interest when rendering investment advice. In addition, the adviser must comply with antifraud provisions.

As to the life insurance industry, the application of the Investment Advisers Act arises in at least two contexts: (1) advice rendered to the separate accounts funding the insurance products and (2) advice to individuals who are prospective purchasers of insurance products. The former is considered here; the latter will be discussed in the context of financial planners.

Prior to 1970 the Act excluded those investment advisers whose only clients were investment and insurance companies. Consequently, insurers could act as advisers to their separate account/investment companies without registering. However, upon SEC urging, Congress amended the law, limiting the exemption to those whose only clients were insurance companies. Since the separate account was deemed to be an investment company, if an insurer wants to serve as its adviser, it would have to register as an investment adviser. Once insurers began to register, the SEC took a no action position as to several provisions in the Act which would have been difficult if not impossible for the entire insurance company to comply with. Many insurers, however, chose to register a subsidiary, rather than the insurer itself, as the investment adviser so as to avoid these issues.