With respect to the federal securities laws, insurance products can be classified as falling into one of three categories.

First, there are the "traditional" contracts under which virtually all of the investment risk remains with the insurer. Contract values do not vary. Such contracts are excluded from the definition of a security under the Securities Act of 1933, which explicitly excludes insurance and annuity contracts from the definition of a security. These contracts are issued through the insurer’s general accounts, which are not required to be registered as investment companies under the Investment Company Act of 1940, which excludes insurance companies from the definition of an investment company. Consequently, the regulation of these contracts remains within the domain of state insurance regulation.

Second, there are variable insurance contracts under which the investment risk is transferred to the buyer and contract values vary frequently in accordance with investment performance. These contracts must be registered as a security under the 1933 Act. They are issued through separate, rather than general, accounts. These separate accounts are registered as investment companies under the 1940 Act. Variable contracts are subject to substantial dual regulation by the SEC and the state insurance departments.

Third, there are "hybrid" contracts under which some investment risk is transferred to the buyer. Although contract values do not vary daily, they may be adjusted in some manner to reflect investment experience. Although registered as securities under the 1933 Act, the insurer’s general account through which the contracts are issued need not be registered as an investment company under the 1940 Act.

Responding to high interest rates in the 1970s, life insurers commenced offering a variety of new annuity products generally referred to as guaranteed investment contracts (GICs). Although GICs possess investment guarantees substantially equivalent to those contained in a traditional annuity, they also involve the payment of interest in excess of that guaranteed. GICs are funded through a life insurance company’s general account rather than through the establishment of a separate account structure. The contractholder places funds on deposit with the insurer. The insurer promises to repay the deposit(s) plus interest according to a schedule specified in the contract. The principal and minimum rate of interest are commonly guaranteed for the life of the contracts as is the case with traditional annuities. In addition, however, guaranteed investment contracts offer pre-annuity accumulation at either current discretionary interest rates in excess of the guaranteed rate or at current high interest rates guaranteed for only a short period of time.

GICs typically permit the purchase of an annuity at the end of the accumulation period based upon annuity purchase rates which may or may not be guaranteed in the contract, whereas traditional annuities usually guarantee at the time the contract is issued the amount of annuity benefits to be paid at the annuity or retirement date. Another feature distinguishing GICs from traditional annuities permits the contractholder to vary premium rates as to amount and timing without any specific obligation. The size of the annuity depends upon the amount accumulated up to the commencement of the annuity payments.

Under state law, GICs fall within the definition of deferred annuities and, when sold to qualified pension plans, are sold on a group annuity basis.

Of particular interest to the SEC were the single premium deferred annuities (SPDAs) sold by companies such as Baldwin-United. These were excess interest contracts under which the purchaser typically made a substantial single payment. The insurer guaranteed to pay a minimum interest (typically 4 percent to 6 percent) for the life of the contract and afforded the possibility that it would periodically declare excess interest. The SEC’s attention was drawn to these products by advertisements and marketing of the product primarily as an investment vehicle. Promotion advertisements emphasized high first year guaranteed interest with little focus on the traditional annuity features. Purchasers were able to withdraw money without penalty if minimum discretionary interest rates were not attained. The Baldwin-United insurance subsidiaries did not assume a meaningful mortality risk since the guaranteed annuity conversion rates were so low that the guarantees were said to be a sham. As with other securities, the ability of the contractholders to earn anticipated rates of interest depended upon the investment portfolios and the investment acumen of Baldwin-United. This advertising and marketing effort strongly indicated that the products were being sold as tax-deferred investment vehicles and as alternatives to certificates of deposit and municipal bonds. Because of the marketing of the products as investments and the fact that the payment of excess interest at the discretion of the company shifted some of the investment risk to the purchaser, the SEC undertook to determine whether such contracts were securities which should be subject to the registration, prospectus and antifraud provisions of the Federal Securities Act of 1933.

Although federal securities law imposes a substantial and complex additional layer of regulation on insurance companies issuing variable annuities and variable life insurance policies, such regulation has been essentially confined to products funded by insurer separate accounts. When the SEC turned its attention to excess interest GICs, such as Baldwin-United’s SPDAs, the Commission embarked upon a road which significantly broadened the sweep of SEC activities to life insurance company operations, including general account products.

Backdrop. As discussed earlier, in the VALIC (1959) case, the Supreme Court held that a variable annuity placing all of the investment risk on the annuitant and none on the insurer did not come within the exclusion from the Securities Act of 1933. The variable annuity at issue did not guarantee anything other than an interest in the equity portfolio. The Court noted that insurance typically involves the insurer guaranteeing at least some fraction of the benefits that will be payable. In the following 30 years or so, both regulators and insurers have wrestled with the issue of just how much investment risk must an insurer assume under an annuity or life insurance contract in order to come within the exclusion.

Sec. 3(a)(8) expressly exempts

Since the antifraud provisions of the 1933 Act are specifically applicable to securities exempt under this section, the language suggests that annuity contracts falling within Sec. 3(a)(8), while exempt from other requirements of the Act, remain subject to the antifraud provisions. Nevertheless, the general view, including that of the SEC, has been that this section constitutes an exclusion from the entire Act rather than an exemption from certain provisions of the Act.

The courts and the SEC have evolved criteria for determining whether a particular product falls within the Sec. 3(a)(8) exemption. The courts have focused upon the extent to which the insurer bears the investment risk, how the contract is marketed and, to a lesser extent, whether the insurer assumes the mortality risk.

Although GICs possess investment guarantees substantially equivalent to those contained in a traditional annuity, the SEC evinced concern over those life insurers marketing these contracts to individuals primarily as tax sheltered investments through investment oriented advertising and sales literature. The sales appeal of the contracts arose from the relatively high tax-deferred interest rates based upon current market yields. The payment of excess interest at the discretion of the company shifted some of the investment risk to the purchaser.

After withdrawing a proposed rule to provide guidance as to which contracts were not annuities within the meaning of the Securities Act of 1933, in 1979, the SEC adopted a Statement of Policy in the form of Securities Act Release 6051 rather than a formal rule. In this Release, the SEC took the position that for any insurance or annuity contract to be excluded under Section 3(a)(8) of the 1933 Act, hence out from under the Act’s registration requirements, the insurer must assume both meaningful mortality and investment risk with a corresponding absence of an assumption of significant investment risk by the contractholder. The assumption of a meaningful mortality risk depended upon whether the annuity purchase rate guarantees were significantly lower than those otherwise generally available and upon how long they were guaranteed.

As to the investment risk, the Release suggested a facts and circumstances test based on the terms of the contract and the emphasis placed on investment in the sales literature. The Release particularly questioned those contracts with a low guaranteed interest rate, but which were sold by emphasizing the possibility that a high discretionary rate, currently being credited, would continue to be credited. The examination of "excess" interest in addition to guarantees by the SEC represented a significant new step in the broadening application of the federal securities laws to insurance products.

During the years immediately following the promulgation of the Statement, only one insurer marketed a guaranteed interest contract registered under the Securities Act. Nevertheless, the Statement impacted the design of products. Furthermore, the SEC has sought justification from individual insurers for the nonregistration of guaranteed interest contracts under the standards set forth in the Statement.

More important than actions in individual situations, the Statement of Policy positions the SEC to assert broad jurisdiction over traditional as well as new life insurance products based upon the manner in which the product is sold as distinguished from the basic nature of the product. Although under the Statement the SEC may not find that excess interest provisions are themselves inherently objectionable, they can become so when contracts are promoted as investments and the traditional annuity features are relegated to the background.

Rule 151. After a few years of dealing with numerous opinions of insurance company counsel as to whether a given product was entitled to a Sec. 3(a)(8) exemption under the general standards of Release 6051, in 1986, the SEC rescinded the Release and adopted Rule 151 in lieu thereof. This occurred in the wake of the financial impairment of Baldwin-United with the resultant inability to meet obligations to its contractholders. The SEC came under considerable pressure to clarify the status of fixed annuity contracts under the federal securities laws. Furthermore, the SEC exhibited a desire to effectuate a more objective standard in applying Sec. 3(a)(8).

Rule 151 indicates that if a contract meets three basic conditions, the insurer can rely on the Sec. 3(a)(8) exclusion: (1) The annuity is issued by an insurer subject to the supervision of the state insurance commissioner. (2) The issuing insurer assumes the investment risk under the contract. (3) The contract must not be marketed primarily as an investment. With respect to assuming the investment risk under (2) above, the Rule goes on to state that the insurer will be deemed to assume the investment risk if (i) the value of the contract does not vary according to the investment experience of the account, (ii) the insurer for the life of the contract (a) guarantees the principal amount of purchase payments and interest credited (net of any sales, administrative or other expenses or charges) and (b) credits a minimum specified rate of interest, and (c) the insurer guarantees that the rate of any excess interest to be credited above the required minimum will not be modified more frequently than once per year.

The thrust of Rule 151 is said to deny safe harbor treatment to certain annuity contracts, even though they are not variable and are not based upon separate accounts. The most threatened contracts are those which have market value adjustments and those which are marketed essentially as money market or savings instruments.

Investment Risk. Through the early 1990s, the courts and the SEC continue to agree that the investment risk assumption by the insurer is the most crucial factor in determining whether a contract falls within the parameters of Sec. 3(a)(8). Both generally concur that purchase payments and minimum interest rates must be guaranteed. However, considerable uncertainty continues as to the extent to which excess interest rates and credited excess interest must be guaranteed, as to what level of minimum interest will be sufficient for purposes of Sec. 3(a)(8) as distinguished from Rule 151, as to whether a contract with less than a yearlong guarantee of excess rates on new or old monies can fall within Sec. 3(a)(8), and as to whether a contract which does not guarantee credited excess interest can fall within Sec. 3(a)(8). The life insurance industry would like a rule excluding from the 1933 Act those contracts guaranteeing purchase payments, guaranteeing minimum interest rate and credited minimum interest, but not requiring a yearlong guarantee of the excess interest rate or credited excess interest.

Nature of Marketing. With respect to marketing, the courts and the SEC continue to agree that the nature of the marketing of the contract is an important factor in determining the availability of the Sec. 3(a)(8) exclusion. However, for the most part, the courts have found the marketing element to have been met despite references to the "investment" aspects of the insurer’s abilities, the excess interest rates and the tax advantages. Although marketing efforts have referred to the insurer’s investment abilities, its interest rates and the tax consequences, there is judicial recognition that such emphasis is simply a consequence of the nature of an annuity as a retirement funding vehicle. Good investment is necessary to save enough for a comfortable retirement. There is also judicial recognition that investment management is the lifeblood of life insurance companies. Consequently, it is not inappropriate for the insurer to tout its investment experience in relation to its insurance and annuity products. Thus, while the SEC maintains that a contract will not qualify if it is marketed with primary emphasis on current discretionary interest rather than the product’s usefulness as a long term device for retirement or income security purposes, there is some court suggestion that this may not be the case. The life insurance industry seeks a rule with no marketing test and, as a fall back position, a rule with a marketing test based upon objective criteria.

Mortality Risk. Both the SEC and the courts agree that mortality risk assumption as a factor for falling within Sec. 3(a)(8) is less important than investment risk assumption and the manner of marketing. There continues to be considerable uncertainty as to the extent to which this is a factor and how the meaningfulness of any mortality risk assumption is to be evaluated. The life insurance industry seeks a rule that would not require mortality risk assumption.

Although Rule 151 applies specifically to annuities, the SEC indicated in the accompanying Release that the same principles also apply to life insurance. Furthermore, there has been judicial application of the standards of Rule 151 to a life insurance policy as distinguished from an annuity contract.

Rule 151 as Safe Harbor vis-à-vis Defining Outside Parameters of Sec. 3(a)(8) Exclusion. In adopting Rule 151, the SEC emphasized that the Rule is designed to provide a safe harbor rather than to delineate the outer limits of Sec. 3(a)(8). That is, if a contract meets the standards of the Rule, the exemption is available. However, even if a contract does not meet the standards of Rule 151, the contract still may be within the statutory exemption based upon an analysis of the principles embodied in the Rule and the relevant judicial interpretations of Sec. 3(a)(8).

In Otto v. Variable Annuity Life Insurance Company (1987), sometimes referred to as VALIC II, the Seventh Circuit Court of Appeals altered the landscape. First, notwithstanding the SEC’s statements to the contrary, the
Court’s opinion suggests that Rule 151 is not simply a safe harbor, but rather constitutes the exclusive means of relying on Sec. 3(a)(8). The decision held that a discretionary excess interest annuity contract fell outside the safe harbor of Rule 151, and, without further analysis, outside Sec. the 3(a)(8) exclusion. Second, the Court added the frequency of changes in the excess interest rate more often than annually as an element in the analysis, an element which previously had only been a part of Rule 151. The Court said that the amount of discretion retained by the insurer to alter the interest it paid under the fixed annuity is relevant to the amount of investment risk assumed by the insurer. The Court combined the concept of discretion to change the rate with the concept of investment risk and viewed Rule 151’s most critical provision as the guarantee of excess interest rate for one year. By refusing to hear the appeal in the Otto case, the United States Supreme Court has let stand the lower Court’s pronouncements.

Because of the sharp disagreement between the views of the SEC and the Court of Appeals in the Otto decision as to the requisites for reliance upon the Sec. 3(a)(8) exemption, Otto has created substantial uncertainty as to the status of excess interest contracts under the federal securities laws. At worst, the thrust of the decision is that Rule 151 mandates securities status for those contracts which do not conform to the standards of Rule 151. At best, the decision gives rise to much uncertainty as to which contracts invoke the Sec. 3(a)(8) exemption. Furthermore, the decision also gives rise to concerns as to the Investment Company Act of 1940. If a substantial portion of an insurer’s business involves contracts with excess interest features similar to those at issue in Otto, the insurer itself could be deemed an investment company under the 1940 Act.

Several implications of the Otto decision have been summarized as follows: (1) The concept of guarantee as a key factor in establishing that the risk is on the insurer (so as to qualify for the exemption from registration) includes a guarantee on excess interest. With Rule 151’s setting of a one year guarantee being supported by the Otto decision, it appears vital that annuity providers meet this element if they want to avoid registration under the 1933 Act. (2) The importance of the manner in which the product is sold remains a critical factor. If marketing material touts the interest return, presumably compliance with Rule 151 is necessary to obtain the exemption. (3) The federal courts have become more inclined to find an annuity to be a security. (4) Despite numerous court decisions and administrative pronouncements, the key concept in determining whether an insurance product is exempt from registration as a security is that the insurer must bear the brunt of the risk.

Registering a Hybrid Contract under the 1933 Act. Registering a general account product under the Securities Act of 1933, especially if no registration of the general account under the Investment Company Act of 1940 is required, possesses advantages as well as disadvantages. First, the primary advantage is the flexibility afforded in product design. Since market value adjusted contracts and frequent interest rates changes would be permitted except to the extent limited by state law and since interest rate guarantees are not required, insurers may be able to offer higher interest rates than they would be able to if the product were unregistered while at the same time protecting themselves from disintermediation. Second, registering the product would eliminate any legal uncertainty and potential liability under the 1933 Act for illegally selling an unregistered product. Third, a registered product could be marketed as an investment. On the other hand, the disadvantages of registering such a product include registration and prospectus disclosure requirements and costs, periodic reporting requirements, restrictions on advertisements, and the requirement that agents must have a securities license.

The assertion of potential SEC jurisdiction in the area of hybrid contracts such as SPDAs, coupled with SEC efforts to draw lines in Rule 151, gives rise again to whether regulatory jurisdiction over their sales lies with the SEC or the respective states under the McCarran Act. The problem here is more complex than was the case with variable annuities because of the growth of interest sensitive products in the life insurance arena, including such modern forms as universal life insurance and single premium whole life insurance. The potential, if not actual, assertion of regulatory jurisdiction is moving beyond the more narrow context of annuities, which was the original focus of Rule 151. The issues involve the changing face of the life insurance industry and give rise to renewed fundamental questions of federal versus state jurisdiction over the sale of insurance products.

Sec. 3(c)(3) of the Investment Company Act of 1940 excludes "any . . . insurance company" from the definition of an investment company. In the context of hybrid (GIC) contracts, this raises at least two fundamental issues as to the Act’s applicability.

First, an insurance company is defined in Sec. 2(a)(17) as "a company which is organized as an insurance company, whose primary and predominant business activity is the writing of insurance . . ." and which is subject to appropriate state supervision (emphasis supplied). The Prudential case held that a segregated asset account funding a variable annuity is separable from the insurance company and such separate account constitutes an investment company not covered by the exclusion for insurance companies. In contrast, hybrid contracts are funded out of an insurer’s general rather than separate account. This poses the issue whether such general accounts are subject to the 1940 Act as investment companies. However, to date, the SEC has not sought to regulate the general account underlying contracts.

The second fundamental issue is at what point an insurer loses its ability to rely on the Sec. 3(c)(3) exclusion for insurance companies. This becomes a problem when an insurer’s general account products, which are registered as securities under the 1933 Act, become a sufficiently high percentage of its business that its "primary and predominant business" is no longer issuing unregistered (traditional) insurance products. The rapid growth of various types of excess interest contracts and variable insurance contracts during periods of high interest rates, such as occurred in the 1980s, demonstrated that such a possibility is not a remote one. If the 1940 Act ever does become applicable to a life insurer’s general account, the regulatory complexities and the potential for dual and/or preemptive regulation would be greatly magnified.

The SEC and the courts have established general parameters as to whether an insurance product is excluded from the federal securities laws under Sec. 3(a)(8) of the 1933 Act. These relate to whether such product is subject to state insurance regulation, the extent to whether the buyer vis-à-vis the insurer bears the investment risk, the extent to which the product is promoted as an investment and, although perhaps to a lesser extent, the extent to which the insurer bears mortality risk. Although these governing principles can be readily stated, their application to a given situation tends to be much more difficult.

In 1991, a federal district court in Louisiana enjoined persons from further violations of the antifraud provisions of the 1933 and 1934 Acts in offering unregistered securities, including securities in the form of single premium deferred annuities (SPDAs). The SEC charged that the defendants mis-represented the risks, the returns and the purported guaranteed nature of the securities. The SEC successfully argued that these SPDA contracts did not fall within either Rule 151 safe harbor or the outer limits of Sec. (3(a)(8) because of the investment risk assumption factor and the marketing factor. Hence, they were securities subject to the 1933 Act.

Federal Securities Regulation. A market value adjustment feature (MVA) generally is designed by insurers to avoid the problem of disintermediation when the current or market interest rate is guaranteed for a specified period and a withdrawal occurs prior to the end of the guaranteed period. Upon early withdrawal (that is, withdrawal or surrender before the end of the period of guaranteed excess or discretionary interest), the insurer adjusts the proceeds paid to reflect changes in the market value of its portfolio securities supporting the contract. If the value of the securities has decreased, the amount payable on surrender decreases. The converse also applies.

The adjustment, which is designed to avoid a mismatch between the assets which the insurer holds and its obligations to contractholders, typically is based upon the difference between the interest rate being credited on new contracts and that being credited on the contract being surrendered. On occasion, the adjustment could invade previously credited interest or principal. Even though the purchaser can avoid an MVA by holding on to the contract until the end of the term, the MVA feature does shift investment risk to the contractholder who decides to surrender the contract during the contract period.

In attempting to render an opinion as to the availability of Sec. 3(a)(8) exclusion, counsel would consider a variety of factors, such as the length of time the contract must be held before there can be a surrender without an MVA, whether the MVA can invade only current interest and whether the sales material placed undue emphasis on the investment aspects of the contract.

MVA features a shift of investment risk from the insurer to the contractholder. Whether the shift is enough to require registration under the 1933 Act depends upon the terms of the MVA feature. For example, an MVA can be limited so that any decrease in the surrender proceeds will not exceed the excess interest credited in the previous year or will not exceed some other defined limitation. An MVA feature without any such limit is one that can invade principal since the proceeds payable on surrender may be less than the premiums paid.

Under Rule 151, one requirement to obtain a safe harbor is that the insurer guarantee the principal amount of purchase payments (premiums) and all interest credited thereto. The SEC has indicated that this requirement precludes an MVA featured contract from relying on the Rule for an exclusion from the 1933 Act. However, the SEC indicated an MVA feature does not necessarily preclude reliance directly upon Sec. 3(a)(8). Whether it can do so depends upon, among other things, the degree to which the MVA shifts the investment risk.

State Insurance Regulation. In the mid 1980s, the NAIC adopted the Modified Guaranteed Annuity Model Regulation. Such an annuity is defined as a deferred annuity contract whose underlying assets are held in a separate account and whose values are guaranteed for a specified period of time. The contract contains nonforfeiture values based upon a market adjusted formula if held for a shorter period of time. The assets must be held in a separate account during the period in which the contractholder can surrender his or her contract. The regulation mandates contract benefit and design requirements, including a statement of essential features and procedures, a grace period, a reinstatement provision, the market adjustment formula for nonforfeiture values and the non-forfeiture benefits. The regulation also covers reserve liabilities, separate accounts and annual reports to contractholders. An agent must hold a variable annuity license to sell modified guaranteed annuity contracts in the state. As of 1994 six states had adopted either the model or something similar and two states had adopted related legislation.

Initially, separate accounts were used for both variable and pension products where the business need was to value the assets in the separate account at market value and the product functioned to pass through the investment results, in some manner, to the contractholder. Other insurer products continued to be funded through the insurer general accounts. More recently, additional types of products with a guaranteed nature have come onto the scene, funded by the insurer through a separate rather than its general account. One such product is an individual separate account annuity containing a market adjustment feature, that is, a modified guaranteed annuity. Sec. 1C of the NAIC Model Variable Contract Law provides that benefits guaranteed as to dollar amount and duration and funds guaranteed as to principal amount or stated rate of interest may not be maintained in a separate account unless approved by the commissioner and under such conditions as to investments and other matters as the commissioner may prescribe which shall recognize the guaranteed nature of the benefits and reserves. In implementing this "conditions" language of the Model Law, the NAIC Model Variable Annuity Regulation provides that the reserves for benefits guaranteed as to dollar amount and duration and funds guaranteed as to principal amount or rate of interest may be maintained in a separate account if a portion of the assets in such account, which at least equal the reserve liability, is invested in accordance with the investment laws of the state. Additionally, under the Model Modified Guaranteed Annuity Regulation, unless otherwise approved by the commissioner, separate accounts relating to modified guaranteed annuities are subject to the investment laws applicable to the insurer’s general asset account. However, unlike the Model Variable Contract Law and the Model Variable Annuity Regulation, the MGA Model Regulation is effective in only a few states.

Within this statutory/regulation framework, there is a tension between life insurers’ desire to freely develop products which make business sense and the regulators’ interest from a solvency perspective to limit the risks to the general account from such new products. The industry is working toward a regulatory regime which includes appropriate restrictions on such products without prohibiting them. To date most of the activity in this area has arisen at the individual state level rather than the NAIC level.

Prior to Rule 151, annuity contracts whose accumulation rates were tied to external indices were thought by the insurance industry to fall within the Sec. 3(a)(8) exemption. Although the buyer bears the investment risk of the external index going up and down, the insurer bears the investment risk that its investments underlying the contract may achieve a higher or lower rate than the external index. Nevertheless, the SEC apparently holds the view that Rule 151 does not protect indexed interest rate annuity contracts from application of the 1933 Act on the theory that such externalization shifts the investment risk to the contractholder. Thus, interest indexed contracts may be subject to the Act.

In 1988, the NAIC adopted the Interest-Index Annuity Contracts Model Regulation covering individual annuity contracts where interest credits are linked to an external reference. The Model Regulation would require the submission of certain information, along with the filing of such contracts, including (1) a description of how the interest credits are determined, (2) a description of the insurer’s investment policy (including the amounts and types of assets held for such contract), and (3) an actuarial opinion that the investments are appropriate in light of the index used. In addition, the insurer must annually file information covering the insurer’s ongoing situation with respect to such contracts. The insurer must demonstrate its ability to meet future contractual obligations and must comply with minimum reserve requirements. As of 1994 no state had enacted this Model Regulation.

The late 1970s and early 1980s witnessed soaring inflation, spiraling interest rates, increased demands for term vis-à-vis permanent insurance, a flood of policy loans and surrenders to take advantage of higher interest rates available elsewhere, and increased sophistication of consumers. An increasing number of life insurance companies concluded that new products were needed to respond to the changes in the market place. These were some of the factors that led to the emergence of universal life insurance as well as other products such as SPDAs, MVA contracts, and indexed annuities.

Description. Universal life generally refers to a whole life insurance policy providing for flexible premiums, adjustable death protection, crediting current rates of interest on the cash value, and funding through the insurer’s general account. These basic characteristics reflect a significant, but evolutionary rather than revolutionary, step from traditional whole life insurance. Through universal life insurance insurers seek to satisfy both the protection and savings needs of the public within the framework of one product.

In essence, the premiums go into a side fund from which the insurer makes two deductions. The first deduction constitutes a charge for insurance protection (in effect, term insurance). The insurer can change the risk charge but cannot charge more than the maximum charge guaranteed by the policy. The second deduction constitutes a charge for insurance company expenses and profit. The money remaining in the side fund, after these deductions, earns interest for the policyholder. The insurer guarantees that the annual rate of interest credited on the cash value will not be less than a stated percentage. (Such rate may not exceed the maximum rate permitted under the Standard Nonforfeiture Law). In addition to the specified guaranteed interest rate, excess interest is provided at a rate determined by either the company’s discretion (although the excess rate may be guaranteed for a specified period of time such as a year) or according to a stipulated external financial index (for example, 90-day treasury bills or long-term corporate bonds). Typically, however, to qualify for excess interest, the fund must be a minimum size (for example, $1,000). This fund of money is referred to as the policy’s cash value, but unlike traditional cash value, its growth is based upon variable rather than a fixed rate of interest. Unlike variable contracts utilizing a separate account, the funding vehicle for universal life is the insurer’s general portfolio (some times referred as the general account).

Commonly, a universal life policy grants the policyholder an option of electing either a level or an increasing death benefit. Akin to the traditional whole life policy, under the level death benefit option, the death benefit remains constant as the cash value increases over the life of the policy. Under the increasing death benefit option, the death benefit consists of the face amount of the policy plus the policy’s cash value. (Here, the policyholder pays a larger premium for the larger amount of the insurance protection element.) Typically, the policyholder may from time to time change the death benefit option elected and may increase (subject to evidence of insurability) or decrease the face amount of the policy, thereby affording substantial flexibility. Some policies also provide cost of living increases in the amount of the death benefit.

Within limits, the policyholder may vary either upward or downward the amount of annual premium he or she pays, depending on personal circumstances and preferences. If a premium payment is skipped, the insurance charge will simply be taken out of accumulated cash value. However, if the policy cash value is permitted to drop below that adequate to cover the expense and mortality charges for the next 60 days, the policy will lapse.

Under a traditional whole life policy, funds can be withdrawn by either a policy loan (on which interest must be paid) or by surrendering the whole policy for its cash values minus a surrender charge, if any. In contrast, universal life permits partial withdrawals from the cash value investment fund. Thus, universal life functions much like a savings account or money market investment funds. In addition, a policyholder may elect to withdraw funds in the form of a policy loan. However, to discourage disintermediation, many currently sold universal life policies credit the cash value with the current interest or earnings rate for non-borrowed funds and a lower rate (for example, 2 percent lower) for the portion of the cash value associated with the borrowed funds.

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

SEC Involvement. SEC concern with life insurance company general account products did not conclude with its consideration of guaranteed interest contracts (GICs). In 1981, the SEC Division of Investment Management sent a letter to several life insurance companies issuing universal life policies requesting views as to the status of the product under the Securities Act of 1933. This inquiry suggested possible assertion of SEC jurisdiction over even general account products containing traditional insurance guarantees. Such an expansive application of the federal securities laws would constitute pervasive federal regulation of the core of the life insurance business. However, to date, the SEC has not concluded that universal life falls outside the parameters of Rule 151 and/or Sec. 3(a)(8) exclusion from the 1933 Act.

State Regulation of Universal Life Insurance. As insurers began to offer universal life insurance policies, various states began issuing formal and informal guidelines which not only differed widely in their comprehensiveness but also sometimes conflicted with one another. Consequently, the NAIC undertook the development of a model regulation to address several areas of regulatory concern, including (1) compliance with the standard valuation and nonforfeiture laws, (2) the matching of assets and liabilities, (3) the need for mandatory or prohibited policy design features, and (4) disclosure and periodic reporting. The purposes in drafting the model were to supplement existing regulations of life insurance policies, provide guidance in areas where regulatory gaps existed and treat universal life as another insurance product rather than as some form of investment requiring a wholly new regulatory treatment.

In 1983, the NAIC adopted the Universal Life Insurance Model Regulation to supplement applicable existing regulations governing life insurance policies in general and to accommodate regulation to the unique characteristics of universal life. By the early 1990s, over 10 states had adopted the model regulation (last amended in 1989) or something similar thereto. It applies to individual universal life insurance policies other than those embraced by the Variable Life Insurance Model Regulation (variable universal life insurance).

The regulation establishes the minimum valuation standard for universal life policies, establishes a minimum reserve requirement, and governs nonforfeiture values for both flexible and fixed premium policies. Valuation and nonforfeiture regulations applicable to traditional life insurance policies are based upon fixed assumptions as to premiums, interest and expenses. The absence of these fixed assumptions in universal life requires valuation and nonforfeiture provisions designed specifically for this flexible product design. The nonforfeiture provisions are calculated on a retrospective rather than the traditional prospective basis.

The Model Regulation also deals with mandatory policy provisions. An insurer must provide periodic disclosure, at least annually, to policyholders since it is not feasible to project the status of the policy at the time of issue. At policyholder request, periodic disclosure is to be provided in illustration form. The Model specifies that there must be a guarantee of minimum interest credits and maximum mortality and expense charges. However, the Regulation does not specify the minimum amounts. No figures based upon nonguaranteed amounts shall be included in the policy. Because of the uncertainty as to many aspects of the policy, the policy must describe the method of calculating the cash surrender values. The policy must provide for a 30-day grace period.

Specific disclosure requirements are imposed with respect to the advertising, solicitation or negotiation of a universal life insurance policy. At the time of application, the agent shall furnish the applicant a summary statement of the policy substantially in accord with a prescribed form. The illustration of policy premium, death benefits and cash values shall be shown (1) for the current interest rate actually being paid on existing policies in force and (2) for the interest rate guaranteed in the policy. If the statement of information is not furnished at the time of application, it must be provided within 15 days and at least 5 days before delivery of the policy. The Regulation is not intended to conflict with or supersede the Unfair Trade Practices Act or the Model Regulation on Advertising and Solicitation.

As with conventional whole life insurance, the insurer maintains life insurance reserves required by state law as to the death benefit payable under the universal life policy. The calculation is based on the Commissioners 1958 Standard Ordinary Mortality Table assuming a specified interest rate that complies with the limitations set forth in the Standard Valuation Law.

The cash value of a universal policy is computed in a manner consistent with the calculation of cash values for traditional whole life policies, albeit on a monthly rather than an annual basis. The cash value so computed must comply with the minimum requirements of the Standard Nonforfeiture Law.

In addition, the Model Regulation sets forth information which must be furnished to the insurance department, thus better enabling the commissioner to assure that the insurer is adequately matching assets and liabilities. Also required is a "Statement of Actuarial Opinion" including an assurance of sound investment practices.

A few insurers have registered other types of general account products as securities under the 1933 Act without registering under the Investment Company Act of 1940. Although these products lacked the MVA feature, presumably their status was sufficiently doubtful because of insufficient interest rate guarantees.

In a different arena, which is more on the margin of life insurer activity, the SEC has opened a foray into an area which might ultimately further inject the Commission into the insurance business; that is, viatical settlements. In the mid- 1980s, insurers began to offer accelerated death benefit payments as a means to provide terminally ill insureds with access to cash while still alive. (These benefits were originally geared to afford a means to pay for nursing home stays.) Although originally excluding AIDS as a trigger, the accelerated death benefit now permits insureds with any terminal condition (or at least any of several terminal conditions listed in the policy, including AIDS) to withdraw up to a specified percentage of the policy face value. Typically, such benefits are not available unless the policyholder has at most 12 months to live. However, several insurers offering accelerated benefits restrict the diagnosis trigger to 6 months or less.

A related but separate development has been the emergence of the viatical settlement industry which offers an alternative means of affording terminally ill life insurance policyholders access to a portion of their policy’s death benefits before they die. Viatical firms either buy or broker the sale of insurance policies of terminally ill individuals. In exchange for cash and the payment of future premiums, the buyer obtains the right to the death benefit proceeds when the insured dies. Viatical settlements may be made for policyholders with up to 2 years to live. The sooner the insured dies, the more money the viatical company makes. Profits can be quite substantial for a buyer, perhaps as large as 50 percent.

When available the accelerated death benefit paid out by insurers tends to be more advantageous to the policyholder since the portion of face value benefits not accelerated remain in his or her policy, retain their tax benefits and pass on to his or her beneficiary. Virtually all of the death benefit is received. In contrast, if an insured viaticates a policy, he or she only realizes a portion of the face amount, that portion reflecting the amount a buyer is willing to pay for the policy subject to whatever regulatory minimums are required. However, for those terminally ill policyholders either having a policy with no accelerated death benefit or having a life expectancy longer than the period permitted under the policy’s accelerated death benefit, the viatical route may be his or her only viable option to obtain needed cash. As a consequence, viatical companies have become a significant source of cash for the dying.

Because of concern as to the vulnerability of the critically ill who are receiving an inadequate income stream, a handful of states have vested regulatory authority in their insurance departments over viatical firms. If someone offers a small settlement in exchange for the person’s life insurance policy, the person may tend to grab it without being aware of alternatives and/or the consequences. Consequently the NAIC became involved. Following the adoption of a Model Act in late 1993, in late 1994 the NAIC adopted a Model Viatical Regulation that (1) imposes licensing requirements on viatical settlement brokers, (2) requires advertising by viatical companies to disclose specified information, and (3) establishes minimum returns consumers should expect from a viatical settlement. As to brokers, the commissioners may suspend, revoke, or refuse to renew the license for misrepresentation in the application for the license, fraudulent activity, or violation of the regulation. As to advertising, standards are established to assure that consumers are provided with accurate information. As to the minimum return guidelines, the Model Regulation suggests that the minimum percent of the face value of the policy received be 80 percent if the insured’s life expectancy is less than 6 months, ranging down to 50 percent if the expectancy is 2 years or more.

In late 1994, the SEC entered the scene by bringing suit against a major viatical firm seeking to declare that viatical transactions, as structured by that firm, are securities which must be registered with the SEC as a security and for which prospectuses must be issued. The SEC has expressed concerned as to the manner in which some policies are offered for sale. For example, when a group of policies is packaged together and units of such package are sold, the offering is deemed to be a security and should be registered. In addition, the SEC has hinted that it may also look at transactions involving individual policies and individual buyers. (If viatical transactions are deemed to be securities, the question has been raised as to whether the terminally ill policyholder selling his or her policy is an issuer under the Securities Act of 1933.) Although not directly impacting life insurers, if the SEC is successful, a precedent could be established with respect to secondary market insurance transactions.