WASHINGTON -- While the annuity industry remains hush-hush on the topic of the market-timing cases being brought by the Securities and Exchange Commission and the New York Attorney General, this silence does not indicate a lack of opinion. Speakers and attendees alike voiced their views on the brewing market-timing trouble and regulatory implications for the variable annuity industry here at the Regulatory Affairs Conference sponsored by the National Association for Variable Annuities of Reston, Va. And the consensus was that preventing market timing in annuities is more complex than preventing it in mutual funds.
Kathleen Schulze, VP and assistant general counsel for Aegon Insurance Group in Louisville, Ky., moderated a session called "Market Timing
Policies and Procedures: Developing Effective Solutions to Today's Challenges." Paul Fischer, a partner with Jorden Burt in Washington, Neil Lang, a partner with Sutherland Asbill & Brennan in Washington, and Joseph Rath, assistant vice president, assistant general counsel and assistant secretary for Allstate Financial in Northbrook, Ill., spoke about the pros and cons of various strategies, as well as anticipated reaction by regulators and others.
Clearly, market timing is an issue that is not going to simply blow over for insurers. While the bulk of trouble for mutual funds may have passed, the SEC and New York A.G. are only now assembling their cases.
One of the issues is that investigators at both agencies have not dealt with many, or any, variable annuity cases in the past, so it is taking longer for them to understand the issues behind market timing in variable annuities, said a source familiar with the matter. This has been evident as regulators have been building their cases, during which time investigators have repeatedly returned to carriers asking follow-up questions, Rath said.
The lengthy investigations have also been expensive. The e-mail sweep alone at Allstate cost the firm more than $250,000. However, the greatest implication may come in the form of new regulatory requirements and increased scrutiny from the SEC, the National Association of Securities Dealers and state regulators. The SEC and NASD are proposing new rules to help control market timing, and enforcement of the Conseco/Inviva case (see MME 8/16/04) demonstrates that the regulators expect carriers to back up prospectus-based statements about timing limitations with action.
"By adding restrictions and limits, we've created a new obligation for ourselves that we didn't have previously," Rath said. Especially given the vagueness of market timing itself and some uncertainty as to when it harms other policyholders, there are many ways to skin this particular cat. No matter what approach carriers take, however, "whatever the solution, insurers must enforce that solution," Lang said.
While the market-timing scandal will, hopefully, pass, market timing itself is sure to resurface. As one attendee commented, "[Market-timing hedge funds] are like chop shops, constantly coming up with new tax IDs or new annuitants. You can't keep up with them."
Insurers and broker/dealers are going to have to stay on their toes to keep tabs on timers, and the regulators will be watching. However, just as investigations into the mutual fund industry don't carry over completely into the variable annuity arena, so must the regulation of timing in variable annuities differ, speakers said. For instance, the 2% redemption fee for funds traded within five days of purchase proposed by the SEC creates several problems when applied to variable annuities. For one thing, trades in variable insurance portfolios are accounted for on an omnibus basis, with the insurer considered a single institutional shareholder, Rath said.
Not Just a Sale, a Contract
Another fundamental difference between mutual funds and variable annuities is that annuities are contracts between carriers and individual policyholders. One implication of this relationship is the fact that the contract may stipulate that fees will not be increased, so it may be contractually impossible for carriers to add a 2% fee.
The contractual nature of annuities also creates problems for the broker/dealers. Many companies have added a box on applications that the policyholder can check off, allowing the registered representative to make transfers on behalf of the client. "If the rep does that, he's aiding and abetting and facilitating a transaction," Schulze said. "This creates an obligation on the part of the broker/dealer, but if the application goes directly to the insurer, the broker/dealer may not know [about this obligation]." Furthermore, Schulze added, unlike mutual funds, transfers within a variable annuity do not create a ticket for the broker/dealer to monitor.
Perhaps more dramatically, the mandatory 2% redemption fee could generate questions about constitutionality, Fischer said. It potentially interferes with Article I, Section 10 of the U.S. Constitution, which guarantees that the government cannot interfere with the obligation of contracts. The contractual nature of annuities also limits carriers' ability to alter existing contracts to accommodate new rules imposed by insurers to restrict or forbid excessive trading. In some states, such as Connecticut, Florida, Oregon, South Carolina and Texas, insurers have had trouble getting the states to accept changes that would impose trading restrictions on those contracts that currently allow unfettered trading, Rath said.
"I wonder whether insurance commissions would be more open-minded in the current environment," Fischer said, given that "courts have been pretty sympathetic to the argument [that a change should be made]."
Schulze also mentioned that, with so many sub-accounts, many operated by different money managers, it could be virtually impossible for a company to spell out a specific policy that would be consistent with all the different portfolios. And in some cases, language restricting market timing is in the prospectus but not in the contract. Kay Lackey, assistant regional director for the Northeast Regional Office of the SEC, said that, from an enforcement standpoint, the Commission concerns itself only with the prospectus language. However, Schulze pointed out that this discrepancy still opens carriers up to civil suits.
Vulnerability to Civil Suits
The market-timing issue represents a double-edged sword for carriers. While they need to meet the growing requirements and scrutiny of regulators, they will still need to grapple with the continuing problem of the market timers themselves. At least four contract owners have sued 10 insurance companies in a total of 13 suits because of limitations imposed to prevent market timing, according to Gary Cohen, a partner with Foley & Lardner in Washington.
Inconsistencies or changes in policy or contract by the carrier automatically make the insurance company vulnerable to litigation in the private arena, even while they may protect insurers from enforcement actions by regulators. "You may be saving yourself a problem with the regulators but making a problem with the timers," Fischer said.
Where carriers do place limitations on market timers, the SEC is expecting carriers to have some kind of monitoring system in place. One question this raises is whether to institute a policy where a timer, once identified, goes through a warning process or is immediately restricted in trades, Schulze said. Furthermore, once a carrier establishes a set of monitoring rules, it also must figure out how and when it will break those rules. "You always have to craft procedures for exceptions," she said, because undoubtedly a client will have a legitimate reason for a trade that violates the carrier's rules.
It's not clear how the SEC will view exceptions, which can either facilitate or curb market timing. One option for gracefully escorting timers out of an annuity is to grant an exception by extending the "free-look" period so they can exit without incurring a surrender charge penalty. Rath said the SEC examiners did ask whether Allstate made such exceptions, so the agency is aware of the practice. "Whatever the array of remedies, will we be accused of being inconsistent because we didn't apply those remedies evenly?" Rath asked.
Nihilistically, carriers could simply fail to mention any stance on market timing at all, Schulze said. However, "this will be made more difficult [by regulators]," she said, because "there is the question of monitoring."
Recognizing that it is impossible to ensure complete control over timing activity, insurers could go the disclosure route, Lang said, letting policyholders know, "We may not be able to stop it, and that's a risk of investing."
Top 10 Implications of Canary
Paul Fischer, a partner with Jorden Burt in Washington, presented a list of the top 10 implications of the New York Attorney General's case against Canary Capital Partners of Secaucus, N.J. The New York A.G. charged the hedge fund with abusive trading practices stemming from agreements it had made with various mutual fund companies for special market-timing and late-trading arrangements. Canary was also a culprit in a recent case for market-timing arrangements inside variable annuities.
1. Variable products will be the likely focus of regulatory and private bar attention for the foreseeable future.
2. Heightened interest in variable product sales practices by both regulators and the private bar.
3. More litigation, both government and private, will result in more expenses.
4. More investigations and regulation will also result in more expenses.
5. Scrutiny of fees by the New York Attorney General and the reduction of fees as part of timing settlements.
6. Heightened attention to the financial relationship between insurers and the
distribution chain because of undisclosed compensation.
7. Increased coordination between contract language and prospectus language: Carriers will need to better coordinate the two, since actuaries typically write
contract language whereas securities lawyers typically write prospectuses.
8. Continued lack of appreciation of the difference between mutual funds and
9. Shift of market-timer litigation from fighting market timers to defending against regulators and the private bar.
10. Shift of attention on the insurance industry from insurance regulators to
securities regulators and state attorney generals.