Insurance companies have increasingly been seeking exemptions under Section 26(b) of the Investment Company Act to substitute one annuity sub-account for another without holding a shareholder vote, raising SEC concerns.

The SEC is likely to begin granting fewer 26(b) exemptions - particularly if the proposed replacement sub-account has higher fees than the existing one, said Paul Roye, director of the division of investment management.

"The commission staff has seen an increase in the number of applications requesting Section 26(b) approval for the substitution of underlying funds, [often with] . . . the addition of the insurance company affiliate as investment adviser, or manager of managers . . . for an additional fee to be borne by shareholders," said Roye at the National Association for Variable Annuities regulatory affairs conference in Washington, D.C. early this summer.

"The staff is concerned when it finds that the expense ratio of the proposed substituted funds is higher than that of the replaced fund, particularly where the difference is attributable to advisory fees or 12b-1 fees which, absent a substitution, would be subject to shareholder approval," Roye said.

While the SEC has always tried to make sure that substituting sub-account fees did not increase, there may have been cases that have "slipped through," said Susan Nash, associate director of the SEC's division of investment management. But this will no longer be the case, Nash said.

Industry attorneys and executives said that because of the commission's tough new stand on Section 26(b), they would avoid submitting exemption applications.

Some executives, who did not want their names used, said that some insurers have tried to make use of the exemption to raise fees on unsuspecting policyholders.

"Let's face it, they want higher fees," said one insurance executive.

"This is an abuse that has gone on for some time," said Mercer Bullard, president of Fund Democracy of Chevy Chase, Md. "His [Paul Roye's] complaint is a little belated since the commission has been allowing this for a while. His division has been signing off on applications for exemptions to all kinds of provisions, including substituting a sub-account with one carrying higher fees. They don't want to be embarrassed by a hearing request."

However, other industry executives defended the use of Section 26(b), saying that there are sometimes sound business reasons for insurance companies wanting to use the exemption to substitute funds without shareholder approval.

One such reason is that holding a proxy vote is time-consuming and costly, said Fred Bellamy, a partner with Southerland, Asbill & Brennan of Washington, D.C.

Also, an insurance company frequently wants to substitute one sub-account for another that has higher fees because fees on the original sub-account were going to be raised anyway, said Ray O'Hara, a partner with Blazzard, Grodd & Hasenauer of Westport, Conn. This is particularly true with an annuity start-up, when an insurer often absorbs some of the fees to get the product off the ground at a reasonable cost, O'Hara said.

It might also make sense to replace a poor performing sub-account with a better-performing one that has higher fees, O'Hara said.

These are all cases in which there are mitigating circumstances justifying the substitution of one sub-account for another with a higher fee, said O'Hara. The division of investment management in the early 1990's clearly recognized this by setting the precedent of allowing 26(b) substitutions of sub-accounts with higher fees, he said.

The commission is doing an about face in taking a skeptical view towards 26(b) exemptions, he said. It is important for the insurance industry to know about the SEC position so as to avoid the time and cost of submitting Section 26(b) applications for sub-accounts with higher fees, he said.

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