Insurance Company General Accounts

DEPARTMENT OF LABOR

Pension and Welfare Benefits Administration

29 CFR Part 2550

RIN 1210-AA58

Insurance Company General Accounts

AGENCY: Pension and Welfare Benefits Administration, Labor.

ACTION: Final rule.

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SUMMARY: This document contains a final regulation which clarifies the

application of the Employee Retirement Income Security Act of 1974 as

amended (ERISA or the Act) to insurance company general accounts.

Pursuant to section 1460 of the Small Business Job Protection Act of

1996, section 401 of ERISA was amended. Section 401 now provides that

the Department of Labor (the Department) must issue regulations to:

provide guidance for the purpose of determining, where an insurer

issues one or more policies to or for the benefit of an employee

benefit plan (and such policies are supported by assets of the

insurer's general account), which assets held by the insurer (other

than plan assets held in its separate accounts) constitute assets of

the plan for purposes of Part 4 of Title I of ERISA and section 4975 of

the Internal Revenue Code of 1986 (the Code), and provide guidance with

respect to the application of Title I to the general account assets of

insurers. This regulation affects participants and beneficiaries of

employee benefit plans, plan fiduciaries and insurance company general

accounts.

DATES: Effective Date: This rule is effective January 5, 2000.

Applicability Dates: Except as provided below, section 2550.401c-1

is applicable on July 5, 2001. Section 2550.401c-1(c) [except for

paragraph (c)(4)] and (d) are applicable on July 5, 2000. The first

annual disclosure required under Sec. 2550.401c-1(c)(4) shall be

provided to each plan not later than 18 months following January 5,

2000. Section 2550.401c-1(f) is applicable on January 5, 2000.

FOR FURTHER INFORMATION CONTACT: Lyssa E. Hall or Wendy M. McColough,

Office of Exemption Determinations, Pension and Welfare Benefits

Administration, U.S. Department of Labor, Room N-5649, 200 Constitution

Avenue, N.W., Washington, DC 20210, (202) 219-8194, or Timothy Hauser,

Plan Benefits Security Division, Office of the Solicitor, (202) 219-

8637. These are not toll-free numbers.

SUPPLEMENTARY INFORMATION: On December 22, 1997, the Department

published a notice of proposed rulemaking in the Federal Register (62

FR 66908) which clarified the application of ERISA to insurance company

general accounts. The Department invited interested persons to submit

written comments or requests that a public hearing be held on the

proposed regulation. The Department received more than 37 written

comments in response to the proposed regulation. A public hearing, at

which 13 speakers testified, was held on June 1, 1998 in Washington,

D.C.

The following discussion summarizes the proposed regulation and the

major issues raised by the commentators.1 It also explains

the Department's reasons for the modifications reflected in the final

regulation that is published with this notice.

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\1\ References to ``comments'' and ``commentators'' include both

written comment letters as well as prepared statements and oral

testimony at the public hearing.

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Discussion of the Regulation and Comments

Pursuant to section 1460 of the Small Business Job Protection Act

of 1996 (SBJPA), Public Law 104-188, the proposed regulation amended 29

CFR Part 2550 by adding a new section, 2550.401c-1. This new section

was divided into ten major parts. Paragraph (a) of the proposed

regulation described the scope of the regulation and the general rule.

Proposed paragraphs (b) through (f) contained conditions which must be

met in order for the general rule to apply. Specifically, paragraph (b)

addressed the requirement that an independent fiduciary expressly

authorize the acquisition or purchase of a Transition Policy. Paragraph

(c) described the disclosures that an insurer must make both prior to

the issuance of a Transition Policy to a plan and on an annual basis.

Paragraph (d) provided for additional disclosures regarding separate

account contracts. Paragraph (e) contained the procedures that must

apply to the termination or discontinuance of a Transition Policy by a

policyholder. Paragraph (f) contained notice provisions regarding

contract terminations and withdrawals in connection with insurer-

initiated amendments. Proposed paragraph (g) set forth a prudence

standard for the management of general account assets by insurers. The

definitions of certain terms used in the proposed regulation were

contained in paragraph (h). Proposed paragraph (i) described the effect

of compliance with the regulation and proposed paragraph (j) contained

the effective dates of the regulation. For a more complete statement of

the background and description of the proposed regulation, refer to the

notice published on December 22, 1997 at 62 FR 66908.

1. Scope and General Rule

Proposed Sec. 2550.401c-1(a) and (b) essentially followed the

language of section 401(c) of ERISA. Paragraph (a) described, in cases

where an insurer issues one or more policies to or for the benefit of

an employee benefit plan (and such policies are supported by assets of

an insurance company's general account), which assets held by the

insurer (other than plan assets held in its separate accounts)

constitute plan assets for purposes of Subtitle A, and Parts 1 and 4 of

Subtitle B, of Title I of the Act and section 4975 of the Internal

Revenue Code, and provided guidance with respect to the application of

Title I and section 4975 of the Code to the general account assets of

insurers.

Paragraph (a)(2) stated the general rule that when a plan acquires

a policy issued by an insurer on or before December 31, 1998

(Transition Policy), which is supported by assets of the insurer's

general account, the plan's assets include the policy, but do not

include any of the underlying assets of the insurer's general account

if the insurer satisfies the requirements of paragraphs (b) through (f)

of the regulation.

One commentator stated that paragraph (a)(2) lacked clarity and did

not properly cross-reference the definition of the term ``Transition

Policy.'' In response to this comment, the Department has clarified

paragraph (a)(2) to provide that ''* * * when a plan acquires a

Transition Policy (as defined in paragraph (h)(6)), the plan's assets

include the policy, but do not include any of the underlying assets of

the insurer's general account if the insurer satisfies the requirements

of paragraphs (c) through (f) of this section.''

Several commentators requested that the final regulation contain a

total exclusion from the definition of ``plan assets'' for all assets

held in or transferred from the estate of an insurance company in

delinquency proceedings in which an impaired or insolvent insurer is

placed under court supervision pursuant to State insurance laws

governing rehabilitation or liquidation. One commentator explained that

delinquency proceedings are initiated when the insurance regulator in

the State where the insurer is domiciled files a petition in State

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court requesting a takeover of the insurer's operations from existing

management. Such a petition is predicated on the regulator's conclusion

that continued operation of the insurer by management would be

hazardous to policyholders, creditors or the public. The precipitating

event is usually the insolvent condition of the insurer. Upon the

granting of the petition, a new legal entity called the estate is

created. The court gives control over the estate to a receiver who is

charged under State law with the fiduciary duty to fairly represent the

interests of all policyholders, creditors and shareholders of the

insolvent insurer. To stabilize the situation, the court is almost

always compelled to order a moratorium or other restrictions on cash

withdrawals, subject to individual hardship exceptions. All activity in

the proceedings is carried out under the close supervision of the

court.

In consideration of the concerns expressed by commentators, the

Department has adopted a new paragraph (a)(3) which specifically

provides that a plan's assets will not include any of the underlying

assets of the insurer's general account if the insurer fails to satisfy

the requirements of paragraphs (c) through (f) of the regulation solely

because of the takeover of the insurer's operations as a result of the

granting of a petition filed in delinquency proceedings by the

insurance regulatory authority in the State court where the insurer is

domiciled.

2. Authorization by an Independent Fiduciary

Proposed paragraph (b)(1) stated the general requirement that an

independent fiduciary ``who has the authority to manage and control the

assets of the plan must expressly authorize the acquisition or purchase

of the Transition Policy.'' A fiduciary is not independent if the

fiduciary is an affiliate of the insurer issuing the policy. Paragraph

(b)(2) of the proposed regulation contained an exception to the

requirement of independent plan fiduciary authorization if the insurer

is the employer maintaining the plan, or a party in interest which is

wholly-owned by the employer maintaining the plan, and the requirements

of section 408(b)(5) of ERISA are met.2

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\2\ This exception for in-house plans of the insurer under

section 401(c)(3) of ERISA is similar to the statutory exemption

contained in section 408(b)(5) of ERISA which provides relief from

the prohibitions of section 406 for purchases of life insurance,

health insurance or annuities from an insurer if the plan pays no

more than adequate consideration and if the insurer is the employer

maintaining the plan.

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The Department notes that, because section 401(c)(1)(D) of the Act

and the definition of Transition Policy preclude the issuance of any

additional Transition Policies after the publication of the final

regulation, the requirement for independent fiduciary authorization of

the acquisition or purchase of the Transition Policy no longer has any

application. Accordingly, the Department generally has determined not

to respond to the comments which raised issues regarding this

requirement. However, the Department has determined to respond to the

comments concerning the definition of ``affiliate'' contained in

paragraph (h)(1) of the proposed regulation because of its potential

relevance to other conditions under the final regulation.

One commentator suggested that the definition of ``affiliate''

contained in paragraph (h)(1) of the proposed regulation should be

expanded to include: (1) 10% or more shareholders or equity holders of

insurers and of persons controlling, controlled by, or under common

control with insurers; (2) businesses in which a person described in

proposed subparagraph (h)(1)(ii) is a 10% or more shareholder or equity

holder; and (3) relatives of persons who are officers, directors,

partners or employees of the insurer. Other commentators requested that

the definition of affiliate be narrowed. A commentator noted that the

proposed definition of affiliate would include all insurance agents and

brokers of the insurer, even non-exclusive agents, as well as all

employees of the insurer and of all entities in which an employee of

the insurer is an officer, director, partner or employee. The

commentator noted that the proposed definition would force the insurer

to assume a difficult monitoring function with respect to its

employees, agents and brokers. As a result, this commentator argued

that the definition of affiliate in the proposed regulation need not be

broader than the affiliate definition contained in Prohibited

Transaction Class Exemption 84-14 (the QPAM Exemption).3

Additionally, according to this commentator, it was unclear under the

definition of affiliate whether a ``partner of'' an insurer is intended

to mean a partner in the insurer or a partner with the insurer.

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\3\ Class Exemption for Plan Asset Transaction Determined by

Independent Qualified Professional Asset Managers (QPAMs), 49 FR

9494 (March 13, 1984) as corrected at 50 FR. 41430 (Oct. 10, 1985).

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After consideration of the comments, the Department has determined

that it would be appropriate to narrow the category of persons included

under the affiliate definition and to clarify certain of the terms used

in the definition. Accordingly, the Department has modified

subparagraph (h)(1)(ii) to provide that an affiliate of an insurer

includes any officer of, director of, 5 percent or more partner in, or

highly compensated employee (earning 5 percent or more of the yearly

wages of the insurer) of, such insurer or any person described in

subparagraph (h)(1)(i) including in the case of an insurer, an

insurance agent or broker (whether or not such person is a common law

employee) if such agent or broker is an employee described above or if

the gross income received by such agent or broker from such insurer or

any person described in subparagraph (h)(1)(i) exceeds 5 percent of

such agent's gross income from all sources for the year. In addition,

under subparagraph (h)(1)(iii), the Department has determined to delete

those corporations, partnerships, or unincorporated enterprises of

which a person described in subparagraph (h)(1)(ii) is an employee or

less than 5 percent partner.

3. Duty of Disclosure

Section 401(c)(3)(B) of the Act provides that the regulations

prescribed by the Secretary ``shall require in connection with any

policy issued by an insurer to or for the benefit of an employee

benefit plan to the extent the policy is not a guaranteed benefit

policy * * * (B) that the insurer describe (in such form and manner as

shall be prescribed in such regulations), in annual reports and in

policies issued to the policyholder after the date on which such

regulations are issued in final form * * *, (i) a description of the

method by which any income and expenses of the insurer's general

account are allocated to the policy during the term of the policy and

upon termination of the policy, and (ii) for each report, the actual

return to the plan under the policy and such other financial

information as the Secretary may deem appropriate for the period

covered by each such annual report.''

Proposed paragraph (c)(1) of the regulation similarly imposed a

duty on the insurer to disclose specific information to plan

fiduciaries prior to the issuance of a Transition Policy and at least

annually for as long as the policy is outstanding. Paragraph (c)(2)

required that the disclosures be clear and concise and written in a

manner calculated to be understood by a plan fiduciary.

Although the Department did not mandate a specific format for the

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disclosures, the information should be presented in a manner which

facilitates the fiduciary's understanding of the operation of the

policy. The Department expected that, following disclosure of the

required information and any other information requested by the

fiduciary pursuant to proposed paragraph (c)(4)(xii), the plan

fiduciary, with independent professional assistance, if necessary,

would be able to ascertain how various values or amounts relevant to

the plan's policy such as the actual return to be credited to any

accumulation fund under the policy, would be determined.

Many of the commentators expressed a number of general objections

to the disclosure provisions. These commentators stated that the level

of disclosure required by the proposed regulation exceeded

Congressional intent and the requirements of section 401(c) of ERISA.

They also asserted that the disclosure provisions were too broad and

vague to provide an insurer who is attempting to comply with the

regulation any level of comfort. Moreover, the commentators maintained

that other financial service providers are not required to provide the

same level of disclosure to their investors. The commentators further

asserted that compliance by insurers with the regulation would result

in increased costs for plans without adding anything of value. In this

regard, many of the commentators expressed the belief that the

disclosure provisions, as proposed, impose unnecessary financial and

administrative burdens on plans and insurance companies. The

commentators suggested that the information required to be disclosed

goes well beyond that which is necessary for a plan fiduciary to

determine whether or not to invest in or retain a Transition Policy.

One commentator stated that disclosure should be limited to matters

immediately connected to the contract and the contract's ``bottom

line''. Finally, several commentators asserted that the proposed

disclosure provisions require an insurer to disclose proprietary

information but did not specifically identify which items would require

the disclosure of such information as the Department requested in the

preamble to the proposed regulation.

Other commentators expressed the opposite view and generally

supported the proposed disclosure provisions, stating that the

provisions would allow plan fiduciaries to get the basic information

necessary to analyze a general account contract for investment

purposes. More specifically, one commentator offered the following

concerns with respect to the level of disclosure currently provided in

connection with insurance company general account contracts:

The insurance companies issuing the general account contracts

have not provided sufficient information for fiduciaries to monitor

contractual compliance. The insurance companies have not provided

sufficient information to allow fiduciaries to validate that all

contractholders are receiving equitable treatment within the general

account. The insurance companies have not provided sufficient

information for fiduciaries to calculate the rate of return on

general account contracts comparable to the rate of return

information they obtain for other plan investments.

Similarly, several commentators indicated that currently, plan

fiduciaries often have a difficult time obtaining any meaningful

information to assist them in making informed decisions concerning

whether to purchase or retain a Transition Policy. In this regard,

commentators also noted that the disclosures set forth in the proposed

regulation are even more important for small plans, which do not

normally have the economic leverage to negotiate any voluntary

disclosure of information by the insurer. Another commentator expressed

his belief that the proposed disclosure provisions are consistent with

the intent of the Congressional Conferees.

Two commentators supported the disclosures mandated by the proposed

regulation but asserted that those provisions did not go far enough.

These commentators suggested that a clear and comprehensive standard

form for disclosures should be issued to assist plan fiduciaries as

well as small insurance companies seeking to comply with the

regulation. One commentator suggested that the Department create sample

written disclosures or issue a guide to writing disclosures in plain

English. The commentator also stated that the regulation does not

provide any penalties for an insurer's failure to comply with a

policyholder's request for information. In this regard, the Department

notes that paragraph (i) of the final regulation contains an

explanation of the consequences of an insurer's failure to comply with

the provisions of the regulation.

The Department has considered the comments regarding the scope and

level of detail required by the proposed disclosure provisions in light

of the Congressional mandate set forth in section 401(c)(3) of ERISA.

The Department continues to believe that it was given broad discretion

to require that insurers provide meaningful disclosure of information

regarding Transition Policies in order to enable plan fiduciaries to

evaluate the suitability of such policies. The Department notes that,

with respect to the annual report, section 401(c)(3)(B) of ERISA

expressly directs the Department to require the disclosure of ``* * *

such other financial information as the Secretary may deem appropriate

for the period covered by such annual report.'' The Department believes

that a plan fiduciary, at a minimum, must be provided with sufficient

information about the methods used by the insurer to allocate amounts

to a Transition Policy, and the actual amounts debited against, or

credited to, the Transition Policy on an ongoing and on a termination

basis in order to evaluate whether to invest in or to retain the

Policy. In this regard, the Department notes that an insurance company

general account, which necessarily operates under a complex allocation

structure for fees, expenses and income, is unlike other investment

vehicles. Thus, the Department believes that the information that an

investor must be furnished in order to compare an investment in a

general account contract to other available investment options must

necessarily be more comprehensive. However, the Department recognizes

that providing a plan fiduciary with the financial information needed

to evaluate the suitability of a particular policy may place additional

administrative costs and burdens on both insurers and plans. After

careful consideration of all of the comments, the Department has

concluded that modifications to the disclosure provisions are necessary

in order to balance the costs of additional disclosures against the

fiduciary's need for sufficient information to make informed investment

decisions. Accordingly, the Department has determined, as discussed

further below, to modify paragraph (c) of the disclosure provisions in

the final regulation to more precisely define the scope of the

information which must be furnished to the policyholder. In recognition

of the variety of insurance arrangements available to plans, the

Department has not been persuaded that it is necessary or feasible for

plan fiduciaries to receive the information required to be disclosed to

them pursuant to the regulation in a standard format. Therefore, the

Department has not adopted the commentator's suggestion regarding

developing a standard format or a guide for writing such disclosures.

In addition, the Department has made minor modifications to the final

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regulation to reflect the fact that the initial disclosures cannot be

provided by an insurer prior to issuing a Transition Policy because no

new Transition Policies can be issued after December 31, 1998.

Proposed paragraph (c)(3) set forth the content requirement for the

information which must be provided to the plan either as part of the

Transition Policy, or as a separate written document which accompanies

the Transition Policy. For Transition Policies issued before the date

which is 90 days after the date of publication of the final regulation,

the proposed regulation required the insurer to provide the information

identified in paragraph (c)(3)(i) through (iv) no later than 90 days

after publication of the final regulation. For Transition Policies

issued 90 days after the date of publication of the final regulation,

the proposed regulation required the insurer to provide the information

to a plan before the plan makes a binding commitment to acquire the

policy.

Under paragraph (c)(3), an insurer must provide a description of

the method by which any income and expenses of the insurer's general

account are allocated to the policy during the term of the policy and

upon its termination. The initial disclosure under this paragraph must

include, among other things, a statement of the method used to

determine ongoing fees and expenses that may be assessed against the

policy or deducted from any accumulation fund under the policy. The

term ``accumulation fund'' is defined in paragraph (h)(5) as the

aggregate net considerations (i.e., gross considerations less all

deductions from such considerations) credited to the Transition Policy

plus all additional amounts, including interest and dividends, credited

to the contract, less partial withdrawals and benefit payments and less

charges and fees imposed against this accumulated amount under the

Transition Policy other than surrender charges and market value

adjustments.

Under the proposed regulation, the insurer must also include, in

its description of the method used to allocate income and expenses to

the Transition Policy: an explanation of the method used to determine

the return to be credited to any accumulation fund under the policy; a

description of the policyholder's rights to transfer or withdraw all or

a portion of any fund under the policy, or to apply such amounts to the

purchase of benefits; and a statement of the precise method used to

calculate the charges, fees or market value adjustments that may be

imposed in connection with the policyholder's right to withdraw or

transfer amounts under any accumulation fund. Upon request, the insurer

must provide the information necessary to independently calculate the

exact dollar amounts of the charges, fees or market value adjustments.

A number of commentators objected to the provisions contained in

subparagraphs (c)(2), (c)(3)(i)(D) and (c)(4) of the proposed

regulation which, in their view, would require insurers to disclose or

make available upon request by a plan fiduciary, information relating

to the pricing of their products, internal cost calculations and/or

methodologies sufficient to enable the fiduciary to independently

calculate the insurer's adjustments. The commentators stated their

belief that such information is proprietary. In this regard, the

commentators argued that disclosure of very detailed pricing

information would place insurance companies at a severe competitive

disadvantage vis-a-vis other financial institutions that market

products or services to employee benefit plans. Moreover, they stated

that, while disclosure of fees and returns is common and appropriate,

disclosure of the underpinnings of such fees and returns is neither

common nor necessary. The commentators further asserted that plan

fiduciaries do not need such information to make prudent investment

decisions.

Two commentators requested that the Department eliminate the last

two sentences of paragraph (c)(2) of the proposed regulation and all of

paragraph (c)(3)(i)(D) other than the following: ``A statement of the

method used to calculate any charges, fees, credits or market value

adjustments described in paragraph (i)(C) of this section.'' According

to the commentators, these modifications would eliminate the

requirement that an insurer provide all of the data necessary to enable

a plan fiduciary to replicate the insurer's internal adjustments.

One commentator suggested that, because the method used to

determine a market value adjustment involves several layers of internal

general account calculations, the Department should provide more

clarity with respect to how far back an insurer should ``unpeel'' the

market value adjustment calculation to satisfy the disclosure

requirements in subparagraph (c)(3)(i)(D). The commentator further

urged the Department to eliminate the requirements in paragraphs (c)(2)

and (c)(3)(i)(D) that the insurer disclose any data necessary to permit

the fiduciary, with or without professional assistance, to

independently calculate the exact dollar amount of the charges, fees or

adjustments. The commentator offered the following language in lieu of

the deleted text in subparagraph (c)(3)(i)(D):

Upon request of the plan fiduciary, the insurer must provide as

of a stated date: (1) The formula actually used to calculate the

market value adjustment, if any, to be applied to the unallocated

amount in the accumulation fund upon distribution to the

policyholder; and (2) the actual calculation of the applicable

market value adjustment, including a reasonably detailed description

of the specific variables used in the calculation.

One commentator suggested that the final regulation establish a 30

day time limit for responding to a fiduciary's request for information

from an insurer pursuant to subsection (c)(3)(i)(D). Other commentators

expressed general support for the disclosure provisions but maintained

that the Department should require that additional items of information

be disclosed to policyholders. Specifically, one commentator requested

that the initial disclosure provisions be expanded to require that

insurers disclose the following additional information upon the request

of a policyholder: Copies of reports relating to the financial

condition of the insurer pursuant to subparagraphs (c)(3)(i)(A) and

(B); amounts which have been offset, subtracted or deducted from the

gross earnings of the general account before income is credited to a

Transition Policy pursuant to subparagraph (c)(3)(i)(B); gross and net

return and income prior to returns being credited to the Transition

Policy; and, pursuant to subparagraph (3)(c)(i)(C), any alternative

withdrawal options which might scale-back charges, fees or adjustments

in exchange for a longer withdrawal term. Finally, the commentator

suggested that a condition should be imposed which would require

insurers to disclose the treatment of capital gains and losses, any

establishment of reserves or contingency funds, or smoothing or

stabilization funds, as well as areas in which management of the

insurer has discretion in creating or modifying the above.

Another commentator stated that, in order to maintain transparency

of all material features and aspects of general account contracts, the

following requirements should be added to the regulation: disclosure of

the assets supporting specific general account contracts; disclosure of

data that permits comparison of a plan's contract to other contracts

within the same class; and comparison of the class of contracts to all

classes of contracts participating in the general account. The specific

data

[[Page 618]]

would include: gross and net returns, and the methodology and data to

verify such returns; investment income generated by the general

account; allocation of contract assets within the general account; and

allocation procedures, risk and reserve charges, and other expenses

attributable to all classes of contracts, as well as quarterly

disclosure of gross and net rates of return.

As previously noted, the Department believes that it is important

for plan fiduciaries to be provided with the information necessary to

adequately assess the financial strength of an insurer, the suitability

of a particular policy for the plan, as well as the appropriateness of

continuing a plan's investment in a such policy. Nonetheless, the

Department agrees with the commentators' views that a plan fiduciary

need not replicate all of an insurer's internal cost calculations in

order to make these assessments. However, the Department continues to

believe that information necessary to calculate the exact dollar amount

of the charges, fees or adjustments upon contract terminations must be

disclosed to plan fiduciaries. In order for the termination provisions

in the regulation to be meaningful, plan fiduciaries must have access

to the information necessary to calculate and monitor the charges which

would be assessed against a Transition Policy in the event of

termination. Therefore, the Department has determined not to make all

of the deletions to subparagraphs (c)(2) and (c)(3) requested by the

commentators. However, the Department has determined that it would be

appropriate to modify paragraph (c) to narrow the scope of the

disclosures which must be provided in order to enable a plan fiduciary

to determine the charges or adjustments applicable to the plan's

policy. Pursuant to these modifications, the last two sentences of

subparagraph (c)(2) have been deleted and subparagraphs (c)(3)(i)(A)-

(C) have been modified to delete the requirement regarding disclosure

of the data necessary for application of the methods or methodologies

for determining the various values or amounts relevant to the plan's

policy. The Department has retained the requirement in subparagraph

(c)(3)(i)(D) that the insurer provide, upon request of a policyholder,

data relating to any charges, fees, credits or market value adjustments

relevant to the policyholder's ability to withdraw or transfer all or a

portion of any fund under the policy. However, this requirement has

been restated to clarify the level of ``unpeeling'' which must be

provided by the insurer and to require that such information must be

provided to the policyholder within 30 days of the request for

disclosure. Accordingly, upon the request of a plan fiduciary, the

insurer must provide the formula actually used to calculate the market

value adjustment, if any, applicable to the unallocated amount in the

accumulation fund upon distribution of a lump sum payment to the

policyholder, the actual calculation as of a specified date of the

applicable market value adjustment, including a description of the

specific variables used in the calculation, the value of each of the

variables, and a general description of how the value of each of the

variables was determined.

In response to the commentators who suggested that the Department

expand the disclosure requirements in the regulation, the Department

agrees with their assertions that there are a number of additional

items of financial information regarding an insurance company general

account, which may be relevant to a plan's fiduciary's consideration of

the appropriateness or the prudence of a Transition Policy. In this

regard, the Department notes that the disclosure requirements in the

regulation reflect what the Department believes is the minimum level of

information that an insurer must provide to a fiduciary of a plan which

has invested in a Transition Policy. If the fiduciary believes that

there are additional items of information which must be reviewed to

evaluate a Transition Policy, the Department encourages the fiduciary

to request, or to negotiate for, where appropriate, such information

from the insurer.

Proposed paragraph (c)(4) described the information which must be

provided at least annually to each plan to which a Transition Policy

has been issued. The proposal required the insurer to provide the

following information at least annually to each plan regarding the

applicable reporting period: the balance in the accumulation fund on

the first and last day of the period; any deposits made to the

accumulation fund; all income attributed to the policy or added to the

accumulation fund; the actual rate of return credited to the

accumulation fund; any other additions to the accumulation fund; a

statement of all fees, charges or expenses assessed against the policy

or deducted from the accumulation fund; and the dates on which the

additions or subtractions were credited to, or deleted from, the

accumulation fund.

In addition, the proposed regulation required insurers to annually

disclose all transactions with affiliates which exceed 1 percent of

group annuity reserves of the general account for the reporting year.

The annual disclosure also had to include a description of any

guarantees under the policy and the amount that would be payable in a

lump sum pursuant to the request of a policyholder for payment of

amounts in the accumulation fund under the policy after deduction of

any charges and any deductions or additions resulting from market value

adjustments.

As part of the annual disclosure, the proposed regulation requires

that an insurer inform policyholders that it will make available upon

request certain publicly-available financial information relating to

the financial condition of the insurer. Such information would include

rating agency reports on the insurer's financial strength, the risk

adjusted capital ratio, an actuarial opinion certifying to the adequacy

of the insurer's reserves, and the insurer's most recent SEC Form 10K

and Form 10Q (if a stock company).

Several commentators objected to the annual disclosure provisions

in subparagraph (c)(4)(xii) of the proposed regulation which required

an insurer to make available on request of a plan, copies of certain

publically available financial data or reports relating to the

financial condition of the insurer, including the insurer's risk

adjusted capital ratio, and the actuarial opinion with supporting

documents certifying the adequacy of the insurer's reserves. The

commentators asserted that the risk-based capital report and actuarial

opinions should not be disclosed because the information contained

therein could be misleading to plan fiduciaries. With respect to the

risk-based capital reports, the commentators explained that these

documents are designed as a regulatory tool and are not intended as a

means to rank insurers. They noted that the NAIC Risk-Based Capital for

Insurers Model Act specifically prohibits publication of such reports

and recognizes that such information is confidential.4 The

commentators further noted that the supporting memoranda to the

actuarial opinions are not publically available and that the memoranda

contain proprietary information such as interest margins and expense

and pricing assumptions. With respect to the

[[Page 619]]

actuarial opinion, one commentator stated that pension plan

administrators do not have the expertise and may not be sufficiently

knowledgeable about insurance to understand the limitations of this

opinion. This commentator also expressed concern regarding the

Department's characterization of the actuarial opinion as a

certification of the insurer's reserves, noting that ``no one can offer

absolute assurance of the continued solvency of an insurance company.''

Lastly, the commentator was concerned that the provision of the

actuarial opinion could subject the appointed actuary to unanticipated

liability and costs as a plan fiduciary.5 Another

commentator suggested that to the extent that information regarding the

financial condition of the insurer is publicly available, the insurer

should be required to inform policyholders where such information may

be found on the Internet.

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\4\ The Department notes that subparagraph (c)(4)(xii)(C) of the

proposed regulation required annual disclosure of the risk based

capital ratio and a brief description of its derivation and

significance, rather than disclosure of the risk based capital

report as suggested by the commentators. It is the Department's

further understanding that the risk based capital ratio is currently

publicly available to policyholders. .

\5\ In this regard, the Department notes that ERISA establishes

a functional approach to determine whether an activity is fiduciary

in nature. Under section 3(21) of ERISA, a fiduciary includes anyone

who exercises discretion in the administration of an employee

benefit plan; has authority or control over the plan's assets; or

renders investment advice for a fee with respect to any plan assets.

The Department has indicated that it examines the types of functions

performed, or transactions undertaken, on behalf of the plan to

determine whether such activities are fiduciary in nature and

therefore subject to ERISA's fiduciary responsibility provisions.

See 29 CFR 2509.75-8, D-2. To the extent that an actuary performs

none of the functions discussed under section 3(21) or the

applicable regulations, the actuary's activities would not be

subject to ERISA's fiduciary responsibility provisions.

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The Department notes that there is nothing in the regulation that

would preclude an insurer from providing a statement, accompanying the

reports or data made available to a plan upon request, which contains a

clear and concise explanation of the disclosures, including an

objective recitation as to why such information may be misleading to

policyholders. Accordingly, the Department has determined not to delete

these disclosure requirements. However, in response to the concerns

raised by the commentators, the Department has revised subparagraph

(c)(4)(xii)(D) under the final regulation to delete the requirement

that the supporting documentation be provided in connection with

disclosure of the actuarial opinion.

One commentator noted that the information regarding expense,

income and benefit guarantees under the policy, which is required to be

disclosed annually pursuant to subparagraph (c)(4)(x) of the proposed

regulation, is contained in the contract. The commentator opined that,

since contractholders already have this information, requiring insurers

to reproduce it on an annual basis is unnecessary. As a result, the

commentator urged the Department to delete this disclosure from the

final regulation. The Department finds merit in this comment and has

modified subparagraph (c)(4)(x) to require annual disclosure of the

expense, income and benefit guarantees under the policy only if such

information is not provided in the policyholder's contract, or is

different from the information on guarantees previously disclosed in

the contract.

Two commentators expressed concern regarding the requirement in

subparagraph (c)(4)(iv) that the actual rate of return credited to the

accumulation fund under the policy be disclosed on an annual basis in

connection with Transition Policies that are issued to individuals.

According to the commentators, it will be difficult to determine the

actual plan level rate of return in cases where interest is calculated

at the participant level. Consequently, the commentators sought

clarification that, in the case of individual policies issued by an

insurer to plan participants, the requirement of subparagraph

(c)(4)(iv) will be deemed satisfied by annual disclosure of the rate of

return under the policy to the individual policyholder. The Department

is of the view that subsection (c)(4)(iv) will be satisfied where an

insurer which issues individual policies to plan participants makes an

annual disclosure of the rate of return to the individual

policyholders.

With respect to the required annual disclosure of termination

values in subparagraph (c)(4)(xi) of the proposed regulation, two

commentators asserted that determining termination values is a manual

time-consuming customized procedure which cannot be automated without

significant difficulty and associated cost. One commentator noted that

its pension division policyholders receive an annual statement which

gives them, among other things, their account value, without charges

being applied, and a ``surrender'' value, which is their account value

less all applicable charges except the market value adjustment. The

commentator maintains that it is impossible, if not almost impossible,

to have a firm withdrawal amount reported to all pension division

policyholders on an annual basis. The commentator recommended that

subparagraph (c)(4)(xi) be modified to permit insurers to comply with

this requirement by approximating the amount that would be payable in a

lump sum at the end of such period.

On the basis of these comments, the Department has determined to

modify subparagraph (c)(4)(xi) of the final regulation to make clear

that the insurer generally may comply with its annual disclosure

obligations by disclosing to the plan the approximate amount that would

be payable to the plan in a lump sum at the end of such period. In this

regard, the Department expects that any approximation of the lump sum

payment would be determined in good faith as a result of a rational

decision-making process undertaken by the insurer. As modified,

subparagraph (c)(4)(xi) additionally provides, however, that the

policyholder may request that the insurer provide the more exact

calculation of termination values specified in subparagraph

(c)(3)(i)(D) as of a specified date that is no earlier than the last

contract anniversary preceding the date of the request.

One commentator stated that the disclosure of affiliate

transactions is not relevant or useful to plan policyholders in

evaluating the merits of a contract or the performance of an insurer.

Moreover, the commentator argued that affiliate transactions are

monitored and regulated by State insurance authorities which require,

among other things, that any such transaction be effected on arm's-

length terms. Accordingly, the commentator requested that the

Department delete subparagraph (c)(4)(ix) and replace that requirement

with a statement in subparagraph (c)(3) to the effect that an insurer

may engage in transactions with corporations or partnerships (including

joint ventures), controlling, controlled by, or under common control

with, the insurer along with a general description of the basis on

which such transaction will be effected. Another commentator stated

that the disclosure of related party transactions is necessary to

evaluate the potential impact of such transactions on the general

account contract and the potential impact the transaction may have in

affecting a contract's returns. The commentator would add the following

to subparagraph (c)(4)(ix):

Whether the 1% threshold for reporting related party

transactions has been met should be based on whether the aggregate

of related party transactions exceeds this threshold, since there

may be many cases when this threshold far exceeds any individual

transaction amounts. If the threshold is met, all related party

transactions should then be reported.

In addition, the commentator suggests that the focus of the

disclosure requirement in subparagraph (c)(4)(ix)

[[Page 620]]

should only be with respect to the reserves attributable to the assets

that have been compartmentalized (segmented) within the general account

to support the specific contract. In response to the comments, the

Department continues to believe that disclosure of large affiliate

transactions is relevant to a plan fiduciary's determination regarding

the appropriateness of continuing a plan's investment in a Transition

Policy. Accordingly, the Department has determined to retain this

requirement in the final regulation.

Several of the commentators believe that there is a need to further

enhance the information required to be disclosed annually. One

commentator suggested that the annual disclosure provisions be amended

to require the following: pursuant to subparagraph (c)(4)(iii)--the

disclosure of all gross investment results, including interest income

and realized capital charges generated by the assets in the group

annuity segment, and all of the offsets, deductions, charges, fees,

reductions due to smoothing techniques, etc. that are taken off before

a rate of return is credited to the policyholder or the accumulation

fund. In addition, the commentators stated that plan fiduciaries need

access to relevant general account portfolio statistics in order to

assess risk and evaluate investment income in relation to risk. The

commentators further stated that pension fiduciaries need to evaluate

factors such as the vulnerability of the portfolio to manipulation such

as churning. They concluded that the general information that should be

made available with respect to a general account portfolio should

include types of exposure for given asset classes, performance

characteristics such as delinquencies and write-downs; the proportion

of loans that are public, those that are direct placements and those in

default. In addition, the commentators also urged disclosure of other

types of information relative to risk assessment such as pending

material litigation, adverse regulatory rulings and material corporate

reorganizations.

The Department believes that the annual disclosure provisions

reflect a balance between the plans' need for information about general

account contracts against the costs associated with providing such

information. Accordingly, after consideration of the comments, the

Department has determined that it would not be appropriate to mandate

the disclosure of additional information. However, this determination

does not preclude a plan fiduciary from requesting, or negotiating for,

where appropriate, any additional information from an insurer which the

fiduciary believes is necessary to properly evaluate a Transition

Policy.

Two commentators stated that there should be quarterly reporting in

the following situations: significant write-downs, delinquencies,

adverse events with respect to reinsurance, and the possibility of

demutualization. Although the Department has determined not to require

more frequent reporting, the Department notes that an insurer's

unwillingness to provide more frequent disclosures with respect to

material events that may impact on the insurer is a factor that should

be considered by the fiduciary in its evaluation of the continued

appropriateness of the Transition Policy.

4. Alternative Separate Account Arrangements

Proposed paragraph (d)(1) contained an additional disclosure

requirement regarding the availability of separate account contracts.

Under this paragraph, the insurer must explain the extent to which

alternative contract arrangements supported by assets of separate

accounts of the insurer are available to plans; whether there is a

right under the policy to transfer funds to a separate account; and the

terms governing any such right. An insurer also must disclose the

extent to which general account contracts and separate account

contracts pose differing risks to the plan. Proposed paragraph (d)(2)

contained a standardized statement describing the relative risks of

separate accounts and general account contracts which, if provided to

policyholders, will be deemed to comply with paragraph (d)(1)(iii) of

the regulation.

A commentator questioned whether the Department intended to require

that the disclosure to policyholders concerning alternative separate

account arrangements be provided both with the initial and annual

disclosures, or only with the initial disclosure. The Department has

clarified paragraph (d)(1) to require that the insurer provide the plan

fiduciary with information about alternative separate account

arrangements at the same time as the initial disclosure under

subparagraph (c)(3).

Another commentator suggested that the Department insert the

following phrase within the parenthetical contained in the second

sentence in subparagraph c. of the separate account disclosure

statement ``and except any surplus in a separate account.'' The

commentator noted that, to the extent that insurance companies place

some of their funds in these separate accounts to provide for

contingencies, this separate account ``surplus'' should not be subject

to the fiduciary responsibility rules.6 Although the

Department agrees with the commentator that the separate account

surplus would not constitute plan assets with respect to other plan

investors in the separate account, the Department is unable to conclude

that such surplus would not constitute plan assets under all

circumstances. Section 401(b)(2)(B) provides, in part, that the term

``guaranteed benefit policy'' includes any surplus in a separate

account, but excludes any other portion of the separate account. In

light of the holding in the Harris Trust decision, the Department is

unable to conclude that the surplus in an insurance company separate

account would never constitute plan assets with respect to plan

policyholders who have purchased general account contracts. Therefore,

the Department has determined not to make the requested modification.

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\6\ The Department notes that language identical to the

commentator's appears in the Report of the ERISA Conference

Committee at pages 296 and 297. H.R. Conf. Rep. No. 1280, 93rd

Cong., 2d Sess. 296 (1974).

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One commentator suggested that the Department delete subparagraph

d. from the separate account disclosure statement based upon the view

that State regulation of insurance company accounts is irrelevant to

protections under the Act, and may lull plan fiduciaries into believing

that they have protections for their investment decisions when they do

not. In response to this comment, the Department clarified subparagraph

(d)(2)d. of the separate account disclosure statement to provide that

State insurance regulation of general accounts may not offer the same

level of protection to plan policyholders as ERISA regulation.

5. Termination Procedures

Paragraph (e)(1) of the proposed regulation provided that a

policyholder must be able to terminate or discontinue a policy upon 90

days notice to an insurer. Under the proposal, the policyholder must

have the option to select one of two payout alternatives, both of which

must be made available by the insurer.

Under the first alternative, an insurer must permit the

policyholder to receive, without penalty, a lump sum payment

representing all unallocated amounts in the accumulation fund after

deduction of unrecovered expenses and adjustment of the book value of

the policy to its market value equivalency. The Department noted that,

for purposes

[[Page 621]]

of paragraph (e), the term penalty did not include a market value

adjustment (as defined in proposed paragraph (h)(7)) or the recovery of

costs actually incurred, including unliquidated acquisition expenses,

to the extent not previously recovered by the insurer.

Under the second alternative contained in proposed paragraph

(e)(2), an insurer must permit the policyholder to receive a book value

payment of all unallocated amounts in the accumulation fund under the

policy in approximately equal annual installments, over a period of no

longer than five years, with interest.

General Comments

Several commentators objected to the lump sum and five year book

value payment requirements in the proposed regulation. The

commentators' objections were based on their assertions that most

insurers do not provide the termination rights set forth in the

proposed regulation in their existing contracts. Many of the

commentators stated that the Department should not impose retroactive

amendment of in-force contracts.7 The commentators assert

that the following problems would result from inclusion of the proposed

termination provisions in existing contracts: requiring insurers to

amend their contracts to include the new termination provisions would

subject insurers to increased risk of disintermediation and anti-

selection that was not evaluated either when the contract was priced or

when the types and durations of general account investments made to

support the policies were determined; insurers would have to reduce the

duration of the general account investment portfolios which support

Transition Policies in order to mitigate the increased risks of

disintermediation and anti-selection; the consequences of this change

in duration would be reduced earnings for the general account, lower

yields being realized by Transition Policies, and a limitation on the

insurer's ability to participate in the private placement market.

---------------------------------------------------------------------------

\7\ The Department recognizes that this regulation may give

rights to plan policyholders which their contracts did not

independently contain. The regulation, however, also benefits

insurers by enabling them to limit exposure to the full panoply of

fiduciary obligations and liabilities normally associated with the

management of plan assets. If an insurer complies with the

regulation, it avoids substantial potential liabilities to plan

policyholders. In exchange, however, the regulation requires the

insurer to give the plan the disclosures necessary to evaluate the

contract's performance and the right to withdraw the plan's funds

when that performance proves inadequate. The Department's insistence

on these disclosure and termination rights is consistent with the

requirement in section 401(c)(2)(B) that the regulation ``protect

the interests and rights of the plan and of its participants and

beneficiaries * * *'' The Department cannot, consistent with the

statute, give an insurer a safe-harbor from ERISA's fiduciary

responsibility provisions without also granting additional rights to

plan policyholders.

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Other commentators stated that the three standard termination

options (lump sum payout, five year book out and ten year book out) in

New York's Regulation 139 (11 NYCRR 40) afford ample protection to

plans and their participants, without locking plans into

disadvantageous relationships. One of the commentators noted that

Regulation No. 139 permits additional flexibility in negotiating

contract terms by permitting the ``Superintendent'' to waive or modify

applicable requirements through the approval process. The commentator

further stated that the lack of flexibility in the proposed regulation

would impair the insurance industry's ability to satisfy plan sponsors'

long-term investment goals and it would also force the costly

realignment (or transfer) of general account assets and pass the

realignment (or transfer) expenses and the losses on the sale of assets

to general account policyholders. One commentator asserted that: (1) No

State other than New York has set minimum termination standards

applicable to group annuity contracts; (2) the proposed regulation is

considerably more restrictive than New York's regulations, and (3) the

New York regulation applies only to contracts issued after the

regulation was adopted.

One commentator stated that if the proposed termination rules are

retained, the Department should revise the proposed regulation to allow

an insurer the discretion to use an installment payout option that

financially approximates the lump sum market value adjusted payout, in

whatever combination of interest rate reduction and payout period that

State insurance laws may permit. According to one commentator,

permitting policyholders to terminate at any time, and to choose from

the more favorable of a book value installment option or market value

option, would create opportunities for some policyholders to ``game''

the system by timing terminations to take advantage of differing

interest rate environments.

The Department stated in the preamble to the proposed regulation

that the proposed termination provisions were designed to protect the

interests and rights of plans by ensuring that they were not locked

into relationships which had become economically disadvantageous. The

Department noted in footnote 5 of the proposed regulation that the

termination provisions in the proposal were similar to the Department's

rule governing contracts between plans and service providers under 29

CFR section 2550.408b-2(c). Several commentators objected to this

reference and enumerated the differences between group annuity

contracts and service provider contracts. In this regard, the

Department wishes to note that the reference to the two types of

contracts was intended to indicate that the underlying rationale for

the rule and the proposed termination provisions was similar, not that

insurance contracts and service contracts are alike in all respects.

Thus, the footnote was intended to express the Department's belief that

plans should not be locked into economically disadvantageous

relationships under either type of contract.

A number of other commentators believe that the termination

procedures in the proposed regulation should not be diminished in any

respect in the final regulation. One commentator supported the

Department's premise that the termination procedures are necessary to

ensure that plans are not locked into economically disadvantageous

relationships. The commentator stated that the inability to withdraw

from a contract would be a result that would defeat the progress that

would have been made by requiring insurers to provide additional

disclosure. The commentator further stated that without such

protections, plans may be subject to such large and arbitrary penalties

at termination that the fiduciaries would be obligated to continue

disadvantageous and poorly-performing contracts to the detriment of

plan participants and beneficiaries. The commentator believed that the

termination provisions would not materially change how most insurers

invest contract assets because over time, market conditions and forces,

as well as competitive factors, rather than termination procedures,

would determine how assets are invested.

Another commentator stated that the terms set forth in the proposed

rule are all absolutely essential for the protection of plan and

participant interests. The commentator further stated that, if insurers

are left with the discretion to impose either an installment or lump

sum option, in the commentator's experience the insurer would act out

of self-interest, not the interest of plan participants, in selecting

the option.

One commentator stated that the regulation's disclosure provisions

will

[[Page 622]]

be rendered nugatory without specified termination procedures. The

commentator supported the regulation's attempts to balance the economic

interests of employee benefit plans with the day-to-day operations of

insurance company general accounts and stated that it is imperative to

ensure that the regulation specifies an appropriate time frame and

method for an insurer's payment to a plan upon the plan's termination

of a contract. The commentator believed that without these procedures,

insurers may hold plan assets longer than necessary, thus preventing

participants and beneficiaries from gaining higher rates of return on

their retirement monies.

Pursuant to the SBJPA, Congress required the Department to

promulgate regulations to implement the new amendment to section 401 of

ERISA that would ensure the protection of the interests and rights of

the plans and of its participants and beneficiaries. While the

Department intended that the disclosure provisions in paragraphs (c)

and (d) of this regulation would ensure that plan fiduciaries have

sufficient information upon which to make appropriate decisions

regarding a plan's investment in a Transition Policy, the Department

continues to believe that those provisions would be rendered

meaningless if plans were not offered the right to terminate their

Transition Policies under terms which are both objective and fair for

all parties. Therefore, the Department has determined to retain the

termination provisions in paragraph (e) of the regulation with certain

modifications, as discussed further below.

Lump Sum Payment

Several commentators objected to proposed paragraph (e)(1) and the

definition of the term ``market value adjustment'' as a method which

permits both upward and downward adjustments to the book value of the

accumulation fund. According to one commentator, a two-way market value

adjustment requirement may provide an artificial incentive for

contractholders to terminate their contracts. The commentators further

asserted that if a disproportionate number of contractholders elect to

terminate and withdraw their funds in a lump sum at any one time, the

resulting disintermediation may impair the insurer's solvency.

The commentator further argued that paying the contractholder the

book value of the accumulation fund upon contract termination, when

market value exceeds book value , is fair because the contractholder

receives all guaranteed amounts, without reduction.

One commentator asserted that a large number of group annuity

contracts provide only for negative adjustments and that the particular

market value adjustment terms contained in any group annuity contract

were put in place at the inception of the policy. The commentator was

concerned that the proposed regulation would retroactively graft

positive market value adjustment terms upon policies in a way that

would be inconsistent with reasonable insurer expectations. This

commentator also observed that no State law requires insurers to offer

positive market value adjustments.

Other commentators stated that many insurers do not provide for

positive market value adjustments because experience-rated group

annuity contracts are intended to be long-term funding instruments

supported by long-term investments. These commentators asserted that

encouraging withdrawals from these contracts for arbitrage purposes by

providing for positive market value adjustments disrupts the insurer's

ability to make and implement investment decisions on the basis of

accurate predictions of cash flow and interferes with asset-liability

matching to the detriment of non-withdrawing contractholders.

Based on the Department's understanding that the purpose of a

market value adjustment is to protect the policyholders who remain

invested in the insurer's general account, the Department defined the

term ``market value adjustment'' under the proposed regulation to

reflect the economic effect (positive and negative) on a Transition

Policy of an early termination or withdrawal in the current market.

Thus, depending upon the economic environment at the time of

termination, the terminating policyholder would either bear the costs

or receive the benefit of the adjustment. The Department is not

persuaded by the commentators' objections to the condition in

subsection (e)(1) of the proposed regulation which requires an upward

as well as a downward adjustment of the book value of the Transition

Policy. Since an insurer cannot predict the direction of the economic

markets or the timing of a notice to terminate, the Department is not

convinced that insurers price their contracts based on an assumption

that a predictable proportion of contracts will terminate when a

positive market value adjustment would otherwise apply. Although the

commentators argue that policyholders will terminate their Transition

Policies in order to take advantage of an economic market in which they

would receive a positive adjustment, the Department notes that those

same policyholders would have to take into account the fact that the

same market that produced the favorable adjustment would produce lower

returns on reinvestment of the Transition Policy's proceeds. As a

result, a positive market value adjustment would not create an

artificial incentive for policyholders to terminate Transition

Policies. The denial of appropriate positive market value adjustments

would, however, artificially penalize plans for the termination of

Transition Policies by requiring them to accept less than fair market

value for the funds associated with their policies. Such a result would

be inconsistent with the regulation's goal of ensuring that plan

policyholders are not locked into economically disadvantageous

relationships. Because the Department has not been persuaded that

application of an upward market value adjustment on termination of a

Transition Policy would produce inequitable results or cause

significantly larger numbers of policyholders to terminate those

Transition Policies, as claimed by the commentators, subsection (e)(1)

has not been modified as requested.

One commentator asserted that the lump sum alternative in

subparagraph (e)(1) creates serious problems for certain insurers that

avoid registration of their annuity products with the Securities

Exchange Commission under section 3(a)(8) of the Securities Act of

1933. Section (3)(a)(8) excludes an annuity contract or optional

annuity contract from the application of federal securities laws. Rule

151 under the Securities Act of 1933 provides a ``safe harbor'' for

certain forms of annuity contracts issued by insurance companies. An

annuity contract which meets all of the conditions in the Rule comes

within the ``safe harbor'' and is deemed to be an annuity contract

within the meaning of section (3)(a)(8).8 As a result, the

commentator requested that the Department eliminate the termination

provisions in the final regulation.

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\8\ The safe harbor in Rule 151 is not available for a contract

which permits a lump sum payment subject to a market value

adjustment. However, the Rule provides that the presence of a market

value adjustment should not create the negative inference that no

such contract is eligible for the exclusion under section 3(a)(8).

See Definition of Annuity Contract or Optional Annuity Contract,

Securities Act Release No. 33-6645 (May 29, 1986).

---------------------------------------------------------------------------

Another commentator stated that the proposed lump sum termination

feature is contrary to Ohio's standard nonforfeiture law which provides

that

[[Page 623]]

the insurer shall reserve the right to defer the payment of such cash

surrender benefit for a period of six months after demand. See O.R.C.

section 3915.073(C)(2). This provision applies to individual deferred

annuity contracts. The commentator believes that amendment of the

Transition Policies to include the lump sum termination provision will

invalidate the policy under this provision of Ohio law. Similarly, one

commentator determined that several States do not allow market value

adjustments in individual annuity contracts that are subject to State

nonforfeiture laws. Other States do not allow market value adjustments

in individual annuity contracts except with respect to ``modified

guaranteed annuities'' (MGAs). The commentator believes that none of

the Transition Policies that would be subject to the regulation are

MGAs and that, therefore, ERISA plan individual annuity contracts that

would be subject to the regulation are not permitted, under State law,

to impose a market value adjustment upon termination. The commentator

believes that this information and the above comment concerning

insurers that rely on section 3(a)(8) and Rule 151 of the Securities

Act of 1933, present a strong case for only allowing a book value

payout over time as one of the permitted termination options to be

determined at the insurer's discretion under the regulation and not as

a required option.

The Department continues to believe that the disclosure provisions

set forth in subparagraph (c) of this regulation will only be

meaningful if an independent plan fiduciary with respect to a

Transition Policy has the ability to act upon such information by

terminating the Transition Policy and receiving a payout within a

reasonably short time-frame. Moreover, the Department has not been

convinced that changing the lump sum payment option in the manner

requested by the commentators would be in the best interests of the

affected plans. Therefore, the Department has determined that it would

not be appropriate to eliminate or modify the lump sum payment option

as suggested by the commentators.

A commentator requested that the Department modify that portion of

proposed paragraph (e)(1) that deals with contingent sales charges so

that the phrase ``the term penalty does not include * * * the recovery

of costs actually incurred'' is changed to ``the term penalty does not

include * * * charges that are reasonably intended to recover costs.''

In addition, another commentator requested that the definition of

``without penalty'' be revised so that it is similar to the definition

already contained in the regulations under section 408(b)(2) of the Act

which allows the recovery of ``reasonably foreseeable expenses'' upon

early termination. The Department believes that the modifications

suggested by the commentators would diminish the clarity of the

proposed regulation. Subparagraph (e)(1) of the proposed regulation

provides an insurer with an objective standard regarding the allowable

costs which may be recovered in connection with termination of a

Transition Policy under which the policyholder has chosen the lump sum

payout option.

Therefore, the Department has declined to modify the final

regulation as requested by the commentators.

One commentator requested that the language explaining what would

not constitute a ``penalty'' for purposes of paragraph (e), be modified

to refer to subparagraph (e)(1) rather than paragraph (e), to clarify

that market value adjustments can be imposed only on lump sum payments.

The commentator suggested that the cross reference language state, ``*

* * For purposes of this subparagraph (e)(1) * * *.'' The Department

acknowledges that this was the intended meaning of the language of

proposed paragraph (e)(1) and has modified the final regulation

accordingly.

Book Value Installment Option

Several commentators asserted that, if contractholders are able to

withdraw funds over a period of five years at book value at any point

in time when the investment return on such funds was below current

market rates, they will be able to obtain amounts in excess of the

present value of their investment. According to the commentators, when

interest rates are rising, contractholders would inevitably select

against insurers and remaining contractholders by making book value

withdrawals and reinvesting withdrawn funds at current market rates.

The commentators believe that such massive withdrawals would require

insurers to liquidate their assets at substantial losses, thus,

seriously impairing some insurers' financial capability to meet their

contractual obligations.

A number of commentators noted that the terms and conditions of a

book value installment payout are intended to serve the same purposes

as market value adjustments, i.e. the equitable allocation of the

effect of a withdrawal between the withdrawing and remaining

contractholders, and the protection of the general account from severe

anti-selection risks. The commentators represented that the terms of

book value payouts are structured to produce an actuarially equivalent

value to that produced by a lump sum market value adjusted payout.

However, the commentators asserted that the proposed regulation's

payout period of no more than 5 years, coupled with no more than a 1%

interest rate reduction will deprive insurers of the opportunity to

achieve the objective of approximate actuarial equivalence and

undermine the insurer's ability to adequately protect itself and its

non-withdrawing policyholders from anti-selection and

disintermediation. The commentators explained, that for an installment-

payout provision to produce equity between withdrawing and non-

withdrawing contractholders, and to prevent anti-selection and

disintermediation, the length of the payout period must bear some

reasonable relationship to the maturities of the investment portfolio

supporting the insurer's liability to the contractholder under such

provision. The commentators concluded that a five-year payout with a

maximum interest rate reduction of 1% is insufficient to adequately

protect an insurer's general account based on the typically longer

maturities of investments in insurers' general accounts that fund

retirement benefits.

To resolve these concerns, several commentators requested that the

Department modify the proposed regulation to permit insurers to offer

policyholders at least one of several termination methods, at the

option of the insurer. Under this alternative, insurers would have the

discretion to either not offer a lump sum option, offer a lump sum

option without a positive market value adjustment, or offer a book

value payment over a period in excess of 5 years e.g., 10 years) with

interest at a credited rate reduced by more than 1 percent.

The Department believes that allowing the insurer to determine the

termination methods that will be offered to policyholders could have a

negative impact on terminating Transition Policies. Therefore, the

Department has decided not to adopt the commentators' requested

modifications in the final exemption. However, the Department finds

merit in the arguments submitted by the commentators with respect to

the length of the book value payout term and has been persuaded that

the term of the book value payout option should more closely reflect

the maturity of the investments in the general account. Accordingly, on

the basis of the comments, the Department has modified

[[Page 624]]

the book value alternative in subsection (e)(2) of the final regulation

to permit a policyholder to receive book value payment over a period of

no more than ten years with interest at the rate credited on the

contract minus 1 percent.

Several commentators requested that the Department provide an

exception from the termination procedures during extraordinary

circumstances to avoid the risk of severe disintermediation. The

Department concurs with this request and has modified paragraph (e) to

provide that the insurer may defer, for a period not to exceed 180

days, amounts required to be paid to a policyholder under paragraph (e)

for any period of time during which regular banking activities are

suspended by State or federal authorities, a national securities

exchange is closed for trading (except for normal holiday closings), or

the Securities and Exchange Commission has determined that a state of

emergency exists which may make such determination and payment

impractical.

6. Insurer-Initiated Amendments

Proposed paragraph (f) described the notice requirements and payout

provisions governing insurer-initiated amendments. Under the proposed

paragraph, if an insurer makes an insurer-initiated amendment, the

insurer must provide written notice to the plan at least 60 days prior

to the effective date of the amendment. The notice must contain a

complete description of the amendment and must inform the plan of its

right to terminate or discontinue the policy and withdraw all

unallocated funds in accordance with paragraph (e)(1) or (e)(2) by

sending a written request to the name and address contained in the

notice. Proposed paragraph (f), unlike the more general termination

provisions set forth in paragraph (e), was to be applicable upon

publication of the final regulation in the Federal Register.

An insurer-initiated amendment was defined in proposed paragraph

(h)(8) as an amendment to a Transition Policy made by an insurer

pursuant to a unilateral right to amend the policy terms that would

have a material adverse effect on the policyholder; or certain

unilateral enumerated changes that result in a reduction of existing or

future benefits under the policy, a reduction in the value of the

policy or an increase in the cost of financing the plan or plan

benefits, if such change has more than a de minimis effect.

One commentator expressed the view that the definition should be

modified to include any insurer-initiated amendment that is unfavorable

to the plan. Two commentators suggested that any insurer-initiated

amendment to a general account contract should eliminate the contract's

ability to qualify as a Transition Policy. In this regard, one of the

commentators urged the Department to adopt a standard under which there

would be a rebuttable presumption that any insurer-initiated amendment

has a material adverse effect on the policyholder. The Department has

determined not to revise this definition as requested in recognition of

the fact that many Transition Policies represent long term

relationships that may require minor changes over time.

Other commentators requested that the Department reconsider the de

minimis standard set forth in subparagraph (h)(8)(ii) of the

definition. These commentators stated that the definition was so broad

that it would be impossible for any insurer to know whether it is in

compliance with these requirements. The commentators suggested that the

Department modify the definition to include only unilateral changes

that are ``material'' since this is a term that has a well understood

meaning. After consideration of the comments, the Department has

concluded that it would be appropriate under the final regulation to

modify the definition of the term ``insurer-initiated amendment'' to

include only unilateral changes that have a material adverse effect on

the policyholder. To further clarify this matter, paragraph (h)(8) of

the final regulation includes a definition of the term ``material.''

Several commentators requested that the Department restate

subparagraph (h)(8)(ii)(G), from ``[a] change in the annuity purchase

rates'' to ``[a] change in the guaranteed annuity purchase rates.'' A

commentator stated that changes in the market purchase rates for

annuities are based on current interest rates and, accordingly, should

not be considered an insurer-initiated amendment. Conversely, the

commentator represented that modifying the guaranteed purchase rate

would be considered an insurer-initiated amendment since it is usually

prohibited by the contract or by State law. Another commentator

suggested that the Department modify subparagraph (h)(8)(ii)(G) to

include ``a change in the annuity purchase rates guaranteed under the

terms of the contract or policy, unless the new rates are more

favorable for the policyholder.'' On the basis of these comments, the

Department has determined to make modifications to subparagraph

(h)(8)(ii)(G).

Several commentators requested that the Department clarify that any

amendment or change that is required to be made to a Transition Policy

to comply with applicable federal or State law or regulation (including

this regulation), or to convert the policy to a ``guaranteed benefit

policy,'' is not an insurer-initiated amendment. A number of

commentators urged the Department to clarify that a demutualization

9 or similar reorganization will not result in an insurer-

initiated amendment. The commentators represented that policyholders

retain all of the benefits under the policies to which they would have

been entitled if the reorganization had not occurred. The policies

remain in force with no change in their terms, except that the

membership interest in the mutual company is removed from the policy

and evidenced separately (e.g., by shares of stock). In further support

of their position, the commentators argue that the Internal Revenue

Service has held that where the terms and conditions of the contracts

remain the same, a reorganization will not cause contracts issued by

the insurer on or before the date of the proposed reorganization to be

treated as new contracts for purposes of determining the date of

issuance of the contract.10

---------------------------------------------------------------------------

\9\ This involves a conversion from a mutual insurance company

to a publicly owned stock company.

\10\ See Rev. Proc. 92-57, 1992-2 C.B. 410.

---------------------------------------------------------------------------

The Department is unable to conclude that all changes made to a

Transition Policy in order to comply with any applicable federal or

State law, or to convert the policy to a guaranteed benefit policy, are

changes that would not have a material adverse effect on a

policyholder. However, the Department has determined to modify

subparagraph (h)(8)(iv) to clarify that amendments or changes which are

made: (1) With the affirmative consent of the policyholder; (2) in

order to comply with section 401(c) of the Act and this regulation; or

(3) pursuant to a merger, acquisition, demutualization, conversion, or

reorganization authorized by applicable State law, provided that the

premiums, policy guarantees, and the other terms and conditions of the

policy remain the same, except that a membership interest in a mutual

insurance company may be relinquished in exchange for separate

consideration (e.g. shares of stock or policy credits); are not

insurer-initiated amendments for purposes of the final regulation. The

Department also has made parallel changes to subparagraph (h)(6)(ii) of

the final regulation to clarify that such changes will not cause a

policy to fail to be a Transition Policy.

[[Page 625]]

One commentator suggested that subparagraph (h)(8)(iii) be revised

to omit the word ``affirmative'' which precedes the word ``consent'' in

the proposed regulation. According to the commentator, it should be

acceptable to the Department for the insurer to send notice of a

prospective change to the policyholder with an appropriate lead time

during which the policyholder has time to object to the change. The

policyholder's affirmative consent to an amendment or change was a

necessary element of the Department's determination to exclude such

amendments or changes from the definition of insurer-initiated

amendment. Because the Department continues to believe that the

policyholder's affirmative consent is a necessary protection against

insurer-initiated amendments which may be adverse to the policyholder,

it has determined not to adopt the commentator's suggested

modification.

7. Prudence

Proposed paragraph (g) set forth the prudence standard applicable

to insurance company general accounts. Unlike the prudence standard

provided in section 404(a)(1)(B) of ERISA, prudence for purposes of

section 401(c)(3)(D) of ERISA is determined by reference to all of the

obligations supported by the general account, not just the obligations

owed to plan policyholders.11

---------------------------------------------------------------------------

\11\ In this regard, the Department notes in the proposal that

nothing contained in the proposal's prudence standard modified the

application of the more stringent standard of prudence set forth in

section 404(a)(1)(B) of ERISA as applicable to fiduciaries,

including insurers, who manage plan assets maintained in separate

accounts, as well as to assets of the general account which support

policies issued after December 31, 1998.

---------------------------------------------------------------------------

Two commentators concurred with the standard of prudence

established in the regulation. One of the commentators was pleased

because paragraph (g) makes it clear that the prudence standard applies

regardless of whether general account assets are also considered to be

plan assets under ERISA. The commentator believed that the prudence

standard contained in paragraph (g) addresses the conflict between

State insurance laws which require that general account assets be

managed so as to maintain equity among all contractholders,

policyholders, creditors and shareholders and the ERISA fiduciary rules

which require that plan assets be managed solely in the interests of,

and for the exclusive purpose of, providing benefits to plan

participants and their beneficiaries. The other commentator suggested

that application of this standard could lead to more limited investment

opportunities for general account assets and lower returns than

currently achievable under State investment laws. In turn, this could

lead to increased plan contributions for defined benefit plans in order

to maintain current benefit levels. In this regard, the Department

notes that the prudence standard set forth in the proposal merely

implements subsection 401(c) of ERISA which contains the prudence

standard that is the subject of the commentator's concern.

8. Definitions

Accumulation Fund

Proposed paragraph (h)(5) defined the term ``accumulation fund'' as

the aggregate net considerations (i.e., gross considerations less all

deductions from such considerations) credited to the Transition Policy

plus all additional amounts, including interest and dividends, credited

to such Transition Policy less partial withdrawals, benefit payments

and less all charges and fees imposed against this accumulated amount

under the Transition Policy other than surrender charges and market

value adjustments.

A commentator requested modification of the term ``accumulation

fund'' to satisfy the commentator's concern that upon termination, a

policyholder would not be able to withdraw from the policy amounts set

aside to pay benefits under the policy. The commentator suggested that

the definition be revised to read as follows:

The term ``accumulation fund'' means the aggregate net

considerations (i.e., gross considerations less all deductions from

such considerations) credited to the Transition Policy plus all

additional amounts, including interest and dividends, credited to

such Transition Policy less partial withdrawals, benefit payments,

amounts accrued or received under the Transition Policy for the

purpose of providing benefits which are guaranteed by the insurer

and less all charges and fees imposed against this accumulated

amount under the Transition Policy other than surrender charges and

market value adjustments.

The Department believes that the term ``accumulation fund'' as

defined and used in context in the proposed regulation correctly

reflects the meaning intended by the Department. Therefore, after

consideration of the comment, the Department has determined not to

adopt the requested modification.

Market Value Adjustment

Proposed paragraph (h)(7) defined the term ``market value

adjustment'' as an adjustment to the book value of the accumulation

fund to accurately reflect the effect on the value of the accumulation

fund of its liquidation in the prevailing market for fixed income

obligations, taking into account the future cash flows that were

anticipated under the policy. An adjustment is a ``market value

adjustment'' within the meaning of this definition only if the insurer

has determined the amount of the adjustment pursuant to a method which

was previously disclosed to the policyholder in accordance with

paragraph (c)(3)(i)(D), and the method permits both upward and downward

adjustments to the book value of the accumulation fund.

One commentator stated that the market value adjustment definition

needs to be clarified and modified in order to encompass all reasonable

types of market value adjustment formulas currently in use by the

industry, but did not suggest any specific types of market value

adjustment formulas for the Department's consideration. A commentator

suggested that, for purposes of clarification, the first sentence of

the market value adjustment definition in paragraph (h)(7) should be

revised to read as follows:

For purposes of this regulation, the term ``market value

adjustment'' means an adjustment to the book value of the

accumulation fund to accurately reflect the effect on the value of

the accumulation fund of its liquidation in the prevailing market

for fixed income obligations, taking into account the future cash

flows that were anticipated under general account assets.

After consideration of the comments regarding market value

adjustment, the Department believes that the definition, as set forth

in the proposed regulation, is sufficiently flexible to address the

commentator's concerns and that no further modification is necessary.

9. Limitation on Liability

Proposed paragraph (i)(1) provided that no person shall be liable

under Parts 1 and 4 of Title I of the Act or section 4975 of the Code

for conduct which occurred prior to the effective dates of the

regulation on the basis of a claim that the assets of an insurer (other

than plan assets held in a separate account) constitute plan assets.

Paragraph (i)(1) further provided that the above limitation on

liability will not apply to: (1) An action brought by the Secretary of

Labor pursuant to paragraph (2) or (5) of section 502(a) of the Act for

a breach of fiduciary responsibility which would also constitute a

violation of Federal or State criminal law; (2) the application of any

Federal criminal law; or (3) any civil

[[Page 626]]

action commenced before November 7, 1995.

Proposed paragraph (i)(2) stated that the regulation does not

relieve any person from any State law regulating insurance which

imposes additional obligations or duties upon insurers to the extent

not inconsistent with this regulation. Thus, for example, nothing in

this regulation would preclude a state from requiring an insurer to

make additional disclosures to policyholders, including plans.

Proposed paragraph (i)(3) of the regulation made clear that nothing

in the regulation precludes a claim against an insurer or others for a

violation of ERISA which does not require a finding that the underlying

assets of a general account constitute plan assets, regardless of

whether the violation relates to a Transition Policy. For example, a

Transition Policy would give rise to fiduciary status on the part of

the insurer if the insurer had discretionary authority over the

administration or management of the plan. See section 3(21) of the Act.

Thus, nothing in ERISA or this regulation would preclude a finding that

an insurer is liable under ERISA for breaches of its fiduciary

responsibility in connection with plan management or administration.

Similarly, neither ERISA nor the regulation precludes a finding that an

insurer is a fiduciary by reason of its discretionary authority or

control over plan assets. If the insurer breaches its fiduciary

responsibility with respect to plan assets, it would be liable under

ERISA regardless of whether the insurer has issued a Transition Policy

to a plan or ultimately placed the plan's assets in its general

account.

Paragraph (i)(4) of the proposed regulation provided that if an

insurer fails to meet the requirements of paragraphs (b) through (f) of

the regulation with respect to a specific plan policyholder, the result

of such failure would be that the general account would be subject to

ERISA's fiduciary responsibility provisions with respect to the

specific plan for that period of time during which the requirement of

the regulation was not met. Once back in compliance with the

regulation, the insurer would no longer be subject to ERISA (other than

this regulation) or have potential liability under ERISA's fiduciary

responsibility provisions for subsequent periods of time when the

requirements of the regulation are met. In addition, the regulation

made clear that the underlying assets of the general account would not

constitute plan assets for other Transition Policies to the extent that

the insurer was in compliance with the requirements of the regulation.

Several commentators were concerned that under proposed paragraph

(i)(4), an insurer's single (or de minimis) inadvertent failure to

satisfy the conditions in the regulation might require a portion of

every asset in the insurer's general account to be a plan asset for the

period of noncompliance, thus subjecting the insurer to increased

liability for fiduciary violations. The commentators believed that this

``all or nothing'' rule could cause significant disruption to the

insurer and hinder the insurer's investment activities. The

commentators believed that this result was not compelled by section

401(c) of the Act.

The commentators suggested that the Department: (1) Clarify that

any finding that assets of an insurer are plan assets as a result of an

instance of noncompliance should be operative only with respect to the

dispute between the policyholder and the insurer; (2) modify the

proposed regulation to state that the transition relief provided will

be available if the insurer adopts reasonable procedures to implement

the requirements of the regulation and takes reasonable steps to

implement those procedures; (3) provide that an insurer's unintentional

failure to comply with the regulation, that is not a result of willful

neglect, will not cause any general account assets to become plan

assets if the insurer cures such failure within 60 (or 90) days after

discovering or being notified of the failure to comply and makes the

plan or plans whole for any monetary loss resulting from the non-

compliance. Alternatively, commentators suggested that the Department

permit the insurer to remedy any failure to comply with the regulation,

due to reasonable cause and not to willful neglect, within 30 days of

receipt of notice of such noncompliance and to extend this ``cure''

period if state insurance department approval is required.

Additionally, a commentator urged the Department to provide that

failure to comply with the regulation should only be effective with

respect to the adjudication of the action in which the finding is made.

The Department concurs with the commentators' assertions that the

consequences of an insurer's de minimis or inadvertent failure to

comply with the regulation may be too severe. Accordingly, the

Department has amended subparagraph (i)(4) of the regulation to provide

that a plan's assets will not include an undivided interest in the

underlying assets of the insurer's general account notwithstanding the

fact that the insurer has failed to comply with the requirements of

paragraphs (c) through (f) of the regulation with respect to a plan if

the insurer cures the non-compliance in accordance with the

requirements of subparagraph (i)(5), which describes the steps that an

insurer may take to avoid plan asset treatment with respect to the

underlying assets of the insurer's general account.

Pursuant to subparagraph (i)(5), an insurer must have in place

written procedures that are reasonably designed to assure compliance

with the regulation, including procedures reasonably designed to detect

and correct instances of non-compliance. In addition, within 60 days of

either detecting an instance of non-compliance or receipt of written

notice of non-compliance from a plan, whichever occurs earlier, the

insurer must comply with the regulation. Under this cure provision, the

insurer would be required to make the plan whole for any losses

resulting from the non-compliance. By following the procedure described

in subparagraph (i)(5), the insurer could continue to take advantage of

the safe harbor provided by the regulation, notwithstanding its initial

failure to comply with one or more of the regulation's requirements.

The Department believes that giving insurers a limited opportunity to

cure their non-compliance and to compensate affected policyholders for

any losses resulting from the non-compliance, will both address the

concerns expressed by the commentators and continue to protect the

interests of the policyholders from expense and unnecessary delays.

10. Effective Date

Proposed paragraph (j)(1) stated the general rule that the

regulation is effective 18 months after its publication in the Federal

Register. Paragraph (j)(2), (3) and (4) of the proposed regulation

provided earlier effective dates for paragraph (b) relating to

independent fiduciary approval, paragraphs (c) and (d) relating to

disclosures, and paragraph (f) relating to insurer-initiated

amendments.

Paragraph (j)(2) of the proposed regulation stated that if a

Transition Policy was issued before the date which is 90 days after the

date of publication of the final regulation, the disclosure provisions

in paragraphs (c) and (d) would take effect 90 days after the

publication of the final regulation. Paragraph (j)(3) of the proposed

regulation provided that paragraphs (c) and (d) were effective 90 days

after the date of publication of the regulation for a Transition Policy

issued after such date.

[[Page 627]]

Proposed paragraph (j)(4) provided that the effective date for

paragraphs (b) and (f) of the proposed regulation is the date of

publication of the final regulation in the Federal Register. In

addition, this paragraph provided a special rule for insurer-initiated

amendments which are made during the period between the dates of

publication of the proposed and final regulations. The rule provided

that, if a plan elected to receive a lump sum payment on termination or

discontinuance of the policy as a result of an insurer-initiated

amendment, the insurer must use the more favorable (to the plan) of the

market value adjustments determined on either the effective date of the

amendment or determined upon receipt of the written request from the

plan in calculating the lump sum representing the unallocated funds in

the accumulation fund.

A number of commentators believed that, in the case of Transition

Policies issued after a date that is 120 days after the date of

issuance of the final regulations, the initial disclosures may be

provided at the time of issuance of the policy. In their view, no other

exception to the general 18 month effective date contained in section

401(c)(1) of the Act is appropriate or would allow insurers sufficient

time to prepare the necessary disclosure with respect to thousands of

previously issued policies to ensure compliance. In addition, the

commentators requested that the date required for distribution of

annual disclosures (contained in paragraph (c)(4) of the proposed

regulation) be extended from 90 days to 180 days following the period

to which it relates to allow for sufficient time for the substantial

amount of information to be disclosed. Another commentator stated that

the earlier effective dates for insurer-initiated amendments do not

provide the insurer with sufficient time to implement the changes

necessary to be able to comply with the regulation or to be able to

determine precisely what constitutes an insurer-initiated amendment.

In the case of a plan electing a lump sum payment, one commentator

objected to the proposed paragraph (j)(4) provision that the insurer

must use the market value adjustment determined on either the effective

date of the amendment or determined upon receipt of the plan's written

request, depending on which is more favorable to the plan. The

commentator believed that this will create serious and damaging anti-

selection potential as the contractholder will have the ability to

determine, at its option, the more favorable of the two dates for the

determination of the market value adjustment. To avoid this result, the

commentator suggested that the market value adjustment should be

determined as of the date the funds are actually withdrawn.

The Department continues to believe that the earlier effective

dates for the disclosure provisions are consistent with section

401(c)(3)(B) of the Act, as added by SBJPA, which states that the

disclosures required by the regulation be provided after the date that

the regulations are issued in final form. In addition, section

401(c)(5)(B)(i) of the Act, as added by SBJPA, provides an exception to

the general 18-month effective date for regulations intended to prevent

the avoidance of the regulations set forth herein. Thus, the Department

proposed an earlier effective date for the provisions relating to the

independent fiduciary approval, disclosure and insurer-initiated

amendments because the Department believed that the earlier effective

dates would protect the interests and rights of a plan and its

participants and beneficiaries by minimizing the potential for insurers

to change their conduct in ways which are disadvantageous to plan

policyholders without compliance with the terms and conditions of the

regulation. The Department, therefore, finds good cause for waiving the

customary requirement to delay the effective date of a final rule for

30 days following publication.

The Department notes that, because no new Transition Policies can

be issued after December 31, 1998, it is no longer necessary to

differentiate between Transition Policies issued before and after the

date of publication of the final regulation. Therefore, those

provisions in proposed subparagraphs (j)(2) and (j)(3) which contain

different effective dates based upon the date of issuance of the

Transition Policy have been eliminated. In response to a number of

comments which indicated that state insurance departments may require

that insurers file for approval of amendments to policies, the

Department has adopted a new subparagraph (j)(2) which states that the

initial disclosure provision and separate account disclosure provision

in paragraphs (c) and (d) are applicable six months after publication

of the final regulation. The Department believes that a period of six

months from the date of publication would allow insurers sufficient

time to produce the disclosure materials and seek any necessary state

approvals.

Several commentators requested that the Department clarify the

applicable date for the initial annual report. The Department has

modified subparagraph (j)(3) to provide that the initial annual report

required under subparagraph (c)(4) must be provided to each plan no

later than 18 months after publication of the final regulation.

Subsequent reports shall be provided at least annually and not later

than 90 days following the period to which it relates. In consideration

of the comments regarding the harshness of the special rule in

subparagraph (j)(4) for insurer-initiated amendments which were made

during the period between publication of the proposed and final

regulations, the Department has determined to eliminate that provision.

The Department has added a new paragraph (k) which contains the

effective date for the regulation.

11. Miscellaneous Comments

Several commentators represented that the Department exceeded the

scope of its authority with respect to a number of the provisions

contained in the proposed regulation. In this regard, the Department

notes that section 401(c)(1)(A) of the Act authorizes the Secretary of

Labor to issue regulations to provide guidance in determining which

assets held by the insurer (other than plan assets held in its separate

accounts) constitute plan assets and to provide guidance with respect

to the application of Title I of ERISA to the general account assets of

insurers. The Department believes that this broad grant of authority to

provide guidance authorized the issuance of the regulations proposed by

the Department. Accordingly, the Department believes that the

commentators' arguments have no legal basis.

A commentator urged the Department to clarify in the preamble to

the final regulation that certain ``traditional'' guaranteed investment

contracts (GICs) are guaranteed benefit policies under the Act. In

support of its position, the commentator explained that, under a

traditional GIC, an insurance company promises to pay a guaranteed rate

of interest for a fixed period (i.e., until a stated maturity date)

with the rate of interest being a fixed rate (e.g., 6.0% ) guaranteed

for the fixed period, or a rate which is periodically reset by

reference to an independently maintained index (e.g., LIBOR ). Under

this type of GIC, the principal invested is guaranteed to be repaid at

maturity, and the rate of return on the amount invested is not

dependent on the performance of the assets in the insurer's general

account or any other assets. In the Department's view, a GIC containing

the above described terms would constitute a guaranteed benefit policy

within the meaning of section 401(b)(2)(B) of the Act. In addition, the

Department wishes

[[Page 628]]

to take the opportunity to state that no presumption should be drawn,

from its determination to provide limited interpretive guidance,

regarding the status of other insurance policies under section

401(b)(2)(B) of the Act.

Some commentators expressed concern that an insurer's decision to

comply with the conditions in the regulation with respect to certain

general account contracts issued to plans would be perceived as a

determination that such policies are not guaranteed benefit policies.

In this regard, the Department notes that no inference should be drawn

regarding the status of any general account contract issued to a plan

merely because the insurer has elected to comply with the regulation.

Economic Analysis Under Executive Order 12866

Under Executive Order 12866 (58 FR 51735, Oct. 4, 1993), the

Department must determine whether a regulatory action is

``significant'' and therefore subject to review by the Office of

Management and Budget (OMB). Section 3(f) of the Executive Order

defines a ``significant regulatory action'' as an action that is likely

to result in, among other things, a rule raising novel policy issues

arising out of the President's priorities. Pursuant to the terms of the

Executive Order, the Department has determined that this is a

``significant regulatory action'' as that term is used in Executive

Order 12866 because the action would raise novel policy issues arising

out of the President's priorities. Therefore, the Department has

undertaken to assess the benefits and costs of this regulatory action.

The Department's assessment, and the analysis underlying that

assessment, are detailed below.

The main features of the regulation which cause an economic impact:

(1) Provide for greater disclosure to employee benefit plans concerning

certain general account contracts with insurance companies; (2)

provide, in those cases where an insurance company chooses to comply

with the regulation, that some employee benefit plans may receive

enhanced termination options; (3) provide insurance companies guidance

in determining the circumstances under which a contract with an

employee benefit plan will cause the general account to hold plan

assets; (4) relieve insurance companies from certain requirements

imposed by ERISA if they were to hold plan assets; and (5) provide

insurers an opportunity to correct compliance errors with respect to

the regulation without facing the full consequences of noncompliance in

terms of being considered to hold plan assets.

The regulation establishes conditions that must be met in order for

certain contractual arrangements to not result in the insurer's general

account holding ERISA plan assets. Compliance with the regulation is

voluntary, except for a general prudence standard. Its economic

consequences, therefore, arise only when insurance companies elect to

avail themselves of this opportunity, presumably only those insurance

companies expecting the benefits of the regulation to exceed its costs.

The Department believes that the benefits of the regulation to

insurance companies, although difficult to quantify, will exceed its

costs to them, and expects that all insurance companies affected by the

Harris Trust decision will choose to comply. Because the regulation

also provides benefits to plans, participants and beneficiaries, as

well as to financial markets generally, while imposing little costs on

them, the Department expects that the benefits of the regulation will

considerably exceed its costs.

The costs and benefits of the regulation concern ``Transition

Policies.'' Transition Policies are general account contracts issued on

or before December 31, 1998 which are, at least in part, not guaranteed

benefit policies. In particular, the value of the benefit provided is

related to the investment performance of the insurer's general account.

The regulation does not apply to general account contracts written

after December 31, 1998, and for that reason the Department believes

that it causes neither benefits nor costs with respect to those

contracts. However, in the absence of the safe harbor provided by this

regulation, the costs to an insurance company of any of those contracts

which would result in the general account holding ERISA plan assets are

so great relative to the benefits that no insurance company will offer

general account contracts with nonguaranteed elements.

The regulation will result in a range of benefits that will

primarily accrue to parties directly involved in the affected

contracts, the insurance companies that have sold the policies and the

employee benefit plans that entered into these arrangements. Insurance

companies will benefit from the clarity regarding the circumstances in

which they will be holding plan assets. This will afford greater

flexibility in their efforts to manage the risks associated with

engaging in transactions with employee benefit plans and the capacity

to more efficiently make investment decisions. They will also obtain

some benefit from the provisions that enable them to correct certain

errors that would otherwise result in their holding plan assets.

Employee benefit plans, and by extension the participants who are

the beneficial owners of the contracts, will obtain some advantages as

a result of the increased disclosure of information that will improve

their ability to develop and adjust investment strategies and through

potentially more favorable circumstances under which contracts could be

terminated. In addition, the regulation will provide some more general

indirect benefits to the economy through greater transparency and

efficiency in the operation of financial markets.

There will be some expenses incurred by insurance companies to

achieve these benefits. The Department perceives these as generally

falling into two categories: (1) Expenses associated with fulfilling

procedural requirements which represent costs in an economic sense, and

(2) expenses that represent payments by insurance companies associated

with the liquidation of contracts at levels above what might have been

made absent the regulation. The Department views the second category as

transfers between affected parties with the expense of one exactly

offset by the gain of another and therefore not to be costs in an

economic sense.

It has also been suggested that the regulation would impose some

indirect costs on insurance companies and employee benefit plans

because insurers electing to restructure their contracts to comply with

the terms of the regulation would alter the composition of their

general account portfolios. Particular attention was focused on the

question of insurers hedging their exposure to interest rate movements

that might diminish the returns available to the policyholders of

general account products. The Department does not interpret this

potential outcome as a cost by virtue of the fact that compliance with

the regulation is elective and employee benefit plans have access to a

range of substitutes for general account products. This enables them to

purchase investment products across the full range of risk and return

available without regard to products offered by insurance companies.

The Department does not construe the outcome of competition in

financial markets by itself to represent economic costs. These outcomes

are instead interpreted to be benefits to the extent that regulatory

actions enhance the transparency and therefore the

[[Page 629]]

efficiency of markets. Changes in relative market share that may result

from enhanced competition are reflective of the reallocation of

resources in a manner more reflective of the preferences of market

participants and, absent direct evidence to the contrary, to represent

efficiency gains.

As is the case with most regulations of this nature, the benefits

of this regulation are difficult if not impossible to specifically

quantify. Most of the advantages accrue through indirect mechanisms or

represent changes relative to a baseline of future behavior and

outcomes that cannot be readily observed or predicted. Some elements of

the costs are similarly difficult to estimate. Others, primarily the

expenses associated with meeting certain procedural or disclosure

requirements are more easily estimated. Recognizing these limitations,

a more complete discussion of the various elements of costs and

benefits relevant to the regulation and specific estimates of the

magnitude where feasible is presented below.

Benefits of the Regulation

The regulation is expected to have significant direct benefits to

employee benefit plans. It satisfies the requirement in section

401(c)(2)(B) of ERISA that the interests of employee benefit plans that

hold insurance company general account contracts be protected, and thus

their participants and beneficiaries, through the requirement of

certain disclosure and termination rights. Through mandatory disclosure

by insurance companies of information concerning the determination of

costs and income from general account contracts, disclosure of the

conditions under which termination may occur, and disclosure of

information about the financial strength of the insurance company, the

regulation will increase the amount of information available to

employee benefit plans concerning insurance company general account

contracts. The information insurance companies disclose will allow

employee benefit plan fiduciaries and participants to fully understand

how insurance companies determine the expenses and rate of return they

assign to a contract.

Greater disclosure of information will enable employee benefit

plans to improve the quality of investment decisions. The complex

nature of the insurance products can make it difficult for employee

benefit plans to determine the risks associated with contracts backed

by insurance company general accounts. With the improved disclosure,

employee benefit plans will better understand the risks associated with

general account contracts and the net rate of return they can expect to

receive. The enhanced information will increase their ability to manage

their portfolios and allocate assets in a manner consistent with the

specific needs and circumstances of the plan. Plans making decisions to

restructure their asset allocation or change other aspects of their

investment strategy will benefit from a clearer explanation of their

rights under specific policies. Enhancing the information about the

specific attributes of complex financial products will have a positive

effect on market efficiency as the purchasers incorporate this

information into investment decisions and vendors respond to the

resulting competitive pressures.

Expected rate of return, risk and correlation of risks are three

elements critical to effective portfolio decisions. The provision of

more complete information by insurance companies due to this regulation

allows employee benefit plans to better approximate the ideal

portfolios that they would choose if they had full information about

the financial characteristics of all possible investments.

This benefit of the regulation in principle could be measured by

determining the increase in total investment income received on the

portfolio the employee benefit plan has, holding constant its level of

portfolio risk. This measure of the benefits of the regulation is

difficult to quantify because of changing conditions over time in

financial markets, so that any change in portfolio rate of return may

be due to other factors. A further complicating factor is that the

provision of more detailed information may also cause employee benefit

plans to change the amount of risk they wish to hold. It is difficult

to assess the value to plans of having better information about the

financial risks associated with these contracts.

The termination provisions are another major source of benefits

from the regulation to employee benefit plans and their participants.

The termination provisions in the regulation may require insurers to

give additional rights to employee benefit plan policyholders that

their general account contracts did not previously contain. For many

general account contracts, the regulation will liberalize payout

options for employee benefit plans beyond those that were previously

available. For other general account contracts, it will create new

payout options. The termination provisions provide at least three

benefits. First, the termination provisions allow employee benefit

plans to terminate general account contracts that contain provisions or

changes in provisions they view as unfavorable. Second, the termination

provisions may discourage some insurance companies from making

unilateral contract changes that are adverse to employee benefit plans.

Third, the termination provisions provide greater liquidity that allows

plans to adjust to changing financial market conditions. A discussion

of these three benefits of the termination provision follows.

First, employee benefit plans will benefit from the regulation by

being able to terminate a general account contract if an insurance

company unilaterally modifies such a contract to the detriment of the

employee benefit plan. The termination provisions considerably enhance

the value to employee benefit plans of the disclosure provisions since

they increase the range of actions that can be taken as a result of

better information being disclosed. Thus, the regulation gives employee

benefit plans greater protection against unilateral action taken by

insurance companies.

A second benefit of the termination provisions to employee benefit

plans is that those provisions will discourage insurance companies from

making some contract changes that are detrimental to the interests of

employee benefit plans that they would otherwise make.

A third benefit of the termination provisions is that they provide

employee benefit plans increased liquidity in their general account

contracts. If an employee benefit plan faces an unanticipated expense

and is forced to terminate its general account contract to obtain cash,

the plan may be able to do so under more favorable conditions. In some

cases, the plans will receive greater proceeds from a contract

liquidation. For lump sum payouts, this is because the regulation

requires that positive market value adjustments be given where they

would not otherwise have been prior to the effective date of the

regulation. Also for structured payouts, a minimum crediting rate that

is also higher than some contracts provide is required. The choice of

two payout options provides increased flexibility to many employee

benefit plans.

The increased liquidity provided by the termination provisions also

allows employee benefit plans to profit from changing conditions. For

example, a change in interest rates may cause an employee benefit plan

to adjust investment strategies. The regulation may permit the plan to

terminate its general account insurance contract and

[[Page 630]]

move its funds to the more attractive alternative.

The value of the benefit to employee benefit plans derived from the

enhanced ability to terminate contracts following unilateral contract

amendments by insurance companies is difficult to quantify. Plans will

not be forced to accept contract modifications that they view as

undesirable. The value of this benefit depends on the frequency that

such modifications would occur and the value placed on this protection

by employee benefit plans. The value of the benefit to employee benefit

plans of discouraging some contract modifications by insurance

companies is also difficult to quantify because there is no reliable

way to estimate the number of contract modifications with adverse

implications for plans that would otherwise occur.

As well as providing benefits to employee benefit plans and their

participants and beneficiaries, the regulation provides benefits to

insurance companies. The most significant of these results from the

ability of insurance companies to expand the universe of investments

that otherwise would be prohibited. In the absence of the regulation,

with insurance companies holding plan assets in their general accounts,

some investments would not be possible because they would involve

potential self-dealing and conflicts of interest.

The regulation may provide significant benefits to insurance

companies because it clarifies and mitigates the constraints imposed by

ERISA on the operation of insurance company general accounts. It does

so by providing that insurance companies that comply with the specific

requirements of the regulation will receive some assurance that their

general accounts do not contain plan assets. Insurance companies thus

could have reduced litigation costs and liabilities with respect to

their general accounts. They will be shielded from the fiduciary

responsibility and prohibited transactions rules under ERISA that would

otherwise apply to them as a result of the Harris Trust decision.

Because of the retroactive effect of the Supreme Court decision,

numerous transactions by insurance company general accounts may have

violated ERISA's prohibited transaction and general fiduciary

responsibility provisions. Without the safe harbor the regulation

affords, some insurance companies would be liable under part 4 of Title

I of ERISA as a result of the operation of their general accounts.

This regulation provides insurance companies the benefit of reduced

uncertainty concerning the application of ERISA. Some insurance

companies may be uncertain as to whether the general account contracts

they have with employee benefit plans are affected by the Harris Trust

decision. This uncertainty arises primarily from what constitutes a

guaranteed benefit policy.

The value to insurance companies of less uncertainty arises in part

through lower fees they would pay to attorneys and other benefits

specialists to try to resolve the uncertainty. Also, insurance

companies may be overly conservative in attempting to avoid holding

ERISA plan assets. The lowering of risk in this regard will allow

insurance companies to pursue business they might otherwise avoid.

The cure provision in the regulation is an additional source of

benefits. Insurance companies under certain circumstances can correct

certain errors in compliance with the regulation without causing the

company to hold employee benefit plan assets. This feature of the

regulation greatly reduces the risk of an inadvertent failure of an

insurer to comply with the regulation that would result in them holding

plan assets.

This cure provision should reduce the likelihood of litigation

between employee benefit plans and life insurance companies. The

ability to correct errors without incurring the risk of future

liability should reduce the incidence of noncompliance and

substantially reduce costs for insurance companies to correct

inadvertent errors.

The value of the benefits arising from the cure provision are

positive but impossible to accurately measure. They will depend on the

extent that insurance companies make inadvertent or good faith errors

and then use the cure provision to correct them. The level depends on

the cost to insurance companies of correcting the errors under the

regulation in relation to what would have otherwise occurred. The cure

provision also affords benefits to employee benefit plans because it

reduces the likelihood of failure to comply with the regulation. This

is similarly impossible to quantify.

The value of these benefits to insurance companies should be

substantially shifted to employee benefit plans over time through a

higher net rate of return received on life insurance company general

account contracts so long as insurance companies remain competitive.

This will increase the investment income of defined benefit plans

holding those contracts. An increase in investment income will over the

longer term lead to either a reduction in contributions required or

allowed by plan sponsors or to an increase in benefits. A reduction in

contributions by plan sponsors would reduce their corporate income tax

deductions and raise their corporate tax payments. Increased benefits

will result in higher taxable income received by beneficiaries.

The regulation will have a relatively small but positive benefit to

the Federal government, and thus taxpayers, by reducing the need for

employee benefit investigation, enforcement and litigation activities

of the government. By reducing the number of violations of ERISA

through compliance with the safe harbor provisions of the regulation,

and by providing through the cure provision the incentive for insurance

companies to self-correct minor compliance problems, investigation,

enforcement and litigation expenses of the government may be reduced.

As well as the direct benefits discussed above, the regulation has

indirect benefits through improved functioning of financial markets.

The indirect benefits are positive externalities that benefit all

participants in financial markets through the greater efficiency of the

functioning of those markets. The positive externalities are benefits

received by parties other than insurance companies and employee benefit

plans, participants and beneficiaries. With more efficiently

functioning capital markets, capital is directed to its best use, which

benefits not only the investor but also enterprises seeking investors.

Thus, this is a benefit to the economy at large. The termination

provisions of the regulation also provide positive externalities in

that by providing greater financial market liquidity, there is freer

movement of capital so it can be applied to its best use.

Costs of the Regulation

As with the benefits, the costs of the regulation are both direct

and indirect. Direct costs should fall nearly exclusively on insurance

companies rather than on plans, participants and beneficiaries.

Although, some commentators have argued that there may be indirect

costs to the economy through effects on the functioning of capital

markets, as discussed in more detail below, the Department believes

those costs to be insignificant or nonexistent.

Three types of direct costs are relevant. Insurance companies will

bear some costs that are effectively transfers to plans. While these

may be viewed as costs in the accounting sense, they result in little

or no net cost to the economy, as the cost to the insurance

[[Page 631]]

company is exactly offset by the benefit received by the employee

benefit plan.

Second, there are direct costs that arise because insurance

companies undertake certain activities in order to fall within the

requirements of the regulation. These will primarily take the form of

increased payments to service providers or insurance company employees.

These type of costs represent costs in both an accounting as well as an

economic sense and are the primary burden imposed by the regulation.

A third type of cost are those potentially associated with a

distortion of economic activity. These also represent a net cost to the

economy. Typically these distortions are associated with taxation.

Distortions can also potentially result from government regulations

requiring activities or expenditures which exceed the associated

benefits.

Insurance companies will incur administrative costs due to the

disclosure and termination requirements. To comply with increased

disclosure requirements, they will incur costs to prepare and

distribute the annual statement to employee benefit plans explaining

the methods by which income and expenses of the insurance company's

general account are allocated to the policy. To minimize these costs,

the regulation requires disclosure of materials that are prepared for

other purposes. One time only administrative costs will be incurred by

insurance companies to modify contracts so that they will comply with

the regulation and to file revised contracts with state regulatory

authorities.

The enhanced options for employee benefit plans to terminate their

contracts will create administrative costs for insurance companies in

that they will be discouraged from making some unilateral contract

modifications they otherwise would make. The magnitude of this cost to

insurance companies is difficult to quantify because the number and

effect of contract modifications that will be discouraged from

occurring is not readily determinable. This cost to insurance companies

is largely a benefit to employee benefit plans and participants and

beneficiaries.

Some commentators have argued that the regulation will impose costs

on insurance companies in financial markets. Because the termination

options will permit some contracts to be terminated earlier than

otherwise, insurance companies may adjust the investments in their

portfolios. The increased probability of early termination shortens the

period over which the preponderance of payments are made. To the extent

that insurance companies attempt to match the timing of their receipts

and payouts, they will shorten the timing of their receipts.

Insurance companies with a significant percentage of affected funds

in their general account may make fewer long maturity investments and

private placements. Long maturity investments are investments where the

preponderance of the payments are received relatively far into the

future. Private placements are investments that are not publicly traded

on financial market exchanges. They may reduce those investments due to

their needs for reduced maturity and greater liquidity of investments

because of the increased probability of early termination of general

account contracts. Both of these changes in maturity of investments and

in private placements would reduce the expected rate of return on their

portfolios. Lower maturity investments generally receive a lower rate

of return than longer maturity investments. Private placements tend to

have relatively low liquidity because they are not publicly traded.

Liquidity is a desirable aspect of investments and therefore investors

must pay a price for it in terms of lowered rate of return. The

termination requirements may also cause insurance companies to incur

costs in determining the market value of some assets that are not

publicly traded, such as private placements. These costs will

discourage investments in those types of assets because they will

reduce the net rate of return (after costs) on those investments.

Because of the sophistication of capital markets, with a large

number of competent purchasers and sellers, any initial effect on

capital markets due to insurance companies changing their portfolios

and their investment strategies probably would be offset by a re-

allocation of investments among investors. If insurance companies

reduce their investments in a certain class of assets, the price of

those assets will fall due to the reduced demand for the investment,

which will raise the rate of return on that investment. The lowered

price and increased rate of return will motivate other investors to

invest in those assets, which will in turn drive the price up towards

its original level. One time only transaction costs will be incurred by

insurance companies and other investors as they adjust their

portfolios. These costs are primarily fees paid to other financial

institutions to transact sales and purchases.

The cure provision creates administrative costs for insurance

companies that choose to use it because they are required to establish

administrative procedures to detect and correct failures to comply with

the regulation. Costs will be incurred in terms of staff time required

for creating and maintaining these procedures. These costs are largely

quantifiable in terms of specific actions that are required, with the

cost of those actions being estimable.

While the increased administrative costs are borne initially by

insurance companies choosing to comply with the regulation, they may be

shifted at least partially through a reduced rate of return net of

expenses to employee benefit plans and then to participants, and to

other investors who have contracts supported by the general accounts of

those companies. A reduction in the net rate of return received on the

general account portfolio may be passed on to employee benefit plans

having contracts with participating features. Whether that occurs may

be a business decision made by insurance companies depending on the

competitive pressures they face or may be determined by their

contracts. It may also reduce the rate of return insurance companies

offer on new contracts. The extent to which they do that depends in

part on the competitive pressures faced by insurance companies. It

should be noted again in this context that new contracts will not be

covered by the regulation.

These effects on the rate of return received by insurance companies

on their general account portfolios generally will be small. For most

insurance companies the percentage of general account assets affected

is small and thus the effect on the insurance company's portfolio rate

of return, which is proportional to the share of those assets in the

general account portfolio, is also small. The effects on employee

benefit plan rates of return is further diminished to the extent that

plans hold other investments. The effect on participants may be even

further reduced to the extent that employee benefit plan sponsors bear

the effects that are shifted to employee benefit plans.

Employee benefit plans can offset lower risk and expected return

from their insurance contracts by increasing the risk and expected

return of their other investments. They may also reduce their

investments held with insurance companies and shift funds to other

financial intermediaries. If these changes are made, there may be no

effect on the expected portfolio rate of return for employee benefit

plans.

[[Page 632]]

Cost Estimates

The following are the Department's estimates of the potential costs

associated with the regulation. The Department's analysis is responsive

to the public comments received on the economic impact of the proposed

regulation that focused on the potential costs attributable to the

regulation. This discussion also reflects additional analysis by the

Department in response to changes to the substantive provisions of the

regulation and the availability of more recent data.

Direct Costs

The direct costs associated with the regulation are attributable to

the disclosure and termination requirements. The discussion that

follows provides details of the direct costs associated with the

regulation.

1. Impact on the Insurance Industry--Amount of Assets Affected

In connection with its publication of the proposed regulation, the

Department solicited comments from the interested public regarding the

economic impact of the proposed regulation. Specifically, the

Department requested current data on the number and characteristics of

potentially affected insurance contracts that would provide the basis

for a more extensive analysis of the costs and benefits of the proposed

regulation.

The Department received a few comments which disagreed with its

estimate of the value of the accounts potentially affected by the

regulation of $40 billion in 1994 (slightly less than 3 percent of

general account assets). These comments provided limited data on the

number of potentially affected insurance contracts. For example, one

commentator estimates that based on their reading of the 1997 Life

Insurance Fact Book (1996 data), the total value of contracts

potentially affected by the regulation is $261.8 billion (15.4 percent

of general account assets). It appears that this estimate includes the

allocated portions of general account group insurance contracts,

whereas the Department excludes the allocated portions of group annuity

contracts from its estimates. Allocated group annuity contracts are

excluded because the benefits from the contracts are guaranteed and the

employee benefit plans do not participate in the risk associated with

those contracts. Representatives of the insurance industry estimated

for 1996 that the amount of unallocated assets that would be affected

by this regulation was approximately $100 billion (6.7 percent of

general account assets).

In response to these comments, the Department asked the insurance

industry to provide specific information on the amount of affected

assets. The industry declined to provide the information, contending

the proprietary nature of the data. As an alternative data source the

Department used information reported on the Form 5500 reports and

attached Schedule A's filed for the 1995 plan year. The Schedule A

attachment is required to be filed for all pension plans holding

insurance contracts with unallocated funds. Both the amount of

unallocated funds and the name of the insurance carrier issuing the

policy are reported on the Schedule A. While the manner of reporting

unallocated funds held in insurance policies does not enable a precise

determination of whether the policies are Transition Policies or other

types of policies, the Department believes that reasonable estimates

can be derived from the data. Using Form 5500 data, the Department

revised its earlier estimates of the amount of assets potentially

affected by the regulation and the distribution of those assets within

the life insurance industry. The Department now estimates between $80

and $98 billion (between 5.8 and 7.1 percent of general account assets)

would have been potentially affected by the regulation in 1995. The

Department believes that this estimate comports with that provided by

the representatives of the insurance industry.

For the 1995 plan year, a total of 123,567 Schedule A reports were

filed by pension plans reporting assets held in contracts with

unallocated funds that appear to be used to pay benefits or purchase

annuities. It is the Department's belief that these policies are most

commonly immediate participation guarantee (IPG) contracts, in which

the value is directly related to the investment performance of the

insurer's general account. These contracts will therefore meet the

definition of a Transition Policy. The total amount of assets reported

in Schedule A for these types of contracts was $98 billion.

The following discussion explains how the figures of between $80

and $98 billion were determined. The Schedule A is used both for the

reporting of assets in accounts used to provide benefits and for the

reporting of assets in accounts used solely for investments. The

Schedule A does not have a specific identifier for the type of policy

being reported. Contracts were assumed to be purely investment

contracts if the Schedule A showed no assets disbursed to pay benefits

or purchase annuities during the year and the Form 5500 report

indicated that all plan benefits were either paid from a trust or, in

the case of a defined contribution plan, were paid through a

combination of a trust and insurance carrier.12 These

filings were excluded from the analysis based on the assumption that

they are most likely to be guaranteed investment contracts and would

therefore not meet the definition of a Transition Policy. The remaining

Schedule A's fell into two categories:

---------------------------------------------------------------------------

\12\ It appears that defined contribution plans which check that

benefits are provided through both a trust fund and an insurance

carrier and which attach a Schedule A are generally trust funded

plans (with investments in insurance products) that commonly offer

participants the choice of a lump sum distribution or an annuity.

For participants choosing the latter form of payment, the value of

the participant's account is used to purchase an individual annuity.

Thus, it was assumed that the assets reported on Schedule A were in

investment accounts rather than Transition Policy accounts used to

provide benefits.

---------------------------------------------------------------------------

(1) If a Schedule A showed funds being disbursed from the account

to pay benefits or purchase annuities or the Form 5500 report indicated

that all benefits were provided through an insurance carrier, then the

funds reported in Item 6 of the Schedule A were assumed to be held in

policies meeting the definition of a Transition Policy. The total

amount of such funds in 1995 was $80 billion. This amount was used as

the lower bound for estimating total general account assets held in

Transition Policies.

(2) If a Schedule A showed no assets disbursed to pay benefits or

purchase annuities and the Form 5500 report indicated that the plan was

a defined benefit plan and benefits were paid both through the trust

and an insurance carrier, then the type of contract funds reported in

Item 6 of Schedule A was categorized as undeterminable. The total

amount of such funds was $18 billion.

The $18 billion estimate of funds in the undeterminable category,

combined with the $80 billion in general account funds determined to be

used to pay benefits, was used as the upper bound for estimating total

general account funds in Transition Policies. There is no way of

accurately estimating how much of the $18 billion in the undeterminable

category was held in Transition Policies. Therefore, in estimating the

total amount of funds held in Transition Policies, the entire $18

billion was added to the lower bound of $80 billion to provide a total

estimate of $98 billion held in Transition Policies.13 This

[[Page 633]]

amount is in line with the $100 billion estimate provided by the

representatives of the insurance industry.

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\13\ The DOL had developed an earlier estimate of $40 billion

held in Transition Policies. This estimate was based on data

reported in Item 31c(16)--(Value of funds held in insurance company

general account)and Item 32e(2)--(Payments to insurance carriers for

the provision of benefits) of the 1994 Form 5500 reports alone and

did not make use of Schedule A data. The use of the Schedule A

attachment in combination with data reported on the Form 5500 allows

for a much more refined estimate to be developed, particularly for

small plans which do not separately report assets held in insurance

company general accounts.

---------------------------------------------------------------------------

One commentator disagreed with the Department's use of an industry

average, i.e., slightly less than 3 percent of general account assets,

to demonstrate the percent of total contracts potentially affected by

the regulation. The commentator stated that this is inappropriate

because many insurers have a significantly higher proportion of assets

supporting contracts potentially affected by the regulation than the

Department's estimate in the proposed regulation for the industry as a

whole. In its re-estimate of the amount of assets affected based on the

most recent complete Form 5500 data available (1995), the Department

determined that approximately 104 insurance companies each managed $25

million or more of private pension plan unallocated assets in insurance

company general accounts and about 63 of those insurance companies

managed $100 million or more in such accounts.

To estimate the impact of the proposed regulation on both the

insurance industry as a whole and on individual companies within the

industry, the ratio of funds in Transition Policies (as reported on

Schedule A of the Form 5500 series) to an insurer's general account

funds was computed. This is one of a number of reasonable measures of

insurer net exposure that could have been chosen. For example, the

ratio of funds in Transition Policies to insurer net worth would be

another reasonable measure.

The ACLI reports that at year-end 1995, a total of $1.683 trillion

was held in the general accounts of life insurance

companies.14 In order to estimate the total value of general

account assets in the 104 companies which have issued Transition

Policies with a total value of $25 million or more, data from the 1996

and 1998 editions of the Best Insurance Reports and Standard & Poor's

Claims-Paying Ability Reports were used along with information provided

by insurance representatives. For a few companies for which data were

not available from the above two sources, telephone calls were made to

the companies to obtain general account asset information. The general

accounts of these 104 companies in 1995 were estimated to be $1.372

trillion. The $98 billion estimated as held to support Transition

Policies by the 104 companies represent 7.1 percent of total general

account assets.

---------------------------------------------------------------------------

\14\ ``1996 Life Insurance Fact Book,'' American Council of Life

Insurance, p. 89.

---------------------------------------------------------------------------

The percentage of general account assets held to support Transition

Policies varied widely among insurance companies, ranging from a low of

0.1 percent to a high of 44 percent. For 74 percent of the companies

(77 companies), the assets held in support of Transition Policies made

up less than 10 percent of total general account assets. For 13 percent

of the companies (14 companies), assets held in support of Transition

Policies made up from 10 to 19 percent of total general account assets,

and for the remaining 13 percent (13 companies), assets in Transition

Policies made up 20 percent or more of general account assets, with a

maximum percentage of 44 percent.

The Department estimates that the proposed regulation will have a

significant impact on the 13 companies in which assets held in

Transition Policies (as reported on Schedule A of the Form 5500 series)

exceed 20 percent of the insurer's general account assets. While any

threshold measure of impact is, to some extent, arbitrary, we believe

that the 20 percent level is a reasonable measure, given the estimated

costs of bringing contracts into compliance and any increased exposure

represented by required changes in policy termination provisions.

2. Costs of Compliance

Insurance industry representatives disagreed with the Department's

estimate of the aggregate cost of compliance with the proposed

regulation of no more than $2 to $5 million per year, indicating that

they believe the costs will be a significant multiple of this estimate.

However, these insurance industry representatives indicated that they

did not have specific information as to the aggregate cost of

compliance with the regulation. The representatives did not provide any

analysis of the sources and methodologies used to derive their cost

bases. Thus, the Department could not replicate these estimates.

The Department now estimates based on the cost estimates provided

by 6 insurance companies and from Form 5500 series reports that the

average annual aggregate costs over the first 10 years of compliance

with the regulation to be approximately $37 million (initial costs plus

the annual costs over 10 years divided by 10 years). This estimate

includes initial costs to insurers for reviewing the language in

current contracts concerning termination provision, drafting policy

riders or amendments, and mailing new policies to policyholders of $1.7

million. The estimate also includes the initial cost to insurers of

preparing the initial disclosure statement to give to employee benefit

plans of $52.7 million and an annual cost for disclosure in subsequent

years of $37 million. The basis for these estimates is provided in the

Paperwork Reduction Act section of this preamble.

Disclosure Provisions

The Department received several comments regarding the disclosure

provisions in the proposed regulation. In response to these comments,

the disclosure provisions have been modified in the final regulation,

thus clarifying the requirements and reducing any potential burdens

associated with these provisions. For example, the Department limited

the disclosure requirements to those items relevant to the

policyholder's ability to withdraw or transfer funds under the policy.

In addition, the Department eliminated the requirement that the insurer

make available upon request of a plan copies of the documents

supporting the actuarial opinion of the insurer's Appointed Actuary.

The Department has determined that these changes have no significant

impact on the costs associated with the regulation.

Termination Provisions

The proposed regulation included two forms of termination payment

that would be available to transition policy holders--a lump sum

payment with a market value adjustment and a book value payout, in

essentially equal installments, over a period of no more than five

years calculated using an interest rate of no less than 1 percent less

than the rate currently crediting on the policy at the time of

termination. The final regulation also includes the two forms of

termination payment but, in response to comments received, lengthens

the period for book value payouts to over no more than ten years and

with a crediting rate of no more than 1 percent less than the current

crediting rate. The Department based this change on a New York state

insurance regulation. The New York regulation serves as the

Department's model because most insurers of group annuity contracts are

licensed to do business in New York. That regulation has applied since

1987 to insurers licensed to do business in New York. The New York

regulation requires that unallocated group annuity contracts issued

after 1987 provide that the policyholder can terminate the contract and

receive either a lump sum payment with a market value adjustment or a

[[Page 634]]

book value payout over no more than 10 years (including a 5 year payout

option) with a crediting rate no less than 1.5 percent less than the

current crediting rate.

For many group annuity contracts, the regulation will liberalize

payout options that were previously available. For other contracts, it

will create new payout options. These changes will have two principal

effects: (1) In situations where contracts did not previously allow for

a positive market value adjustment, they will increase payouts to some

terminating group annuity policyholders, thus transferring value from

insurance companies or their continuing policyholders to pension plans

which terminate their arrangements, and (2) they will tend to change

the investment policies for the assets supporting group annuity

contracts because of the increased likelihood of early terminations of

contracts, in particular shortening the maturity structure and shifting

the asset mix toward a larger portion in marketable securities.

While the transfer of value in situations where contracts did not

previously allow for a positive market value adjustment, may result in

a loss to some insurance companies, at the level of the economy as a

whole that effect will be offset by gains to some pension plans. The

ultimate distributions of the burden and gain are difficult to

determine. The gain may be realized by plan participants or

shareholders of firms sponsoring pension plans and the loss borne by

shareholders of insurance companies or by other purchasers of life

insurance products. While any increase in an insurer's liabilities may

increase the probability of a future insolvency, the Department is

unable to quantify this effect. It believes, however, that those

insurers for whom this regulation has the greatest impact will

aggressively seek to lessen the effects on their financial structures

by appropriate asset/liability matching techniques.

The decrease in insurers' group annuity liability duration is

likely to trigger changes in the way insurers manage the assets

supporting those contracts. That response is likely to take the form of

shifting to assets that are less sensitive to interest rate changes

(i.e., assets with shorter durations). Life insurers will also likely

shift their investments to assets with greater liquidity.

Many of the analyses supplied by the insurance industry in response

to the proposed regulation assumed insurers would shorten their asset

structure to correspond to the interest rate sensitivity of a 5 year

payout of the book value of their Transition Policies. Under the final

regulation, a similar analysis would imply that insurers will shorten

their asset structure to correspond to the interest rate sensitivity of

a 10 year payout of the book value. The 10 year option would imply a

small shortening of insurers' liabilities and thus probably of their

assets. The shortening of the duration of assets would imply, under

most circumstances, a decrease in portfolio rates of return. The 10

year option would require a relatively small reduction in the duration

of the group annuity portfolio for most insurance companies. Because

the yield curve for bonds with respect to maturity is usually fairly

flat in the relevant range of maturities, the difference in the rates

of return associated with such restructuring is fairly small. Thus the

decrease in the portfolio rates of the return would be generally far

smaller than the industry estimates of 50 to 100 basis points that were

derived based on the 5 year book value payout required by the proposed

regulation.

Some commentators have argued that plans will terminate contracts

to take advantage of the upward market adjustments or the difference in

value between the two termination payout options. The Department

believes that few such terminations will occur because other

contractual features, such as guaranteed annuity purchase rates, also

have value. In addition, long-established business relationships are

valuable and Transition Policy contract holders will attempt to

negotiate mutually beneficial agreements for continuing relationships.

Further, as indicated earlier, New York state insurance regulation

requires for recently issued unallocated group annuity contracts issued

by insurers licensed to do business in New York termination provisions

similar to those of this regulation. Most of the major issuers of group

annuity products are licensed to do business in New York. The

Department notes that while there has been more than a decade of

experience with the New York regulation, no written or oral testimony

was submitted to indicate that experience with respect to termination

of such contracts differs from that of other contracts with less

favorable termination provisions.

Cure Provision

As described earlier in this preamble, the Department has added a

cure provision to the final regulation in response to public comment.

This cure provision would allow insurers that have made reasonable and

good faith efforts to comply with the requirements of the regulation up

to 60 days from either the date of the insurers' detection of the

problem or the date of the receipt of written notice of non-compliance

from the plan to comply with the requirements of the regulation. In

addition, interest must be credited on any amounts due the policyholder

on termination or discontinuance of the policy if not paid within 90

days of receipt of notice from the policyholder.

In order for an insurer to make use of the cure, it must have

established written procedures that are reasonably designed to assure

compliance and to detect instances of noncompliance. While the

Department is unable to quantify the benefit of the cure provision, it

is anticipated that the cure provision will allow insurers to avail

themselves of the protections of the regulation with somewhat greater

administrative flexibility. Although there may be certain expenses

associated with the establishment of written compliance procedures, the

Department believes that many insurers would implement such procedures

as part of their usual management practices, and would satisfy

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