Indexed Annuities And Certain Other Insurance Contracts

Federal RegisterJan 16, 2009

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 230 and 240

[Release Nos. 33-8996, 34-59221; File No. S7-14-08]

RIN 3235-AK16

Indexed Annuities And Certain Other Insurance Contracts

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

We are adopting a new rule that defines the terms “annuity contract” and “optional annuity contract” under the Securities Act of 1933. The rule is intended to clarify the status under the federal securities laws of indexed annuities, under which payments to the purchaser are dependent on the performance of a securities index. The rule applies on a prospective basis to contracts issued on or after the effective date of the rule. We are also adopting a new rule that exempts insurance companies from filing reports under the Securities Exchange Act of 1934 with respect to indexed annuities and other securities that are registered under the Securities Act, provided that certain conditions are satisfied, including that the securities are regulated under state insurance law, the issuing insurance company and its financial condition are subject to supervision and examination by a state insurance regulator, and the securities are not publicly traded.

DATES:

Effective Date:

The effective date of § 230.151A is January 12, 2011. The effective date of § 240.12h-7 is May 1, 2009. Sections III.A.3. and III.B.3. of this release discuss the effective dates applicable to rule 151A and rule 12h-7, respectively.

FOR FURTHER INFORMATION CONTACT:

Michael L. Kosoff, Attorney, or Keith E. Carpenter, Senior Special Counsel, Office of Disclosure and Insurance Product Regulation, Division of Investment Management, at (202) 551-6795, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-5720.

SUPPLEMENTARY INFORMATION:

The Securities and Exchange Commission (“Commission”) is adding rule 151A under the Securities Act of 1933 (“Securities Act”)

and rule 12h-7 under the Securities Exchange Act of 1934 (“Exchange Act”).

15 U.S.C. 77a

et seq.

15 U.S.C. 78a

et seq.

Table of Contents

I. Executive Summary

II. Background

A. Description of Indexed Annuities

B. Section 3(a)(8) Exemption

III. Discussion of the Amendments

A. Definition of Annuity Contract

1. Analysis

2. Commenters' Concerns Regarding Commission's Analysis

3. Definition

B. Exchange Act Exemption for Securities that are Regulated as Insurance

1. The Exemption

2. Conditions to Exemption

3. Effective Date

IV. Paperwork Reduction Act

V. Cost-Benefit Analysis

VI. Consideration of Promotion of Efficiency, Competition, and Capital Formation; Consideration of Burden on Competition

VII. Final Regulatory Flexibility Analysis

VIII. Statutory Authority

Text of Rules

I. Executive Summary

We are adopting new rule 151A under the Securities Act of 1933 in order to clarify the status under the federal securities laws of indexed annuities, under which payments to the purchaser are dependent on the performance of a securities index.

Section 3(a)(8) of the Securities Act provides an exemption under the Securities Act for certain “annuity contracts,” “optional annuity contracts,” and other insurance contracts. The new rule prospectively defines certain indexed annuities as not being “annuity contracts” or “optional annuity contracts” under this exemption if the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract.

17 CFR 230.151A. Rule 151A was proposed by the Commission in June 2008.

See

Securities Act Release No. 8933 (June 25, 2008) [73 FR 37752 (July 1, 2008)] (“Proposing Release”).

The definition hinges upon a familiar concept: the allocation of risk. Insurance provides protection against risk, and the courts have held that the allocation of investment risk is a significant factor in distinguishing a security from a contract of insurance. The Commission has also recognized that the allocation of investment risk is significant in determining whether a particular contract that is regulated as insurance under state law is insurance for purposes of the federal securities laws.

Individuals who purchase indexed annuities are exposed to a significant investment risk—

i.e.

, the volatility of the underlying securities index. Insurance companies have successfully utilized this investment feature, which appeals to purchasers not on the usual insurance basis of stability and security, but on the prospect of investment growth. Indexed annuities are attractive to purchasers because they offer the promise of market-related gains. Thus, purchasers obtain indexed annuity contracts for many of the same reasons that individuals purchase mutual funds and variable annuities, and open brokerage accounts.

When the amounts payable by an insurer under an indexed annuity are more likely than not to exceed the amounts guaranteed under the contract, this indicates that the majority of the investment risk for the fluctuating, securities-linked portion of the return is borne by the individual purchaser, not the insurer. The individual underwrites the effect of the underlying index's performance on his or her contract investment and assumes the majority of the investment risk for the securities-linked returns under the contract.

The federal interest in providing investors with disclosure, antifraud, and sales practice protections arises when individuals are offered indexed annuities that expose them to investment risk. Individuals who purchase such indexed annuities assume many of the same risks and rewards that investors assume when investing their money in mutual funds, variable annuities, and other securities. However, a fundamental difference between these securities and indexed annuities is that—with few exceptions—indexed annuities historically have not been registered as securities. As a result, most purchasers of indexed annuities have not received the benefits of federally mandated disclosure, antifraud, and sales practice protections.

In a traditional fixed annuity, the insurer bears the investment risk under the contract. As a result, such instruments have consistently been treated as insurance contracts under the federal securities laws. At the opposite end of the spectrum, the purchaser bears the investment risk for a traditional variable annuity that passes through to the purchaser the performance of underlying securities, and we have determined and the courts have held that variable annuities are securities under the federal securities laws. Indexed annuities, on the other hand, fall somewhere in between—they possess both securities and insurance features. Therefore, we have determined that providing greater clarity with regard to the status of indexed annuities under the federal securities laws will enhance investor protection, as well as provide greater certainty to the issuers and sellers of these products with respect to their obligations under the federal securities laws. Accordingly, we

are adopting a new definition of “annuity contract” that, on a prospective basis, will define a class of indexed annuities that are outside the scope of Section 3(a)(8). We carefully considered where to draw the line, and we believe that the line that we have drawn, which will be applied on a prospective basis only, is rational and reasonably related to fundamental concepts of risk and insurance. That is, if more often than not the purchaser of an indexed annuity will receive a guaranteed return like that of a traditional fixed annuity, then the instrument will be treated as insurance; on the other hand, if more often than not the purchaser will receive a return based on the value of a security, then the instrument will be treated as a security. With respect to the latter group of indexed annuities, investors will be entitled to all the protections of the federal securities laws, including full and fair disclosure and antifraud and sales practice protections.

We are aware that many insurance companies and sellers of indexed annuities, in the absence of definitive interpretation or definition by the Commission, have of necessity acted in reliance on their own analysis of the legal status of indexed annuities based on the state of the law prior to the proposal and adoption of rule 151A. Under these circumstances, we do not believe that insurance companies and sellers of indexed annuities should be subject to any additional legal risk relating to their past offers and sales of indexed annuities as a result of the proposal and adoption of rule 151A. Therefore, the new definition will apply prospectively only—that is, only to indexed annuities that are issued on or after the effective date of our final rule.

Finally, we are adopting rule 12h-7 under the Exchange Act, a new exemption from Exchange Act reporting that will apply to insurance companies with respect to indexed annuities and certain other securities that are registered under the Securities Act and regulated as insurance under state law. We believe that this exemption is necessary or appropriate in the public interest and consistent with the protection of investors. Where an insurer's financial condition and ability to meet its contractual obligations are subject to oversight under state law, and where there is no trading interest in an insurance contract, the concerns that periodic and current financial disclosures are intended to address are generally not implicated.

The Commission received approximately 4,800 comments on the proposed rules. The commenters were divided with respect to proposed rule 151A. Many issuers and sellers of indexed annuities opposed the proposed rule. However, other commenters supported the proposed rule, including the North American Securities Administrators Association, Inc. (“NASAA”),

the Financial Industry Regulatory Authority, Inc. (“FINRA”),

several insurance companies, and the Investment Company Institute (“ICI”).

A number of commenters, both those who supported and those who opposed rule 151A, suggested modifications to the proposed rule. Sixteen commenters addressed proposed rule 12h-7, and all of these commenters supported the proposal, with some suggesting modifications. We are adopting proposed rules 151A and 12h-7, with significant modifications to address the concerns of commenters.

NASAA is the association of all state, provincial, and territorial securities regulators in North America.

FINRA is the largest non-governmental regulator for registered broker-dealer firms doing business in the United States. FINRA was created in July 2007 through the consolidation of NASD and the member regulation, enforcement, and arbitration functions of the New York Stock Exchange.

ICI is a national association of investment companies, including mutual funds, closed-end funds, exchange-traded funds, and unit investment trusts.

II. Background

Beginning in the mid-1990s, the life insurance industry introduced a new type of annuity, referred to as an “equity-indexed annuity,” or, more recently, “fixed indexed annuity” (herein “indexed annuity”). Amounts paid by the insurer to the purchaser of an indexed annuity are based, in part, on the performance of an equity index or another securities index, such as a bond index.

The status of indexed annuities under the federal securities laws has been uncertain since their introduction in the mid-1990s.

Under existing precedents, the status of each indexed annuity is determined based on a facts and circumstances analysis of factors that have been articulated by the U.S. Supreme Court.

Insurers have typically marketed and sold indexed annuities without registering the contracts under the federal securities laws.

See

Securities Act Release No. 7438 (Aug. 20, 1997) [62 FR 45359, 45360 (Aug. 27, 1997)] (“1997 Concept Release”); NASD,

Equity-Indexed Annuities, Notice to Members 05-50

(Aug. 2005), available at:

http://www.finra.org/web/groups/rules_regs/documents/notice_to_members/p014821.pdf

(“NTM 05-50”); Letter of William A. Jacobson, Esq., Associate Clinical Professor, Director, Securities Law Clinic, and Matthew M. Sweeney, Cornell Law School '10, Cornell University Law School (Sept. 10, 2008) (“Cornell Letter”); Letter of FINRA (Aug. 11, 2008) (“FINRA Letter”); Letter of Investment Company Institute (Sept. 10, 2008) (“ICI Letter”).

SEC v. Variable Annuity Life Ins. Co.

, 359 U.S. 65 (1959) (“

VALIC

”);

SEC

United Benefit Life Ins. Co.

, 387 U.S. 202 (1967) (“

United Benefit

”).

In the years after indexed annuities were first introduced, sales volumes and the number of purchasers were relatively small. Sales of indexed annuities for 1998 totaled $4 billion and grew each year through 2005, when sales totaled $27.2 billion.

Indexed annuity sales for 2006 totaled $25.4 billion and $24.8 billion in 2007.

In 2007, indexed annuity assets totaled $123 billion, 58 companies were issuing indexed annuities, and there were a total of 322 indexed annuity contracts offered.

As sales have grown in more recent years, these products have affected larger and larger numbers of purchasers. They have also become an increasingly important business line for some insurers.

NAVA, 2008 Annuity Fact Book

, at 57 (2008).

Id.

See, e.g.

, Allianz Life Insurance Company of North America (Best's Company Reports, Allianz Life Ins. Co. of N. Am., Dec. 3, 2007) (Indexed annuities represent approximately two-thirds of gross premiums written.); American Equity Investment Life Holding Company (Annual Report on Form 10-K, at F-16 (Mar. 14, 2008)) (Indexed annuities accounted for approximately 97% of total purchase payments in 2007.); Americo Financial Life and Annuity Insurance Company (Best's Company Reports, Americo Fin. Life and Annuity Ins. Co., Sept. 5, 2008) (Indexed annuities represent over 90% of annuity premiums and almost 60% of annuity reserves.); Aviva USA Group (Best's Company Reports, Aviva Life Insurance Company, July 14, 2008) (Indexed annuity sales represent more than 85% of total annuity production.); Investors Insurance Corporation (IIC) (Best's Company Reports, Investors Ins. Corp., July 10, 2008) (IIC's primary product has been indexed annuities.); Life Insurance Company of the Southwest (“LSW”) (Best's Company Reports, Life Ins. Co. of the Southwest, June 28, 2007) (LSW specializes in the sale of annuities, primarily indexed annuities.); Midland National Life Insurance Company (Best's Company Reports, Midland Nat'l Life Ins. Co., Jan. 24, 2008) (Sales of indexed annuities in recent years have been the principal driver of growth in annuity deposits.).

The growth in sales of indexed annuities has, unfortunately, been accompanied by complaints of abusive sales practices. These include claims that the often-complex features of these annuities have not been adequately disclosed to purchasers, as well as claims that rapid sales growth has been fueled by the payment of outsize commissions that are funded by high surrender charges imposed over long periods, which can make these annuities unsuitable for seniors and others who may need ready access to their assets.

See

Letter of Susan E. Voss, Commissioner, Iowa Insurance Division (Nov. 18, 2008) (“Voss Letter”) (acknowledging sales practice issues and “great deal” of concern about suitability and disclosures in indexed annuity market).

See also Tcherepnin

Knight,

389 U.S. 332, 342 n.30 (1967) (Congress specifically stated that “insurance policies are not to be regarded as securities subject to the provisions of the [Securities] act,” (

quoting

H.R. Rep. 85, 73d Cong., 1st Sess. 15 (1933)).

The U.S. Supreme Court has addressed the insurance exemption on two occasions.

Under these cases, factors that are important to a determination of an annuity's status under Section 3(a)(8) include (1) the allocation of investment risk between insurer and purchaser, and (2) the manner in which the annuity is marketed.

VALIC, supra

note 8, 359 U.S. 65;

United Benefit, supra

note 8, 387 U.S. 202.

With regard to investment risk, beginning with

SEC

Variable Annuity Life Ins. Co.

(“

VALIC

”),

the Court has considered whether the risk is borne by the purchaser (tending to indicate that the product is not an exempt “annuity contract”) or by the insurer (tending to indicate that the product falls within the Section 3(a)(8) exemption). In

VALIC,

the Court determined that variable annuities, under which payments varied with the performance of particular investments and which provided no guarantee of fixed income, were not entitled to the Section 3(a)(8) exemption. In

SEC

United Benefit Life Ins. Co.

(“

United Benefit

”),

the Court extended the

VALIC

reasoning, finding that a contract that provides for some assumption of investment risk by the insurer may nonetheless not be entitled to the Section 3(a)(8) exemption. The

United Benefit

insurer guaranteed that the cash value of its variable annuity contract would never be less than 50% of purchase payments made and that, after ten years, the value would be no less than 100% of payments. The Court determined that this contract, under which the insurer did assume some investment risk through minimum guarantees, was not an “annuity contract” under the federal securities laws. In making this determination, the Court concluded that “the assumption of an investment risk cannot by itself create an insurance provision under the federal definition” and distinguished a “contract which to some degree is insured” from a “contract of insurance.”

VALIC, supra

note 8, 359 U.S. at 71-73.

United Benefit, supra

note 8, 387 U.S. at 211.

Id.

at 211.

In analyzing investment risk, Justice Brennan's concurring opinion in VALIC applied a functional analysis to determine whether a new form of investment arrangement that emerges and is labeled “annuity” by its promoters is the sort of arrangement that Congress was willing to leave exclusively to the state insurance commissioners. In that inquiry, the purposes of the federal securities laws and state insurance laws are important. Justice Brennan noted, in particular, that the emphasis in the Securities Act is on disclosure and that the philosophy of the Act is that “full disclosure of the details of the enterprise in which the investor is to put his money should be made so that he can intelligently appraise the risks involved.”

We agree with the concurring opinion's analysis. Where an investor's investment in an annuity is sufficiently protected by the insurer, state insurance law regulation of insurer solvency and the adequacy of reserves are relevant. Where the investor's investment is not sufficiently protected, the disclosure

protections of the Securities Act assume importance.

VALIC, supra

note 8, 359 U.S. at 77.

Marketing is another significant factor in determining whether a state-regulated insurance contract is entitled to the Securities Act “annuity contract” exemption. In

United Benefit,

the U.S. Supreme Court, in holding an annuity to be outside the scope of Section 3(a)(8), found significant the fact that the contract was “considered to appeal to the purchaser not on the usual insurance basis of stability and security but on the prospect of `growth' through sound investment management.”

Under these circumstances, the Court concluded “it is not inappropriate that promoters' offerings be judged as being what they were represented to be.”

United Benefit, supra

note 8, 387 U.S. at 211.

Id.

at 211 (quoting

SEC

Joiner Leasing Corp.,

320 U.S. 344, 352-53 (1943)). For other cases applying a marketing test, see

Berent

Kemper Corp.,

780 F. Supp. 431 (E.D. Mich. 1991), aff'd, 973 F. 2d 1291 (6th Cir. 1992);

Associates in Adolescent Psychiatry

Home Life Ins. Co.,

729 F.Supp. 1162 (N.D. Ill. 1989),

aff'd,

941 F.2d 561 (7th Cir. 1991); and

Grainger

State Security Life Ins. Co.,

547 F.2d 303 (5th Cir. 1977).

In 1986, given the proliferation of annuity contracts commonly known as “guaranteed investment contracts,” the Commission adopted rule 151 under the Securities Act to establish a “safe harbor” for certain annuity contracts that are not deemed subject to the federal securities laws and are entitled to rely on Section 3(a)(8) of the Securities Act.

Under rule 151, an annuity contract issued by a state-regulated insurance company is deemed to be within Section 3(a)(8) of the Securities Act if (1) the insurer assumes the investment risk under the contract in the manner prescribed in the rule; and (2) the contract is not marketed primarily as an investment.

Rule 151 essentially codifies the tests the courts have used to determine whether an annuity contract is entitled to the Section 3(a)(8) exemption, but adds greater specificity with respect to the investment risk test. Under rule 151, an insurer is deemed to assume the investment risk under an annuity contract if, among other things,

17 CFR 230.151; Securities Act Release No. 6645 (May 29, 1986) [51 FR 20254 (June 4, 1986)]. A guaranteed investment contract is a deferred annuity contract under which the insurer pays interest on the purchaser's payments at a guaranteed rate for the term of the contract. In some cases, the insurer also pays discretionary interest in excess of the guaranteed rate.

17 CFR 230.151(a).

(1) The insurer, for the life of the contract,

(a) Guarantees the principal amount of purchase payments and credited interest, less any deduction for sales, administrative, or other expenses or charges; and

(b) Credits a specified interest rate that is at least equal to the minimum rate required by applicable state law; and

(2) The insurer guarantees that the rate of any interest to be credited in excess of the guaranteed minimum rate described in paragraph 1(b) will not be modified more frequently than once per year.

17 CFR 230.151(b) and (c). In addition, the value of the contract may not vary according to the investment experience of a separate account.

Indexed annuities are not entitled to rely on the safe harbor of rule 151 because they fail to satisfy the requirement that the insurer guarantee that the rate of any interest to be credited in excess of the guaranteed minimum rate will not be modified more frequently than once per year.

Some indexed annuities also may fail other aspects of the safe harbor test.

In adopting rule 151, the Commission declined to extend the safe harbor to excess interest rates that are computed pursuant to an indexing formula that is guaranteed for one year. Rather, the Commission determined that it would be appropriate to permit insurers to make limited use of index features, provided that the insurer specifies an index to which it would refer, no more often than annually, to determine the excess interest rate that it would guarantee for the next 12-month or longer period. For example, an insurer would meet this test if it established an “excess” interest rate of 5% by reference to the past performance of an external index and then guaranteed to pay 5% interest for the coming year. Securities Act Release No. 6645,

supra

note 35, 51 FR at 20260. The Commission specifically expressed concern that index feature contracts that adjust the rate of return actually credited on a more frequent basis operate less like a traditional annuity and more like a security and that they shift to the purchaser all of the investment risk regarding fluctuations in that rate.

See infra

note 71 and accompanying text.

III. Discussion of the Amendments

The Commission has determined that providing greater clarity with regard to the status of indexed annuities under the federal securities laws will enhance investor protection, as well as provide greater certainty to the issuers and sellers of these products with respect to their obligations under the federal securities laws. We are adopting a new definition of “annuity contract” that, on a prospective basis, defines a class of indexed annuities that are outside the scope of Section 3(a)(8). With respect to these annuities, investors will be entitled to all the protections of the federal securities laws, including full and fair disclosure and antifraud and sales practice protections. We are also adopting a new exemption under the Exchange Act that applies to insurance companies that issue indexed annuities and certain other securities that are registered under the Securities Act and regulated as insurance under state law. We believe that this exemption is necessary or appropriate in the public interest and consistent with the protection of investors because of the presence of state oversight of insurance company financial condition and the absence of trading interest in these securities.

A. Definition of Annuity Contract

The Commission is adopting new rule 151A, which defines a class of indexed annuities that are not “annuity contracts” or “optional annuity contracts”

for purposes of Section 3(a)(8) of the Securities Act. Although we recognize that these instruments are issued by insurance companies and are treated as annuities under state law, these facts are not conclusive for purposes of the analysis under the federal securities laws.

An “optional annuity contract” is a deferred annuity.

See United Benefit, supra

note 8, 387 U.S. at 204. In a deferred annuity, annuitization begins at a date in the future, after assets in the contract have accumulated over a period of time (normally many years). In contrast, in an immediate annuity, the insurer begins making annuity payments shortly after the purchase payment is made,

i.e.

, within one year.

See

Kenneth Black, Jr., and Harold D. Skipper, Jr.,

Life and Health Insurance,

at 164 (2000).

1. Analysis

“Insurance” and “Annuity”: Federal Terms Under the Federal Securities Laws

Our analysis begins with the well-settled conclusion that the terms “insurance” and “annuity contract” as used in the Securities Act are “federal terms,” the meanings of which are a “federal question” under the federal securities laws.

The Securities Act does not provide a definition of either term, and we have not previously provided a definition that applies to indexed annuities.

Moreover, indexed

annuities did not exist and were not contemplated by Congress when it enacted the insurance exemption.

See VALIC, supra

note 8, 359 U.S. at 69. Although the McCarran-Ferguson Act, 15 U.S.C. 1012(b), provides that “No Act of Congress shall be construed to invalidate, impair or supersede any law enacted by any State for the purpose of regulating the business of insurance,” the United States Supreme Court has stated that the question common to both the federal securities laws and the McCarran-Ferguson Act is whether the instruments are contracts of insurance.

See VALIC, supra

note 8. Thus, where a contract is not an “annuity contract” or “optional annuity contract,” which we have concluded is the case with respect to certain indexed annuities, we do not believe that such contract is “insurance” for purposes of the McCarran-Ferguson Act.

The last time the Commission formally addressed indexed annuities was in 1997. At that time, the Commission issued a concept release requesting public comment regarding indexed insurance contracts. The concept release stated that “depending on the mix of features * * * [an indexed insurance contract] may or may not be entitled to exemption from registration under the Securities Act” and that the Commission was

“considering the status of [indexed annuities and other indexed insurance contracts] under the federal securities laws.”

See

1997 Concept Release,

supra

note 7, at 4-5.

The Commission has previously adopted a safe harbor for certain annuity contracts that are entitled to rely on Section 3(a)(8) of the Securities Act. However, as discussed in Part II.B., indexed annuities are not entitled to rely on the safe harbor.

We therefore analyze indexed annuities under the facts and circumstances factors articulated by the U.S. Supreme Court in

VALIC

and

United Benefit.

In particular, we focus on whether these instruments are “the sort of investment form that Congress was * * * willing to leave exclusively to the State Insurance Commissioners” and whether they necessitate the “regulatory and protective purposes” of the Securities Act.

See VALIC, supra

note 8, 359 U.S. at 75 (Brennan, J., concurring) (“* * * if a brand-new form of investment arrangement emerges which is labeled ‘insurance’ or ‘annuity’ by its promoters, the functional distinction that Congress set up in 1933 and 1940 must be examined to test whether the contract falls within the sort of investment form that Congress was then willing to leave exclusively to the State Insurance Commissioners. In that inquiry, an analysis of the regulatory and protective purposes of the Federal Acts and of state insurance regulation as it then existed becomes relevant.”).

Type of Investment

We believe that the indexed annuities that will be included in our definition are not the sort of investment that Congress contemplated leaving exclusively to state insurance regulation. According to the U.S. Supreme Court, Congress intended to include in the insurance exemption only those policies and contracts that include a “true underwriting of risks” and “investment risk-taking” by the insurer.

Moreover, the level of risk assumption necessary for a contract to be “insurance” under the Securities Act must be meaningful—the assumption of an investment risk does not “by itself create an insurance provision under the federal definition.”

Id.

at 71-73.

See United Benefit, supra

note 8, 387 U.S. at 211 (“[T]he assumption of investment risk cannot by itself create an insurance provision. * * * The basic difference between a contract which to some degree is insured and a contract of insurance must be recognized.”).

The annuities that “traditionally and customarily” were offered at the time Congress enacted the insurance exemption were fixed annuities that typically involved no investment risk to the purchaser.

These contracts offered the purchaser “specified and definite amounts beginning with a certain year of his or her life,” and the “standards for investments of funds” by the insurer under these contracts were “conservative.”

Moreover, these types of annuity contracts were part of a “concept which had taken on its coloration and meaning largely from state law, from state practice, from state usage.”

Thus, Congress exempted these instruments from the requirements of the federal securities laws because they were a “form of ‘investment' * * * which did not present very squarely the problems that [the federal securities laws] were devised to deal with,” and were “subject to a form of state regulation of a sort which made the federal regulation even less relevant.”

See VALIC, supra

note 8, 359 U.S. at 69.

Id.

(“While all the States regulate `annuities' under their `insurance' laws, traditionally and customarily they have been fixed annuities, offering the annuitant specified and definite amounts beginning with a certain year of his or her life. The standards for investment of funds underlying these annuities have been conservative.”).

Id.

(“Congress was legislating concerning a concept which had taken on its coloration and meaning largely from state law, from state practice, from state usage.”).

Id.

at 75 (Brennan, J., concurring).

In contrast, when the amounts payable by an insurer under an indexed annuity contract are more likely than not to exceed the amounts guaranteed under the contract, the purchaser assumes substantially different risks and benefits. Notably, at the time that such a contract is purchased, the risk for the unknown, unspecified, and fluctuating securities-linked portion of the return is primarily assumed by the purchaser.

By purchasing this type of indexed annuity, the purchaser assumes the risk of an uncertain and fluctuating financial instrument, in exchange for participation in future securities-linked returns. The value of such an indexed annuity reflects the benefits and risks inherent in the securities market, and the contract's value depends upon the trajectory of that same market. Thus, the purchaser obtains an instrument that, by its very terms, depends on market volatility and risk.

Such indexed annuity contracts provide some protection against the risk of loss, but these provisions do not, “by [themselves,] create an insurance provision under the federal definition.”

Rather, these provisions reduce—but do

not eliminate

—a purchaser's exposure to investment risk under the contract. These contracts may to some degree be insured, but that degree may be too small to make the indexed annuity a contract of insurance.

See United Benefit, supra

note 8, 387 U.S. at 211 (finding that while a “guarantee of cash value” provided by an insurer to purchasers of a deferred annuity plan reduced “substantially the investment risk of the contract holder, the assumption of investment risk cannot by itself create an insurance provision under the federal definition.”).

Id.

at 211 (“The basic difference between a contract which to some degree is insured and a contract of insurance must be recognized.”).

Thus, the protections provided by indexed annuities may not adequately transfer investment risk from the purchaser to the insurer when amounts payable by an insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract. Purchasers of these annuities assume the investment risk for investments that are more likely than not to fluctuate and move with the securities markets. The value of the purchaser's investment is more likely than not to depend on movements in the underlying securities index. The protections offered in these indexed annuities may give the instruments an aspect of insurance, but we do not believe that these protections are substantial enough.

See VALIC, supra

note 8, 359 U.S. at 71 (finding that although the insurer's assumption of a traditional insurance risk gives variable annuities an “aspect of insurance,” this is “apparent, not real; superficial, not substantial.”).

Need for the Regulatory Protections of the Federal Securities Acts

We also analyze indexed annuities to determine whether they implicate the regulatory and protective purposes of the federal securities laws. Based on that analysis, we believe that the indexed annuities that are included in the definition that we are adopting present many of the concerns that Congress intended the federal securities laws to address.

Indexed annuities are similar in many ways to mutual funds, variable annuities, and other securities. Although these contracts contain certain features that are typical of insurance contracts,

they also may contain “to a very substantial degree elements of investment contracts.”

Indexed annuities are attractive to purchasers precisely because they offer participation in the securities markets. However, indexed annuities historically have not been registered with us as securities. Insurers have treated these

annuities as subject only to state insurance laws.

The presence of protection against loss does not, in itself, transform a security into an insurance or annuity contract. Like indexed annuities, variable annuities typically provide some protection against the risk of loss, but are registered as securities. Historically, variable annuity contracts have typically provided a minimum death benefit at least equal to the greater of contract value or purchase payments less any withdrawals. More recently, many contracts have offered benefits that protect against downside market risk during the purchaser's lifetime.

VALIC, supra

note 8, 359 U.S. at 91 (Brennan, J., concurring).

There is a strong federal interest in providing investors with disclosure, antifraud, and sales practice protections when they are purchasing annuities that are likely to expose them to market volatility and risk. We believe that individuals who purchase indexed annuities that are more likely than not to provide payments that vary with the performance of securities are exposed to significant investment risks. They are confronted with many of the same risks and benefits that other securities investors are confronted with when making investment decisions. Moreover, they are more likely than not to experience market volatility because they are more likely than not to receive payments that vary with the performance of securities.

We believe that the regulatory objectives that Congress was attempting to achieve when it enacted the Securities Act are present when the amounts payable by an insurer under an indexed annuity contract are more likely than not to exceed the guaranteed amounts. Therefore, we are adopting a rule that will define such contracts as falling outside the insurance exemption.

2. Commenters' Concerns Regarding Commission's Analysis

Many commenters raised significant concerns regarding the Commission's analysis of indexed annuities under Section 3(a)(8). Commenters argued that the Commission's analysis is inconsistent with applicable legal precedent, particularly the

VALIC

and

United Benefit

cases. Specifically, the commenters argued that the purchaser of an indexed annuity does not assume investment risk in the sense contemplated by applicable precedent, that the Commission failed to take into account the investment risk assumed by the insurer, and that the Commission's analysis ignored the factors of marketing and mortality risk which have been articulated in applicable precedents. In addition, commenters questioned the need for federal securities regulation of indexed annuities, arguing that there is no evidence of widespread sales practice abuse in the indexed annuity marketplace, that state insurance regulators are effective in protecting purchasers of indexed annuities, and that the Commission's disclosure requirements would not result in enhanced information flow to purchasers of indexed annuities. We disagree with each of these assertions for the reasons outlined below.

Commission's Analysis is Consistent With Applicable Precedents

We disagree with commenters who argued that the Commission's analysis is inconsistent with applicable legal precedents, particularly the

VALIC

and United Benefit cases.

These commenters asserted, first, that because of guarantees of principal and minimum interest, the purchaser of an indexed annuity does not assume investment risk in the sense contemplated by applicable precedent which, in their view, is the risk of loss of principal. Second, the commenters argued that the Commission's analysis failed to take into account the investment risk assumed by the insurer, including the risk associated with guaranteeing principal and a minimum interest rate and with guaranteeing in advance the formula for determining index-linked return. Third, commenters argued that the Commission's analysis is inconsistent with precedent because it does not take into account the manner in which indexed annuities are marketed.

Fourth, commenters faulted the Commission's analysis for ignoring mortality risk.

See,

e.g.

, Letter of Advantage Group Associates, Inc. (Nov. 16, 2008) (“Advantage Group Letter”); Letter of Allianz Life Insurance Company of North America (Sept. 10, 2008) (“Allianz Letter”); Letter of American Academy of Actuaries (Sept. 10, 2008) (“Academy Letter”); Letter of American Academy of Actuaries (Nov. 17, 2008) (“Second Academy Letter”); Letter of American Equity Investment Life Holding Company (Sept. 10, 2008) (“American Equity Letter”); Letter of American National Insurance Company (Sept. 10. 2008) (“American National Letter”); Letter of Aviva USA Corporation (Sept. 10, 2008) (“Aviva Letter”); Letter of Aviva USA Corporation (Nov. 17, 2008) (“Second Aviva Letter”); Letter of Coalition for Indexed Products (Sept. 10, 2008) (“Coalition Letter”); Letter of Committee of Annuity Insurers regarding proposed rule 151A (Sept. 10, 2008) (“CAI 151A Letter”); Letter of Lafayette Life Insurance Company (Sept. 10, 2008) (“Lafayette Letter”); Letter of Maryland Insurance Administration (Sept. 9, 2008) (“Maryland Letter”); Letter of the Officers of the National Association of Insurance Commissioners (Sept. 10, 2008) (“NAIC Officer Letter”); Letter of National Association for Fixed Annuities (Sept. 10, 2008) (“NAFA Letter”); Letter of National Association of Insurance and Financial Advisers (Sept. 10, 2008) (“NAIFA Letter”); Letter of National Conference of Insurance Legislators (Nov. 25, 2008) (“NCOIL Letter”); Letter of National Western Life Insurance Company (Sept. 10, 2008) (“National Western Letter”); Letter of Old Mutual Financial Network (Sept. 10, 2008) (“Old Mutual Letter”); Letter of Sammons Annuity Group (Sept. 10, 2008) (“Sammons Letter”); Letter of Transamerica Life Insurance Company (Sept. 10, 2008) (“Transamerica Letter”); Letter of Transamerica Life Insurance Company (Nov. 17, 2008) (“Second Transamerica Letter”).

Other commenters, however, supported the Commission's interpretation of Section 3(a)(8) and applicable legal precedents.

See,

e.g.

, ICI Letter,

supra

note 7; Letter of K&L Gates on behalf of AXA Equitable Life Insurance Company, Hartford Financial Services Group, Inc., Massachusetts Mutual Life Insurance Company, MetLife, Inc., and New York Life Insurance Company (Oct. 7, 2008) (“K&L Gates Letter”).

See,

e.g.

, Coalition Letter,

supra

note 54; Letter of The Hartford Financial Services Group, Inc. (Sept. 10, 2008) (“Hartford Letter”); NAFA Letter,

supra

note 54.

See,

e.g.

, CAI 151A Letter,

supra

note 54; Old Mutual Letter,

supra

note 54; Sammons Letter,

supra

note 54.

Our investment risk analysis is an application of the Court's reasoning in the

VALIC

and

United Benefit

cases, and rule 151A applies that analysis with a specific test to determine the status under the federal securities laws of indexed annuities. Indexed annuities are a relatively new product and are different from the securities considered in those cases. These very differences have resulted in the uncertain legal status of indexed annuities from their introduction in the mid-1990s. Like the contract at issue in

United Benefit

, indexed annuities present a new case that requires us to determine whether “a contract which to some degree is insured” constitutes a “contract of insurance” for purposes of the federal securities laws.

Indexed annuities offer to purchasers a financial instrument with uncertain and fluctuating returns that are, in part, securities-linked. We believe that whether such an instrument is a security hinges on the likelihood that the purchaser's return will, in fact, be based on the returns of a securities index. In cases where the amounts payable by an insurer under an indexed annuity contract are more likely than not to exceed the amounts guaranteed under the contract, the amount the purchaser receives will be dependent on market returns and will vary because of investment risk. In such a case, we have concluded that, on a prospective basis, the indexed annuity is not entitled to rely on the Section 3(a)(8) exemption. Though the contract may to some degree be insured, it is not a contract of insurance because of the substantial investment risk assumed by the purchaser.

See United Benefit, supra

note 8, 387 U.S. at 211 (“The basic difference between a contract which to some degree is insured and a contract of insurance must be recognized.”).

A number of commenters equated investment risk with the risk of loss of principal for purposes of analysis under Section 3(a)(8) and argued that, because of guarantees of principal and minimum interest, the purchaser of an indexed annuity does not assume investment risk. We disagree. While the potential for loss of principal was important in the

VALIC

and

United Benefit

cases and helpful in analyzing the particular products at issue in those cases, it is by

no means the only type of investment risk. Defining risk only as the possibility of principal loss or an approximate equivalent, as suggested by commenters, fails to account for important forms of risk and leads to conclusions inconsistent with the contemporary understanding of investment risk. Such a limited definition of risk would thus be incomplete.

One widely accepted definition of “risk” in financial instruments is the degree to which returns deviate from their statistical expectation.

Accordingly, even investments guaranteeing a positive minimum return over long investment horizons, such as indexed annuities, may have returns that meaningfully and unpredictably deviate from the expected return and therefore have investment risk under this definition.

Zvi Bodie, Alex Kane and Alan J. Marcus,

Investments

, at 143 (2005) (“The standard deviation of the rate of return is a measure of risk.”).

For example, accepting the definition of risk suggested by commenters as a complete characterization of risk would lead to the conclusion that any two assets that both guarantee return of principal equally have no risk. However, we believe that the market would generally view an asset where the future payoff of the amount over the guaranteed principal return is uncertain to be more risky than a zero-coupon U.S. government bond maturing at the same date, which also guarantees principal return but has a nearly certain future payoff. Defining risk as the potential for loss of principal, or principal plus some minimal amount, misses important aspects of risk as commonly understood. While U.S. government bonds are commonly accepted as the standard benchmark of a nominally risk-free rate of return because their returns are considered to be nearly certain at specific horizons, the definition suggested by commenters fails to distinguish between these risk-free assets and assets that are protected against principal loss but that have uncertain payoffs above the guaranteed principal return.

Zvi Bodie, Alex Kane and Alan J. Marcus,

Investments

, at 144 (2005).

Additionally, under the definition of risk suggested by the commenters, most assets with positive expected returns would appear to have little to no risk over long horizons. As an example, using reasonable assumptions it can be estimated that a value-weighted portfolio of New York Stock Exchange (“NYSE”) stocks has approximately a 6% chance of returning less than principal in 10 years, and approximately a 1% chance of returning less than principal in 20 years.

Despite these relatively low probabilities of losing principal over long periods of time, we believe that it is generally understood that market participants, even those with long investment horizons, bear meaningful investment risk when investing in such a diversified portfolio of stocks. Indeed, investors generally consider modest long-term returns, even if greater than 0% or some minimal rate, to be undesirable outcomes when the expected return was substantially greater. We therefore believe that the commenters' suggestion that such a portfolio is without risk is at odds both with the commonly accepted meaning of the term as well as with the definition of risk generally accepted by financial economists.

Our Office of Economic Analysis conducted a simulation, in which annual returns from the Center for Research in Security Prices (“CRSP”) capitalization-weighted NYSE index, annually rebalanced, from 1926 through 2007, are drawn randomly and aggregated (a bootstrap procedure). This procedure replicates the observed mean, standard deviation, skewness, kurtosis, and other observed moments of returns, but assumes that returns are intertemporally independent. Realized 10-year returns in this period are negative 4% of the time, and there have been no 20-year negative returns.

The purchaser of an indexed annuity assumes investment risk because his or her return is not known in advance and therefore varies from its expected value. When the amounts payable to the purchaser are more likely than not to exceed the guaranteed amounts, the investment risk assumed by the purchaser of an indexed annuity is substantial, and we believe that the contract should not be treated as an “annuity contract” for purposes of the federal securities laws. We also note that indexed annuities are not, in fact, without the risk of principal loss. An indexed annuity purchaser who surrenders the contract during the surrender charge period, which for some indexed annuities may be in excess of 15 years, may receive less than his or her original principal. Unlike a purchaser of a fixed annuity, a purchaser of an indexed annuity is dependent on favorable securities market returns to overcome the impact of the surrender charge and create a positive return rather than a loss.

We also disagree with commenters who argued that the Commission's analysis failed to take into account the investment risk assumed by the insurer, including the risk associated with guaranteeing principal and a minimum interest rate and with guaranteeing in advance the formula for determining securities-linked return. We agree with commenters that, in analyzing the status of indexed annuities under the federal securities laws, it is important to take into account the relative significance of the risks assumed by the insurer and the purchaser. In our analysis, the Commission does not ignore the risk assumed by the insurer as the commenters suggest. In fact, the rule, as proposed and adopted, specifically contemplates different outcomes based on the relative risks assumed by the insurer and purchaser. When the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed, the contract loses the insurance exemption under rule 151A.

Unlike a traditional fixed annuity where the investment risk for the contract is assumed by the insurer, or a traditional variable annuity where the investment risk for the contract is assumed by the purchaser, the very mixed nature of indexed annuities led the Commission to carefully consider the relative risks assumed by both parties to the contract. The fact that the rule does not define all indexed annuities as outside Section 3(a)(8), but rather sets forth a test for analyzing these contracts, reflects the Commission's understanding that the status of these contracts under the federal securities laws hinges on the allocation of risk between both the insurer and the purchaser. Specifically, the rule recognizes that where the insurer is more likely than not to pay an amount that is fixed and guaranteed by the insurer, significant investment risks are assumed by the insurer and such a contract may therefore be entitled to the Section 3(a)(8) exemption. Conversely, where the purchaser is more likely than not to receive an amount that is variable and dependent on fluctuations and movements in the securities markets, rule 151A recognizes the significant investment risks assumed by the purchaser and specifies that such a contract would not be considered to fall within Section 3(a)(8). Moreover, both the guaranteed interest rate within an indexed annuity and the formula for crediting interest are typically reset on an annual basis. This provides insurers with a number of ways to reduce or eliminate their investment risks, including hedging market risk through the purchase of options or other derivatives and adjusting guarantees downwards in subsequent years to offset losses in earlier years of a contract. For purposes of analysis under Section 3(a)(8), we do not consider these investment risks to be comparable to

those of the indexed annuity purchaser, who bears the risk of a fluctuating and uncertain return based on the performance of a securities index.

Some commenters argued that the Commission's investment risk analysis is inconsistent with its own position in the Brief for the United States as Amicus Curiae in

Variable Annuity Life Insurance Company

et al.

Otto

(“

VALIC

Otto

”).

That matter involved an annuity in which the insurer guaranteed principal and a minimum rate of interest and also could, in its discretion, credit excess interest above the guaranteed rate. The Commission argued that by guaranteeing principal and an adequate fixed rate of interest, and guaranteeing payment of all discretionary excess interest declared under the contract, the insurer assumed sufficient investment risk under the contract for it to fall within Section 3(a)(8), notwithstanding the assumption of the risk by the contract owner that the excess interest rate could be reduced or eliminated at the insurer's discretion.

Brief for the United States as Amicus Curiae on Petition for a Writ of Certiorari to the United States Court of Appeals for the Seventh Circuit,

VALIC

Otto

, No. 87-600, October Term, 1987.

See

e.g.

, Aviva Letter,

supra

note 54; CAI 151A Letter,

supra

note 54; Coalition Letter,

supra

note 54; NAFA Letter,

supra

note 54.

We agree with commenters that our analysis is different from the position taken by the Commission in the

VALIC

Otto

brief. However, this results from the fact that indexed annuity contracts are different from the contracts considered in

VALIC

Otto

. Unlike the contracts in that case, which were annuity contracts that provided for wholly discretionary payment of excess interest, indexed annuities contractually specify that excess interest will be calculated by reference to a securities index. As a result, the purchaser of an indexed annuity is contractually bound to assume the investment risk for the fluctuations and movements in the underlying securities index. The contract in

VALIC

Otto

did not impose this securities-linked investment risk on the purchaser. Moreover, we note that the Supreme Court did not grant certiorari in

VALIC

Otto

. The final opinion in the case was rendered by the Seventh Circuit and was to the effect that, as a result of the insurer's discretion to declare excess interest under the contract, the insurer's guarantees were not sufficient to exempt the contract from the federal securities laws. Thus, the Commission's position in the case was not adopted by either the Seventh Circuit or the Supreme Court. We believe that the position articulated in the

VALIC

Otto

brief is not relevant in the context of indexed annuities and, to the extent that the brief may imply otherwise, the position taken in the brief does not reflect the Commission's current position. Where the contractual return paid by an insurer under an annuity contract is retroactively determined based, in whole or in part, on the returns of a security in a prior period, we do not believe that fact—and the investment risk that it entails—can be ignored in determining whether the contract is an “annuity contract” that is entitled to the Section 3(a)(8) exemption.

Though rule 151A does not explicitly incorporate a marketing factor, we disagree with commenters who argued that the Commission's analysis is inconsistent with precedent, because it does not take into account the manner in which indexed annuities are marketed.

The very nature of an indexed annuity, where return is contractually linked to the return on a securities index, is, to a very substantial extent, designed to appeal to purchasers on the prospect of investment growth.

This is particularly true in the case of indexed annuities that rule 151A defines as not “annuity contracts”—

i.e.

, indexed annuities where the purchaser is more likely than not to receive securities-linked returns. It would be inconsistent with the character of such an indexed annuity, and potentially misleading, to market the annuity without placing significant emphasis on the securities-linked return and the related risks. We disagree with commenters who argued that purchasers do not buy indexed annuities on the basis of the prospect for investment growth, but rather on the basis of guarantees and stability of principal.

We agree with commenters that purchasers of indexed annuities, just like purchasers of variable annuities, have a blend of reasons for their purchase, including product guarantees and tax deferral.

However, we also believe that purchasers who are uninterested in the growth offered by securities-linked returns would opt for higher fixed returns in lieu of the lower fixed returns, coupled with the prospect of securities-linked growth, offered by indexed annuities. Indeed, data submitted by one indexed annuity issuer confirm that almost half (46.60%) of its 2008 indexed annuity purchasers identify the prospect for growth as a reason for their purchase.

Just as with variable annuities, the fact that indexed annuities appeal to purchasers for a variety of reasons does not detract from the significant appeal of securities-linked growth. Accordingly, we have concluded that, in light of the nature of indexed annuities, it is unnecessary to include a separate marketing factor within rule 151A. The Supreme Court did not address marketing in

VALIC

. Similarly, we have concluded that a separate marketing analysis is unnecessary in the case of indexed annuities that are addressed by rule 151A.

See

e.g.

, Coalition Letter,

supra

note 54; NAFA Letter,

supra

note 54; Old Mutual Letter,

supra

note 54; Sammons Letter,

supra

note 54.

See

e.g.

, K&L Gates Letter,

supra

note 54.

But see

Letter of National Western Life Insurance Company (Nov. 17, 2008) (“Second National Western Letter”) (criticizing the K&L Gates position).

See

e.g.

, Allianz Letter,

supra

note 54; American Equity Letter,

supra

note 54; Coalition Letter,

supra

note 54.

See

e.g.

, Allianz Letter,

supra

note 54 (55.45% purchased indexed annuities because of guarantees and 54.88% because of tax deferral).

See

Allianz Letter,

supra

note 54.

But see

Coalition Letter,

supra

note 54 (sampling by some indexed annuity issuers reveals that a large majority of purchasers acquire fixed annuities for stability of premiums). We are not able to ascertain from the statement in the Coalition Letter the degree to which purchasers identified growth as a goal as the letter addressed only stability of premiums.

Nor do we agree with commenters who argued that the Commission's analysis departs from precedent in that it does not take into account mortality risk.

In both

VALIC

and

United Benefit

, the Supreme Court found the investment risk test to be determinative (together with the marketing test in the case of United Benefit) that an insurance contract was not entitled to the Section 3(a)(8) exemption. While the Commission has stated, and we continue to believe, that the presence or absence of assumption of mortality risk may be an appropriate factor to consider in a Section 3(a)(8) analysis,

we do not believe that it should be given undue weight in determining the status of a contract under the federal securities laws, where it is clear from the nature of the investment risk that the contract is not an “annuity contract” for securities law purposes. We have concluded that this is the case for an indexed annuity where the amounts payable by the insurance company under the contract are more likely than not to exceed the amounts guaranteed under the contract.

See

e.g.

, CAI 151A Letter,

supra

note 54; Old Mutual Letter,

supra

note 54; Sammons Letter,

supra

note 54.

Securities Act Release No. 6645,

supra

note 35.

Some commenters criticized the Commission for failing to adequately address a federal district court decision,

Malone

Addison Ins. Marketing, Inc.

(“

Malone

”),

where the court

determined that a particular indexed annuity was entitled to rely on Section 3(a)(8).

We disagree with the

Malone

court's analysis of investment risk, which, we believe, understated the investment risk to the purchaser of an indexed annuity from the fluctuating and uncertain securities-linked return and therefore is inconsistent with applicable legal precedent. We also disagree with the court's interpretation of the Commission's rule 151 safe harbor, which does not apply to indexed annuities. As we discussed in the proposing release, in that case, the district court concluded that the contracts at issue fell within the Commission's rule 151 safe harbor notwithstanding the fact that they apparently did not meet the test articulated by the Commission in adopting rule 151,

i.e.

, specifying an index that would be used to determine a rate that would remain in effect for at least one year.

Instead, the contracts appear to have guaranteed the index-based formula, but not, as required by rule 151, the actual rate of interest.

225 F.Supp. 2d 743 (W.D. Ky. 2002).

See,

e.g.

, Coalition Letter,

supra

note 54; NAFA Letter,

supra

note 54; Sammons Letter,

supra

note 54.

See supra

note 38.

Need for Federal Securities Regulation

Some commenters agreed that federal securities regulation is needed with respect to indexed annuities.

Other commenters questioned the need for federal securities regulation of indexed annuities, and we disagree with those commenters. These commenters argued, first, that there is no evidence of widespread sales practice abuse in the indexed annuity marketplace, which would suggest a need for federal securities regulation.

Second, commenters argued that state insurance regulators are effective in protecting purchasers of indexed annuities.

Third, commenters argued that the Commission's disclosure requirements would not result in enhanced information flow to purchasers of indexed annuities.

See,

e.g.

, Letter of Joseph P. Borg, Director, Alabama Securities Commission (Aug. 5, 2008) (“Alabama Letter”); Cornell Letter,

supra

note 7; Letter of Financial Planning Association (Sept. 10, 2008) (“FPA Letter”); FINRA Letter,

supra

note 7; Hartford Letter,

supra

note 55; ICI Letter,

supra

note 7; Letter of Max Maxfield, Secretary of State, State of Wyoming (Sept. 9, 2008) (“Wyoming Letter”).

See,

e.g.

, American Equity Letter,

supra

note 54; Coalition Letter,

supra

note 54; Letter of FBL Financial Group (Sept. 8, 2008) (“FBL Letter”); Lafayette Letter,

supra

note 54; Maryland Letter,

supra

note 54; NAIFA Letter,

supra

note 54; Sammons Letter,

supra

note 54.

See,

e.g.

, Allianz Letter,

supra

note 54; Academy Letter,

supra

note 54; Letter of American Bankers Insurance Association (Sept. 10, 2008) (“American Bankers Letter”); American Equity Letter,

supra

note 54; American National Letter,

supra

note 54; Aviva Letter,

supra

note 54; Coalition Letter,

supra

note 54; Letter of Connecticut Insurance Commissioner (Aug. 25, 2008) (“Connecticut Letter”); Letter of Iowa Insurance Commissioner (Sept. 10, 2008) (“Iowa Letter”); Maryland Letter,

supra

note 54; NAFA Letter,

supra

note 54; NAIC Officer Letter,

supra

note 54; NAIFA Letter,

supra

note 54; National Western Letter,

supra

note 54; Old Mutual Letter,

supra

note 54; Sammons Letter,

supra

note 54; Transamerica Letter,

supra

note 54.

See,

e.g.

, Allianz Letter,

supra

note 54; Aviva Letter,

supra

note 54.

We believe that the commenters who argued that regulation of indexed annuities under the federal securities laws is unnecessary because there is no evidence of widespread sales abuse misunderstand the exemption under Section 3(a)(8) of the Securities Act as well as our purpose in proposing, and now adopting, rule 151A. Some of these commenters cited data that they argued demonstrated that the incidence of abuse in the indexed annuity marketplace is low.

Some of these commenters argued that the proposing release failed to present persuasive evidence of sales practice abuse.

See,

e.g.

, Advantage Group Letter,

supra

note 54; American Equity Letter,

supra

note 54; Maryland Letter,

supra

note 54; NAIFA Letter,

supra

note 54; Letter of Old Mutual Financial Network (Nov. 12, 2008) (“Second Old Mutual Letter”); Letter Type A (“Letter A”); Letter Type E (“Letter E”). “Letter Type” refers to a form letter submitted by multiple commenters, which is listed on the Commission's Web site

(http://www.sec.gov/comments/s7-14-08/s71408.shtml)

as a single comment, with a notation of the number of letters received by the Commission matching that form type.

See,

e.g.

, American Equity Letter,

supra

note 54; FBL Letter

supra

note 73; Maryland Letter,

supra

note 54; NAIFA Letter,

supra

note 54; Old Mutual Letter,

supra

note 54; Sammons Letter,

supra

note 54; Second National Western Letter,

supra

note 63.

A vital aspect of the Commission's mission is investor protection. As a result, reports of sales practice abuses surrounding a product, indexed annuities, whose status has long been unresolved under the federal securities laws, are a matter of grave concern to us. However, the presence or absence of sales practice abuses is irrelevant in determining whether an annuity contract is entitled to the exemption from federal securities regulation under Section 3(a)(8) of the Securities Act. Where an annuity contract is entitled to the Section 3(a)(8) exemption, the federal securities laws do not apply, and purchasers are not entitled to their protections, regardless of whether sales practice abuses may be pervasive. Where, however, an annuity contract is not entitled to the Section 3(a)(8) exemption, which we have concluded is the case with respect to certain indexed annuities, Congress intended that the federal securities laws apply, and purchasers are entitled to the disclosure and suitability protections under those laws without regard to whether there is a single documented incident of abuse.

This view is consistent with applicable precedent which makes clear that the necessity for federal regulation arises from the characteristics of the financial instrument itself. This has been the approach of the United States Supreme Court in the two leading precedents. In those cases, the Court made a realistic judgment about the point at which a contract between a purchaser and an insurance company tips from being the sole concern of state regulators of insurance to also become the concern of the federal securities laws.

The

United Benefit

Court observed that the products at issue in that case were “considered to appeal to the purchaser not on the usual insurance basis of stability and security but on the prospect of ‘growth' through sound investment management.”

They were “pitched to the same consumer interest in growth through professionally managed investment,” and, as a result, the Court concluded that it seemed “eminently fair that a purchaser of such a plan be afforded the same advantages of disclosure which inure to a mutual fund purchaser under Section 5 of the Securities Act.”

United Benefit, supra

note 8, 387 U.S. at 211.

Id.

The

United Benefit

decision picked up and extended a theme previously discussed in Justice Brennan's concurring opinion in

VALIC.

Justice Brennan examined the differing nature of state regulation of insurance and federal regulation of the securities markets. He looked at the nature of the obligation the insurer assumed and its connection to the regulation of investment policy. He concluded that there came a point when the “contract between the investor and the organization no longer squares with the sort of contract in regard to which Congress in 1933 thought its `disclosure' statute was unnecessary.”

VALIC, supra

note 8, 359 U.S. at 72.

It is precisely this realistic judgment about identifying the appropriate circumstances in which to apply the disclosure and other regulatory protections of the federal securities laws that rule 151A makes. That is why the rule adopts the principle that an indexed annuity providing for a combination of minimum guaranteed payments plus a potentially higher payment dependent on the performance of a securities index does not qualify for the insurance exclusion in Section

3(a)(8) when the amounts payable by the insurer under the contact are more likely than not to exceed the amounts guaranteed under the contract.

Our intent in adopting rule 151A is to clarify the status of indexed annuities under the federal securities laws, so that purchasers of these products receive the protections to which they are entitled by federal law and so that issuers and sellers of these products are not subject to uncertainty and litigation risk with respect to the laws that are applicable. We expect that clarity will enhance investor protection in the future, and indeed will help prevent future sales practice abuses, but rule 151A is not based on the perception that there are widespread sales abuses in the indexed annuity marketplace. Rather, the rule is intended to address an uncertain area of the law, which, because of the growth of the indexed annuity market and allegations of sales practice abuses, has become of pressing importance.

A number of commenters cited efforts by state insurance regulators to address disclosure and sales practice concerns with respect to indexed annuities as evidence that federal securities regulation is unnecessary and could result in duplicative or overlapping regulation.

Commenters argued that state regulation extends beyond overseeing solvency and adequacy of the insurers' reserves, and that it is also addressed to investor protection issues such as suitability and disclosure.

Commenters cited, in particular, the NAIC Suitability in Annuity Transactions Model Regulation,

which has been adopted in 35 states,

and its adoption by the majority of states as evidence that states are addressing suitability concerns in connection with indexed annuity sales.

Commenters also noted that a number of states have adopted the NAIC Annuity Disclosure Model Regulation,

which has been adopted in 22 states and which requires delivery of certain disclosure documents regarding indexed annuity contracts.

Commenters also cited the existence of state market conduct examinations, the use of state enforcement and investigative authority, and licensing and education requirements applicable to insurance agents who sell indexed annuities.

See,

e.g.

, Allianz Letter,

supra

note 54; American Bankers Letter,

supra

note 74; American Equity Letter,

supra

note 54; FBL Letter

supra

note 73; Maryland Letter,

supra

note 54; NAFA Letter,

supra

note 54; Letter of National Association of Health Underwriters (Sept. 10, 2008) (“Health Underwriters Letter”); National Western Letter,

supra

note 54; Letter of Vermont Department of Banking, Insurance, Securities and Health Care Administration (Nov. 17, 2008).

See,

e.g.

, Allianz Letter,

supra

note 54; American Equity Letter,

supra

note 54; Aviva Letter,

supra

note 54; Coalition Letter,

supra

note 54; Maryland Letter,

supra

note 54; NAFA Letter,

supra

note 54; NAIFA Letter,

supra

note 54; National Western Letter,

supra

note 54; Old Mutual Letter,

supra

note 54; Sammons Letter,

supra

note 54.

NAIC Suitability in Annuity Transactions Model Regulation (Model 275-1) (2003).

National Association of Insurance Commissioners, Draft Model Summaries, available at:

http://www.naic.org/committees_models.htm.

See,

e.g.

, Letter A,

supra

note 76; American Bankers Letter,

supra

note 74; CAI 151A Letter,

supra

note 54; NAFA Letter,

supra

note 54; NAIC Officer Letter,

supra

note 54; NAIFA Letter,

supra

note 54.

NAIC Annuity Disclorues Model Regulation (Model 245-1) (1998).

See,

e.g.

, Aviva Letter,

supra

note 54; CAI 151A Letter,

supra

note 54; NAFA Letter,

supra

note 54; NAIC Officer Letter,

supra

note 54; NAIFA Letter,

supra

note 54.

See,

e.g.

, American Equity Letter,

supra

note 54; Aviva Letter,

supra

note 54; Coalition Letter,

supra

note 54; Maryland Letter,

supra

note 54; NAIC Officer Letter,

supra

note 54; NAFA Letter,

supra

note 54.

Commenters described a number of recent and ongoing efforts by state insurance regulators. Some commenters cited efforts being undertaken by individual states. For example, commenters cited an Iowa regulation which recently became effective requiring that agents receive indexed product training approved by the Iowa Insurance Division before they can sell indexed annuity products.

In addition, commenters stated that Iowa has partnered with the American Council of Life Insurers (“ACLI”) to operate a one-year pilot project with some ACLI members using templates developed for disclosure regarding indexed annuities, with the goal of assuring uniformity among insurers in the preparation of disclosure documents.

Commenters also noted recent efforts by state regulators addressed to annuities generally, such as the creation of NAIC working groups to review and consider possible improvements to the NAIC Suitability in Annuity Transactions Model Regulation and the NAIC Annuity Disclosure Model Regulation.

See,

e.g.

, Aviva Letter,

supra

note 54; Iowa Letter,

supra

note 74; NAIC Officer Letter,

supra

note 54.

See,

e.g.

, Iowa Letter,

supra

note 74; NAIC Officer Letter,

supra

note 54.

See,

e.g.

, NAIC Officer Letter,

supra

note 54.

We applaud the efforts in recent years of state insurance regulators to address sales practice complaints that have arisen with respect to indexed annuities, and it is not our intention to question the effectiveness of state regulation. Nonetheless, we do not believe that the states' regulatory efforts, no matter how strong, can substitute for our responsibility to identify securities covered by the federal securities laws and the protections Congress intended to apply. State insurance laws, enforced by multiple regulators whose primary charge is the solvency of the issuing insurance company, cannot serve as an adequate substitute for uniform, enforceable investor protections provided by the federal securities laws. Indeed, at least one state insurance regulator acknowledged the developmental nature of state efforts and the lack of uniformity in those efforts.

Where the purchaser of an indexed annuity assumes the investment risk of an instrument that fluctuates with the securities markets, and the contract therefore does not fall within the Section 3(a)(8) exemption, the application of state insurance regulation, no matter how effective, is not determinative as to whether the contract is subject to the federal securities laws.

See

Voss Letter,

supra

note 13 (proposing to accelerate NAIC efforts to strengthen the NAIC model laws affecting indexed annuity products and urge adoption by more of the member states).

Some commenters also cited voluntary measures taken by insurance companies, such as suitability reviews and the provision of plain English disclosures, as a reason why federal securities regulation of indexed annuities is unnecessary.

While these voluntary measures are commendable, they are not a substitute for the provisions of the federal securities laws that Congress mandated.

See,

e.g.

, Allianz Letter,

supra

note 54; American Equity Letter,

supra

note 54; Letter of R. Preston Pitts (Sept. 10, 2008) (“Pitts Letter”); Sammons Letter,

supra

note 54; Karlan Tucker, Tucker Advisory Group, Inc. (Sept. 10, 2008) (“Tucker Letter”).

Finally, we note that some commenters argued that regulation of indexed annuities by the Commission would not enhance investor protection, in particular because the Commission's disclosure scheme is not tailored to these contracts.

Commenters cited a number of factors, including the lack of a registration form that is well-suited to indexed annuities, questions about the appropriate method of accounting to be used by insurance companies that issue indexed annuities, questions about advertising restrictions that may apply under the federal securities laws, and concerns about parity of the registration process vis-à-vis mutual funds. We acknowledge that, as a result of indexed annuity issuers having historically offered and sold their contracts without

complying with the federal securities laws, the Commission has not created specific disclosure requirements tailored to these products. This fact, though, is not relevant in determining whether indexed annuities are subject to the federal securities laws. The Commission has a long history of creating appropriate disclosure requirements for different types of securities, including securities issued by insurance companies, such as variable annuities and variable life insurance.

We note that we are providing a two-year transition period for rule 151A, and, during this period, we intend to consider how to tailor disclosure requirements for indexed annuities. We encourage indexed annuity issuers to work with the Commission during that period to address their concerns.

See,

e.g.

, Letter of American Council of Life Insurers (Sep. 19, 2008) (“ACLI Letter”); Allianz Letter,

supra

note 54; Aviva Letter,

supra

note 54; CAI 151A Letter,

supra

note 54; National Western Letter,

supra

note 54; Sammons Letter,

supra

note 54; Transamerica Letter,

supra

note 54.

See

Form N-4 [17 CFR 239.17b and 274.11c] (registration form for variable annuities); Form N-6 [17 CFR 239.17c and 274.11d] (registration form for variable life insurance).

3. Definition

Scope of the Definition

Rule 151A will apply, as proposed, to a contract that is issued by a corporation subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia.

This language is the same language used in Section 3(a)(8) of the Securities Act. Thus, the insurance companies covered by the rule are the same as those covered by Section 3(a)(8).

Rule 151A(a).

In addition, in order to be covered by the rule, a contract must be subject to regulation as an annuity under state insurance law.

The rule will not apply to contracts that are regulated under state insurance law as life insurance, health insurance, or any form of insurance other than an annuity, and it does not apply to any contract issued by an insurance company if the contract itself is not subject to regulation under state insurance law.

Thus, rule 151A itself will not apply to indexed life insurance policies,

in which the cash value of the policy is credited with a guaranteed minimum return and a securities-linked return. The status of an indexed life insurance policy under the federal securities laws will continue to be a facts and circumstances determination, undertaken by reference to the factors and analysis that have been articulated by the Supreme Court and the Commission. We note, however, that the considerations that form the basis for rule 151A are also relevant in analyzing indexed life insurance because indexed life insurance and indexed annuities share certain features (

e.g.

, securities-linked returns).

Id.

We note that the majority of states include in their insurance laws provisions that define annuities. See,

e.g.

, ALA. CODE § 27-5-3 (2008); CAL. INS. CODE § 1003 (West 2007); N.J. ADMIN. CODE tit. 11, § 4-2.2 (2008); N.Y. INS. LAW § 1113 (McKinney 2008). Those states that do not expressly define annuities typically have regulations in place that address annuities.

See,

e.g.

, Iowa Admin. Code § 191-15.70 (5078) (2008); Kan. Admin. Regs. § 40-2-12 (2008); Minn. Stat. § 61B.20 (2007); Miss. Code Ann. § 83-1-151 (2008).

One commenter was concerned that rule 151A might apply to a certain type of health insurance contract, where some portion of any favorable financial experience of the insurer is refunded to the insured.” Letter of America's Health Insurance Plans (Sep. 10, 2008) (“AHIP Letter”). Rule 151A will not apply to contracts that are regulated under state insurance law as health insurance.

See,

e.g.

, Aviva Letter,

supra

note 54; Sammons Letter,

supra

note 54 (requesting clarification that rule 151A does not apply to indexed life insurance policies).

The adopted rule, like the proposed rule, expressly states that it does not apply to any contract whose value varies according to the investment experience of a separate account.

100

The effect of this provision is to eliminate variable annuities from the scope of the rule.

101

It has long been established that variable annuities are not entitled to the exemption under Section 3(a)(8) of the Securities Act, and, accordingly, the new definition does not cover them or affect their regulation in any way.

102

100

Rule 151A(d).

101

The assets of a variable annuity are held in a separate account of the insurance company that is insulated for the benefit of the variable annuity owners from the liabilities of the insurance company, and amounts paid to the owner under a variable annuity vary according to the investment experience of the separate account.

See

Black and Skipper,

supra

note 39, at 174-77 (2000).

102

See, e.g., VALIC, supra

note 8, 359 U.S. 65;

United Benefit, supra

note 8, 387 U.S. 202. In addition, an insurance company separate account issuing variable annuities is an investment company under the Investment Company Act of 1940.

See Prudential Ins. Co. of Am.

SEC,

326 F.2d 383 (3d Cir. 1964).

Definition of “Annuity Contract” and “Optional Annuity Contract”

We are adopting, with modifications to address commenters' concerns, the proposal that an annuity issued by an insurance company would not be an “annuity contract” or an “optional annuity contract” under Section 3(a)(8) of the Securities Act if the annuity has two characteristics. As adopted, those characteristics are as follows. First, the contract specifies that amounts payable by the insurance company under the contract are calculated at or after the end of one or more specified crediting periods, in whole or in part, by reference to the performance during the crediting period or periods of a security, including a group or index of securities.

103

Second, amounts payable by the insurance company under the contract are more likely than not to exceed the amounts guaranteed under the contract.

104

103

Rule 151A(a)(1).

104

Rule 151A(a)(2).

Annuities Subject to Rule 151A

The first characteristic, as proposed and as adopted, is intended to describe indexed annuities, which are the subject of the rule. As proposed, this characteristic would simply have required that amounts payable by the insurance company under the contract are calculated, in whole or in part, by reference to the performance of a security, including a group or index of securities.

105

We have modified this characteristic to address the concern expressed by many commenters that, as proposed, the first characteristic was overly broad and would reach annuities that were not indexed annuities.

106

Commenters were concerned that the rule could, for example, be interpreted as extending to traditional fixed annuities, where amounts payable under the contract accumulate at a fixed interest rate, or to discretionary excess interest contracts, where amounts payable under the contract may include a discretionary excess interest component over and above the guaranteed minimum interest rate offered under the contract.

107

With both traditional fixed annuities and discretionary excess interest contracts, the interest rates are often based, at least in part, on the performance of the securities held by the insurer's general account.

105

Proposed rule 151A(a)(1).

106

See,

e.g.

, ACLI Letter,

supra

note 94; Allianz Letter,

supra

note 54; Aviva Letter,

supra

note 54; Letter of AXA Equitable Life Insurance Company (Sept. 10, 2008) (“AXA Equitable Letter”); Letter of Financial Services Institute (Sept. 10, 2008) (“FSI Letter”); CAI 151A Letter,

supra

note 54; Hartford Letter,

supra

note 55; NAFA Letter,

supra

note 54; NAIFA Letter,

supra

note 54; Letter of NAVA (Sept. 10, 2008) (“NAVA Letter”); Old Mutual Letter,

supra

note 54; Sammons Letter,

supra

note 54; Second Academy Letter,

supra

note 54; Transamerica Letter,

supra

note 54.

107

See,

e.g.

, Letter of Association for Advanced Life Underwriting (Oct. 31, 2008); AXA Equitable Letter,

supra

note 106.

The modified language of the first characteristic addresses commenters' concerns in three ways. First, the language requires that the contract itself specify that amounts payable by the insurance company are calculated by reference to the performance of a security. Thus, a contract will not be covered by the proposed rule unless the insurance company is contractually bound to pay amounts that are

dependent upon the performance of a security. While an insurance company may, in fact, look to the performance of the securities in its general account in, for example, establishing the rate to be paid under a traditional fixed annuity, such a contract does not itself obligate the insurer to do so or undertake in any way that the purchaser will receive payments that are linked to the performance of any security. Second, the language requires that the amounts payable by the insurance company be calculated at or after the end of one or more specified crediting periods by reference to the performance during the crediting period of a security. That is, in order to be covered by the rule, an annuity contract must provide that the amount to be paid with respect to a crediting period is determined retrospectively, by reference to the performance during the period of a security. This retrospective determination of amounts to be paid is characteristic of indexed annuities and eliminates from the scope of the rule discretionary excess interest contracts, pursuant to which a specified interest rate may be established by reference to the past performance of a security or securities and applied on a prospective basis with respect to a future crediting period. Third, limiting the rule to contracts where the amount payable is determined retrospectively addresses the concerns of the commenters that the rule, as proposed, could reach annuity contracts covered by the rule 151 safe harbor.

108

As explained above, contracts where the amount payable is determined retrospectively do not fall within rule 151.

109

108

AXA Equitable Letter,

supra

note 106; Hartford Letter,

supra

note 55; ICI Letter,

supra

note 7; K&L Gates Letter,

supra

note 54.

109

See

supra

note 38 and accompanying text.

Rule 151A, like the proposed rule, will apply whenever any amounts payable under the contract under any circumstances, including full or partial surrender, annuitization, or death, satisfy the first characteristic of the rule. If, for example, a contract specifies that the amount payable under a contract upon a full surrender is not calculated at or after the end of one or more specified crediting periods by reference to the performance during the period or periods of a security, but the amount payable upon annuitization is so calculated, then the contract would need to be analyzed under the rule. As another example, if a contract specifies that amounts payable under the contract are partly fixed in amount and partly dependent on the performance of a security in the manner specified by the rule, the contract would need to be analyzed under the rule.

We note that, like the proposal, rule 151A applies to contracts under which amounts payable are calculated by reference to the performance of a security, including a group or index of securities. Thus, the rule, by its terms, applies to indexed annuities but also to other similar annuities where the contract specifies that amounts payable are retrospectively calculated by reference to a single security or any group of securities.

110

The federal securities laws, and investors' interests in full and fair disclosure and sales practice protections, are equally implicated, whether amounts payable under an annuity are retrospectively calculated by reference to a securities index, another group of securities, or a single security.

110

A commenter inquired whether an annuity product whose returns were indexed to the consumer price index, a real estate index, or a commodities index would be considered a security. Letter of Meaghan L. McFadden (Aug. 13, 2008). Rule 151A, by its terms, does not apply to such an annuity.

The term “security” in rule 151A has the same broad meaning as in Section 2(a)(1) of the Securities Act. Rule 151A does not define the term “security,” and our existing rules provide that, unless otherwise specifically provided, the terms used in the rules and regulations under the Securities Act have the same meanings defined in the Act.

111

17 CFR 230.100(b).

“More Likely Than Not” Test

The second characteristic sets forth the test that would define a class of indexed annuity contracts that are not “annuity contracts” or “optional annuity contracts” under the Securities Act and that, therefore, are not entitled to the Section 3(a)(8) exemption. As adopted, the second characteristic defines that class to include those contracts where the amounts payable by the insurance company under the contract are more likely than not to exceed the amounts guaranteed under the contract.

We are adopting the second characteristic as proposed. As explained above, by purchasing such an indexed annuity, the purchaser assumes the risk of an uncertain and fluctuating financial instrument, in exchange for exposure to future, securities-linked returns. As a result, the purchaser assumes many of the same risks that investors assume when investing in mutual funds, variable annuities, and other securities. The rule that we are adopting will provide the purchaser of such an annuity with the same protections that are provided under the federal securities laws to other investors who participate in the securities markets, including full and fair disclosure regarding the terms of the investment and the significant risks that he or she is assuming, as well as protections from abusive sales practices and the recommendation of unsuitable transactions. Some commenters raised concerns about the proposed rule's treatment of

de minimis

amounts of securities-linked returns.

112

These commenters suggested that the smaller the amount of securities-linked return, the less investment risk is assumed by the purchaser, and the more is assumed by the insurer. In particular, commenters suggested that where the securities-linked return is

de minimis

the purchaser does not assume the primary investment risk under the contract.

113

However, based on our current understanding, we believe that almost all current indexed annuity contracts provide for securities-linked returns that are more likely than not to exceed a

de minimis

amount in excess of the guaranteed return. Nevertheless, in the case of an indexed annuity contract that is more likely than not to provide only a

de minimis

securities-linked return in excess of the guaranteed return, the Commission and the staff would be prepared to consider a request for relief, if appropriate.

112

See,

e.g.

, CAI 151A Letter,

supra

note 54; National Western Letter,

supra

note 54; Sammons,

supra

note 54.

113

See,

e.g.

, CAI 151A Letter,

supra

note 54; National Western Letter,

supra

note 54; Sammons,

supra

note 54.

Under rule 151A, amounts payable by the insurance company under a contract will be more likely than not to exceed the amounts guaranteed under the contract if this is the expected outcome more than half the time. In order to determine whether this is the case, it will be necessary to analyze expected outcomes under various scenarios involving different facts and circumstances. In performing this analysis, the amounts payable by the insurance company under any particular set of facts and circumstances will be the amounts that the purchaser

114

would be entitled to receive from the insurer under those facts and circumstances. The facts and circumstances include, among other things, the particular features of the annuity contract (

e.g.

, the relevant index, participation rate, and other features), the particular options selected

by the purchaser (

e.g.

, surrender or annuitization), and the performance of the relevant securities benchmark (

e.g.

, in the case of an indexed annuity, the performance of the relevant index, such as the Dow Jones Industrial Average, Lehman Brothers Aggregate U.S. Index, Nasdaq 100 Index, or Standard & Poor's 500 Composite Stock Price Index). The amounts guaranteed under a contract under any particular set of facts and circumstances will be the minimum amount that the insurer would be obligated to pay the purchaser under those facts and circumstances without reference to the performance of the security that is used in calculating amounts payable under the contract. Thus, if an indexed annuity, in all circumstances, guarantees that, on surrender, a purchaser will receive 87.5% of an initial purchase payment, plus 1% interest compounded annually, and that any additional payout will be based exclusively on the performance of a securities index, the amount guaranteed after 3 years will be 90.15% of the purchase payment (87.5% × 1.01 × 1.01 × 1.01).

114

For simplicity, we are referring to payments to the purchaser. The rule, however, references payments by the insurer without reference to a specified payee. In performing the analysis, payments to any payee, including the purchaser, annuitant, and beneficiaries, must be included.

Determining Whether an Annuity Is Not an “Annuity Contract” or “Optional Annuity Contract” Under Rule 151A

We are adopting, with modifications to address commenters' concerns, the provisions of proposed rule 151A that address the manner in which a determination will be made regarding whether amounts payable by the insurance company under a contract are more likely than not to exceed the amounts guaranteed under the contract. Rule 151A is principles-based, providing that a determination made by the insurer at or prior to issuance of a contract will be conclusive, provided that: (i) Both the insurer's methodology and the insurer's economic, actuarial, and other assumptions are reasonable; (ii) the insurer's computations are materially accurate; and (iii) the determination is made not earlier than six months prior to the date on which the form of contract is first offered.

115

We have eliminated the proposed requirement that the insurer's determination be made not more than three years prior to the date on which a particular contract is issued. The rule specifies the treatment of charges that are imposed at the time of payments under the contract by the insurer, and we have modified the proposal in order to provide for consistent treatment of these charges in computing both amounts payable by the insurance company and amounts guaranteed under the contract.

116

115

Rule 151A(b)(2).

116

Rule 151A(b)(1).

We are adopting this principles-based approach because we believe that an insurance company should be able to evaluate anticipated outcomes under an annuity that it issues. We believe that many insurers routinely undertake similar analyses for purposes of pricing and valuing their contracts.

117

In addition, we believe that it is important to provide reasonable certainty to insurers with respect to the application of the rule and to preclude an insurer's determination from being second guessed, in litigation or otherwise, in light of actual events that may differ from assumptions that were reasonable when made.

117

See generally

Black and Skipper,

supra

note 39, at 26-47, 890-99. Several commenters who issue indexed annuities disputed that insurers undertake these analyses.

See

e.g.

, American Equity Letter,

supra

note 54; National Western Letter,

supra

note 54; Sammons Letter,

supra

note 54. Other commenters, however, confirmed that these analytical methods exist and are used by insurers for internal purposes.

See

e.g.

, Aviva Letter,

supra

note 54; Academy Letter,

supra

note 54. We give substantial weight to the views of the American Academy of Actuaries (“Academy”) on this point, given their expertise in this type of analysis, and are not persuaded that the contrary comments of several issuers are representative of industry practice. See Black's Law Dictionary 39 (8th ed. 2004) (An actuary is a statistician who determines the present effects of future contingent events and who calculates insurance and pension rates on the basis of empirically based tables.); American Academy of Actuaries, Mission, available at:

http://www.actuary.org/mission.asp

(The mission of the Academy is to, among other things, provide independent and objective actuarial information, analysis, and education for the formation of sound public policy.).

As with all exemptions from the registration and prospectus delivery requirements of the Securities Act, the party claiming the benefit of the exemption—in this case, the insurer—bears the burden of proving that the exemption applies.

118

Thus, an insurer that believes an indexed annuity is entitled to the exemption under Section 3(a)(8) based, in part, on a determination made under the rule will—if challenged in litigation—be required to prove that its methodology and its economic, actuarial, and other assumptions were reasonable, and that the computations were materially accurate.

118

See

e.g.

, SEC v.

Ralston Purina

, 346 U.S. 119, 126 (1953) (an issuer claiming an exemption under Section 4 of the Securities Act carries the burden of showing that the exemption applies).

The rule provides that an insurer's determination under the rule will be conclusive only if it is made at or prior to issuance of the contract. Rule 151A is intended to provide certainty to both insurers and investors, and we believe that this certainty will be undermined unless insurance companies undertake the analysis required by the rule no later than the time that an annuity is issued. The rule also provides that, for an insurer's determination to be conclusive, the computations made by the insurance company in support of the determination must be materially accurate. An insurer should not be permitted to rely on a determination of an annuity's status under the rule that is based on computations that are materially inaccurate. For this purpose, we intend that computations will be considered to be materially accurate if any computational errors do not affect the outcome of the insurer's determination as to whether amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract.

In order for an insurer's determination to be conclusive, both the methodology and the economic, actuarial, and other assumptions used must be reasonable. We recognize that a range of methodologies and assumptions may be reasonable and that a reasonable methodology or assumption utilized by one insurer may differ from a reasonable assumption or methodology selected by another insurer. In determining whether an insurer's methodology is reasonable, it is appropriate to look to methods commonly used for pricing, valuing, and hedging similar products in insurance and derivatives markets.

An insurer will need to make assumptions in several areas, including assumptions about (i) insurer behavior, (ii) purchaser behavior, and (iii) market behavior, and will need to assign probabilities to various potential behaviors. With regard to insurer behavior, the insurer will need to make assumptions about discretionary actions that it may take under the terms of an annuity. In the case of an indexed annuity, for example, an insurer often has discretion to modify various features, such as guaranteed interest rates, caps, participation rates, and spreads. Similarly, the insurer will need to make assumptions concerning purchaser behavior, including matters such as how long purchasers will hold a contract, how they will allocate contract value among different investment options available under the contract, and the form in which they will take payments under the contract. Assumptions about market behavior will include assumptions about expected return, market volatility, and interest rates. In general, insurers will need to make assumptions about any feature of insurer, purchaser, or market behavior, or any other factor, that is

material in determining the likelihood that amounts payable under the contract exceed the amounts guaranteed.

In determining whether assumptions are reasonable, insurers should generally be guided by both history and their own expectations about the future. An insurer may look to its own, and to industry, experience with similar or otherwise comparable contracts in constructing assumptions about both insurer behavior and investor behavior. In making assumptions about future market behavior, an insurer may be guided, for example, by historical market characteristics, such as historical returns and volatility, provided that the insurer bases its assumptions on an appropriate period of time and does not have reason to believe that the time period chosen is likely to be unrepresentative. As a general matter, assumptions about insurer, investor, or market behavior that are not consistent with historical experience would not be reasonable unless an insurer has a reasonable basis for any differences between historical experience and the assumptions used.

In addition, an insurer may look to its own expectations about the future in constructing reasonable assumptions. As noted above, insurers routinely analyze anticipated outcomes for purposes of pricing and valuing their contracts. We expect that, in making a determination under rule 151A, an insurer will use assumptions that are consistent with the assumptions that it uses for other purposes, such as pricing and valuation. In addition, an insurer generally should use assumptions that are consistent with its marketing materials. In general, assumptions that are inconsistent with the assumptions that an insurer uses for other purposes will not be reasonable under rule 151A.

As noted above, we are adopting a principles-based approach because we believe that it will provide reasonable certainty to insurers with respect to the application of the rule. We recognize, however, that a number of commenters expressed concern that the principles-based approach provides insufficient guidance regarding implementation and the methodologies and assumptions that are appropriate and could result in inconsistent determinations by different insurance companies and present enforcement and litigation risk.

119

Some commenters suggested that the Commission address these concerns by providing guidance as to how to make the determination under the rule, which, they asserted, could result in greater uniformity and consistency in the application of the rule.

120

While we believe that further guidance may, indeed, be helpful in response to specific questions of affected insurance companies, we note that commenters generally did not articulate with specificity the areas where they believe that further guidance is required. As a result, in order to provide guidance in the manner that would be most helpful, we encourage insurance companies, sellers of indexed annuities, and other affected parties to submit specific requests for guidance, which we will consider during the two-year period between adoption of rule 151A and its effectiveness.

121

119

See, e.g.

, Academy Letter,

supra

note 54; ACLI Letter,

supra

note 94; Aviva Letter,

supra

note 54; AXA Equitable Letter,

supra

note 106; CAI 151A Letter,

supra

note 54; FINRA Letter,

supra

note 7; Letter of Genesis Financial Products, Inc. (Aug. 29, 2008) (“Genesis Letter”); Letter of Janice Hart (Aug. 15, 2008) (“Hart Letter”); ICI Letter,

supra

note 7; National Western Letter,

supra

note 54; Sammons Letter,

supra

note 54.

120

See, e.g.

, FINRA Letter,

supra

note 7; Hart Letter,

supra

note 119; ICI Letter,

supra

note 7; NAIC Officer Letter,

supra

note 54.

121

See infra

text accompanying notes 129 and 130.

Like the proposal, rule 151A requires that, in order for an insurer's determination to be conclusive, the determination must be made not more than six months prior to the date on which the form of contract is first offered.

122

For example, if a form of contract were first offered on January 1, 2012, the insurer would be required to make the determination not earlier than July 1, 2011. We are not adopting the proposed requirement that the insurer's determination be made not more than three years prior to the date on which the particular contract is issued.

123

We were persuaded by the commenters that if the status of a form of contract under the federal securities laws were to change, over time, from exempt to non-exempt and vice versa, this would present practical difficulties resulting from the possibility that an annuity could be exempted from registration at one time but be required to be registered subsequently and vice versa, as well as heightened litigation and enforcement risk.

124

We believe that the substantial uncertainties and resulting potential costs introduced by the proposed requirement that a contract's status be redetermined every three years would be inconsistent with the intent of rule 151A, which is to clarify the status of indexed annuities.

122

Rule 151A(b)(2)(iii).

123

Proposed rule 151A(b)(2)(C).

124

See, e.g.

, Aviva Letter,

supra

note 54; Sammons Letter,

supra

note 54.

See

also ICI Letter,

supra

note 7 (possibility that indexed annuity's status under the federal securities laws could change is not consistent with the purposes of the federal securities laws).

Rule 151A, as adopted, requires that, in determining whether amounts payable by the insurance company are more likely than not to exceed the amounts guaranteed, both amounts payable and amounts guaranteed are to be determined by taking into account all charges under the contract, including, without limitation, charges that are imposed at the time that payments are made by the insurance company.

125

For example, surrender charges would be deducted from both amounts payable and amounts guaranteed under the contract. This is a change from the proposal, which would have required that, in determining whether amounts payable by the insurance company under a contract are more likely than not to exceed the amounts guaranteed under the contract, amounts payable be determined without reference to any charges that are imposed at the time of payment, such as surrender charges, while those charges would be reflected in computing the amounts guaranteed under the contract.

126

125

Rule 151A(b)(1). In many cases, amounts guaranteed under annuities are not affected by charges imposed at the time payments are made by the insurer under the contract. This is a result of the fact that guaranteed minimum value, as commonly defined in indexed annuity contracts, equals a percentage of purchase payments, accumulated at a specified interest rate, as explained above, and this amount is not subject to surrender charges. However, under some indexed annuity contracts, the amounts guaranteed are affected by charges imposed at the time payments are made. For example, a purchaser buys a contract for $100,000. The contract defines surrender value as the greater of (i) purchase payments plus index-linked interest minus surrender charges or (ii) the guaranteed minimum value. The maximum surrender charge is equal to 10%. The guaranteed minimum value is defined in the contract as 87.5% of premium accumulated at 1% annual interest. If the purchaser surrenders within the first year of purchase, and there is no index-linked interest credited, the surrender value would equal $90,000 (determined under clause (i) as $100,000 purchase payment minus 10% surrender charge), and this amount would be the guaranteed amount under the contract, not the lower amount defined in the contract as guaranteed minimum value ($87,500).

126

Proposed rule 151A(b)(1).

We are making the foregoing change because we are persuaded by commenters who argued that the proposed provision could result in contracts being determined not to be entitled to the Section 3(a)(8) exemption irrespective of the likelihood of securities-linked return being included in the amount payable.

127

Specifically, commenters argued that as long as the surrender charge is in effect, the amount payable would always exceed the amount guaranteed if the surrender

charge were subtracted from the latter but not the former. The commenters further argued that bona fide surrender charges should not result in a contract being deemed a security, since a surrender charge is an expense and does not represent a transfer of risk from insurer to contract purchaser. Because the rule, as adopted, requires surrender charges to be subtracted from both amounts payable and amounts guaranteed, the surrender charges will not affect the determination of whether a contract is a security (

i.e.

, the determination of whether amounts payable are more likely than not to exceed the amounts guaranteed).

127

See, e.g.

, Aviva Letter,

supra

note 54; CAI 151A Letter,

supra

note 54; Coalition Letter,

supra

note 54.

Effective Date

The effective date of rule 151A is January 12, 2011. We originally proposed that rule 151A, if adopted, would be effective 12 months after publication in the

Federal Register

. We are persuaded by commenters, however, that additional time is required for, among other things, making the determinations required by the rule, preparing registration statements for indexed annuities that are required to be registered, and establishing the needed infrastructure for distributing registered indexed annuities.

128

Based on the comments, we believe that a January 12, 2011 effective date will provide the time needed to accomplish these tasks.

129

We note that, during this period, the Commission intends to consider how to tailor disclosure requirements for indexed annuities and will also consider any requests for additional guidance that we receive concerning the determinations required under rule 151A.

130

128

Letter of American International Group (Sept. 10, 2008) (“AIG Letter”); Aviva Letter,

supra

note 54; CAI 151A Letter,

supra

note 54; NAVA Letter,

supra

note 106; Letter of New York Life Insurance Company (Sept. 18, 2008) (“NY Life Letter”); Sammons Letter,

supra

note 54.

129

AIG Letter,

supra

note 128 (recommending transition period of 2 years); Aviva Letter,

supra

note 54 (at least 24 months); CAI 151A Letter,

supra

note 54 (24 months); Letter of NAVA (Nov. 17, 2008) (“Second NAVA Letter”) (at least 24 months); NY Life Letter,

supra

note 128 (at least 24 months).

130

See supra

text accompanying notes 95 and 121.

The new definition in rule 151A will apply prospectively as we proposed—that is, only to indexed annuities issued on or after January 12, 2011. We are using our definitional rulemaking authority under Section 19(a) of the Securities Act, and the explicitly prospective nature of our rule is consistent with similar prospective rulemaking that we have undertaken in the past when doing so was appropriate and fair under the circumstances.

131

See, e.g.

, Securities Act Release No. 4896 (Feb. 1, 1968) [33 FR 3142, 3143 (Feb. 17, 1968)] (“The Commission is aware that for many years issuers of the securities identified in this rule have not considered their obligations to be separate securities and that they have acted in reliance on the view, which they believed to be the view of the Commission, that registration under the Securities Act was not required. Under the circumstances, the Commission does not believe that such issuers are subject to any penalty or other damages resulting from entering into such arrangements in the past. Paragraph (b) provides that the rule shall apply to transactions of the character described in paragraph (a) only with respect to bonds or other evidence of indebtedness issued after adoption of the rule.”).