1. © Copyright, Briggs and Morgan, Professional Association, 2006-2008 Variable Annuities and Other Insurance Products Frank A. Taylor, Esq. Briggs and Morgan, P.A. 2200 IDS Center 80 South Eighth Street Minneapolis, MN 55402 Kenneth M. Cherrier, JD, FLMI Woodbury Financial Svcs, Inc. 500 Bielenberg Dr. Woodbury, MN 55126

2. Today's Agenda Basics on Annuities – What are they, what features are available? Life Settlements Hot Topics in Annuities – Sales to seniors – State enforcement actions – FINRA Suitability Rules – NAIC Proposed Rules – SEC Rule 151A Discussion and Q&A Session

3. The Big Issues Aging population: – The Baby Boomers As a result, three issues: – Sales of variable annuities and other insurance products – Seniors – Mission creep

4. Variable Annuity Sales: Basic Requirements Reasonable basis for recommendation – “Any – that is every – variable annuity sale should be viewed as having been recommended. That’s our view – and compliance should view that way, too.” » Dennis Kosciulek, NASD remarks to Insurance Marketplace Standards Association Best Practices Workshop – Replacements Reasonable effort to get the consumer’s financial information – “Reasonable to us is ‘get the information.’ We want to see it, so you had better have it. We’ve written up firms for not getting it.” » Id.

5. Fixed Index Annuities Rule 151A: treat these annuities as securities. Issue: Exchange of variable annuities into indexed products – Done by unregistered producers like insurance agents who cannot sell variable products unless they have a securities license Issues

6. All tied to Seniors “We’re concerned that scams will become more sophisticated as investors get older....We’re trying to anticipate the problems and address them.” » Id. Tied closely to the senior issue: “It will be a regulatory focus for the next 25 years – until the last Boomer drops….That’s where the money is, and where our focus is going to be.” » Id.

7. What is a Senior? Notice 07-43: focuses on Seniors, but never defines it. Thought: A Senior is someone approaching retirement.

8. Primer on Annuities

9. What Are Annuities? An insurance contract for the right to receive a certain amount of income in the future Similarities and differences with other investment vehicles – 401(k) plans – IRA and Roth IRAs Risks and benefits of purchasing annuities

10. Basic Types of Annuities Immediate Annuity: Provides income now Deferred Annuity: Savings to accumulate before payouts begin Fixed: Deferred Annuity in which money earns interest at a rate guaranteed by the insurance company Variable: Deferred annuity in which money is placed in a separate account that is invested in stock or bond funds. This is a security Fixed (Equity) Indexed Annuity: Deferred annuity in which a portion of the return is guaranteed and a portion is determined by the performance of a specific Index such as the S&P 500 Composite Stock Price Index.

11. When should I receive income? Immediate distributions – When is this appropriate? – What are the disadvantages? Deferred distributions – Accumulation v. distribution – When is income needed? – Any foreseeable need for the principal?

12. Fixed Annuities Guaranteed rate-of-return on principal during accumulation phase Guaranteed income payments during distribution phase – Term of the distribution period Other insurance-product features – General account of insurance company – State guarantee funds Benefits and risks of Fixed Annuities

13. Insurance Features State minimum nonforfeiture rules typically require: – Guaranteed minimum value of fixed annuity contract be at least 87.5% of premiums paid – Accumulated at an annual rate of 1-3% Constant Maturity Rate reported by the Federal Reserve Obligation of an insurance company – Risk of loss remains with the insurance company Not a security Section 3(a)(8) of the Act McCarran-Ferguson Act: federal law shall not be interpreted to “supersede any law enacted by any State for the purpose of regulating the business of insurance.”

14. Variable Annuities Securities SEC v. Variable Annuity Life Ins. Co. of Am., 359 U.S. 65 (1959) and SEC v. United Benefit Life Ins. Co., 387 U.S. 202 (1967) Supreme Court held that an annuity will be treated as a “security” where the insurance guarantees are “superficial” or non-existent.

15. Variable Annuities Annuitant's premium payments invested in traditional investments by the insurer (mutual funds, stocks, bonds, money-market instruments) – Separate accounts – Not the general account of the insurer Distribution phase – Pre-determined, not linked to performance – Variable, linked to investment performance Early withdrawal and surrender charges Life-insurance contract components

16. Fixed (Equity)-Indexed Annuities (“FIA") Annuity contracts where portion of return is fixed and there is a credit based upon performance of equity or bond index Rate of return is the distinguishing feature of an FIA – Guaranteed minimum return – Indexed interest rate, or market index Indexing methods determines interest rate – Annual reset or ratchet method – High-water mark – Point-to-point – Index averaging

17. FIAs, continued FIA components also effect rates of return and gains Participation rates: change allowed in the index participation Minimum interest credit which is never less than zero Spread, margin, and asset fees Interest-rate caps

18. FIAs continued Unlike variable annuities, 100 percent of premiums are deposited in insurer’s general account After deduction for expenses related to sale of annuity, premiums are invested through the general account General account consists of permitted investments under state law High quality fixed income securities, U.S. and governmental agency bonds and other high quality permitted assets – Insurance company may hedge, but not speculate

19. FIAs Insurance company must maintain net capital under state law Minimum nonforfeiture rules – Apply to fixed and FIAs, not variable – 87.5% of initial premiums carried forward with interest at a rate between one and three percent

20. FIAs Liquidity Options – Annual penalty free withdrawals of up to 10% of the value – Annuitization (stream of payments) – Nursing home rider – Terminal illness rider – Borrowing if sold in qualified market Mortality – Generally full contract is paid without deduction – Annuitization based upon life expectancy No sales charge – Sales commissions paid from insurer’s general assets

21. FIA Analysis Need to review sales material, Statement of Understanding and state filings to understand Single Premium Fixed Annuity Balanced Allocation Strategy – Index Allocation Indexed Earnings are calculated using S&P 500, which does not include dividends – Declared Rate Allocation

22. Single Premium Fixed Annuity Fee ranges from 2.25% to 4% – Sales material Industry standard – Administrative fee is $30 per year – Management fee is 100 to 150 bps

23. Lock-in Option Lock in interest or value – Could mean lock in rate of return on S&P Locks in only gain Hypothetical: – Contract with 75% Index and 25% fixed – S&P up 20% after two years Customer “locks” – Six years later, 4.3296% total return, or.72% per year $10,000 investment would have gained $433 per year

24. FIAs Excellent savings tool Even out market adjustments $100,000 investment from October 2004 to October 2008 – $100,000 grew to $136,000 S&P $106,000

25. Life Settlements Viaticals vs. Life Settlements Viatical is imminent death – Settlement Purpose – HIV and Magic Johnson problem Life Settlement – Owner of life insurance policy sells ownership of policy to a third party – Big Issue: No insurable interest – Large Fees Purpose: Immediate economic benefit Regulatory view

26. Life Settlements FINRA will regulate life settlements that include a variable life insurance policy “Any sale of a security, including variable life, has to meet FINRA rule. We recognize commissions of this product are high – up to 45 percent. The argument is that these transactions are great for the consumers. But if that’s true, why [is there a 45 percent commission]?” – Id. Off cycle sweeps.

27. Hot Topics

28. Sales to Seniors High-pressure sales tactics – Attorney General Lori Swanson's testimony before Congress and the Heritage case – April 2008 Dateline NBC "Tricks of the Trade" investigation on annuitiesTricks of the Trade "Annuity University" – fear and anger to make the sale "The FDIC is insolvent; banks are not safe." Misleading sales tactics – Access to investment – Surrender-period misrepresentations Free Lunch Seminars

29. Sales to Seniors, continued Suitability – Ensuring that the annuity is fully explained to the purchaser – The need for liquidity conflicts with the deferral period when the purchaser has a fixed income – Financial and medical emergencies – Surrender penalties

30. FINRA Suitability Requirements Rules 2820 and 2821

31. FINRA Rule 2820 Contract value determined by contract or prospectus Prompt transmittal of payments to the insurer from the FINRA member Sales agreements mandatory – Required clauses about sales commissions Prompt payments on refunds Member compensation

32. FINRA Rule 2821 NTM 96-86: NASD Regulation Reminds Members and Associated Persons that Sales of Variable Contracts Are Subject to NASD Suitability Requirements NTM 99-35 NTM 00-44 Joint SEC/NASD Report on Sales of Variable Insurance Products December 4, 2004: Initial Filing of 2821

33. FINRA Rule 2821 Work in progress Applies to the purchase or exchange of a deferred variable annuity and initial sub-account allocations – Sub-account allocations Four parts to Rule 2821 – Recommendation requirements – Principal review and approval – Supervision – Training programs

34. FINRA Rule 2821, continued Recommendation requirements – Must inquire about the customers basic characteristics, financial situation, and goals Age, income, financial needs, investment experience, net worth, risk tolerance, etc. – "Reasonable bases to believe that a particular transaction is suitable" – Suitability determination accounts for the basic characteristics of the annuity, as applied to the individual – Additional considerations for Section 1035 exchanges

35. FINRA Rule 2821, continued Principal and Supervisory Obligations – "Registered principal" approval – Shall approve if the there is a reasonable basis to believe the transaction is suitable – Approval by customer – Exemption from "promptly transmits" rule and net-capital requirements

36. FINRA Rule 2821, continued Firm supervisory obligations – Consistent with Rules 3010, 3012, 3013, and 3110 and WSPs to address annuities – Enforcement by FINRA Banc One Securities Corp. - $225,000 fine for failing to require firm supervisors to consider necessary information in suitability reviews; $6,500 in restitution Training Programs – Ensure that associated persons know about Rule 2821's suitability requirements – General v. Specific?

37. State Regulation The Suitability in Annuity Transactions Model Regulation The Insurance and Annuity Replacement Model Regulation The Advertisements of Life Insurance and Annuities Model Regulation State “free look” requirements State oversight and approval of products, including Interstate Insurance Product Regulation Commission Unfair trade practice law and regulation Market Conduct Examinations Enforcement actions by state insurance regulators and attorneys general ACLI

38. NAIC Model Suitability Guidelines Addresses recommendations and suitability similar to FINRA Rule 2821 – Reasonable grounds to recommend the annuity to the customer More comprehensive than FINRA Rule 2821 on supervision – Insurers must maintain written procedures, conduct periodic reviews to detect and prevent violations Dangers for securities – Fixed v. variable attestations – Insurance company validations

39. NAIC Suitability in Annuity Transactions Model Regulation Reasonable efforts to obtain: Consumer’s financial status, tax status, investment objectives, other useful data System of supervision reasonably designed to achieve compliance, which includes written procedures and periodic reviews; or contracting with a third party to review. – An insurer…is not required to review or provide for the review of all insurance producer solicited transactions

40. Model Regulation, con’t. Opt-outs. No obligation is the consumer refuses to provide information, rejects recommendation, or fails to provide accurate information Reasonable grounds for suitability Agent oversight – Mandatory training

41. Minnesota Atty General and Calif. DOI Go well beyond state law Review procedures for sales to seniors and deferred annuities generally

42. Minnesota AG and California DOI Detailed requirements for sale of deferred annuities (red flags) $75,000 of liquid net worth No change in circumstances Premium for the annuity should not be more than 25% of net worth Premium of the annuity should not be more than four times the annual income Value of all annuities should not be equal to or greater than 75% of net worth 75 years old

43. Rule 151A Proposed Regulations – SEC Rule 151A would regulate some FIAs as securities Very important from compliance perspective

44. Proposed Rule 151A Section 3(a)(8) of the ’33 Act excludes from the definition of a security and the Act any annuity contract (optional annuity contract) issued by an insurance company that is subject to supervision of a state insurance commissioner – Different from insurance contract

45. Rule seeks to eliminate exemption Amounts payable by the insurer under the contract are calculated, in whole or in part, by reference to a performance of a security, group of securities, or index; and Amounts payable by the insurance company are more likely than not to exceed the amounts guaranteed under the contract

46. SEC Rule 151A Rule 151A will eliminate the exemption for certain insurance contracts based on two principles – Allocation of risk between investor and insurer – Marketing of the annuity to the customer The greater the risk borne by the consumer, and the more the annuity is treated like an investment, the more likely it will lose its exempt status due to Rule 151A.

47. SEC Rule 151A, continued An annuity that would not fall under the exemption has two characteristics: – (1) “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 of indexed securities;” and – (2) “amounts payable by the insurance company under the contract are more likely than not to exceed the amounts guaranteed by the contract.”

48. Rule 151A: Compliance Sales are through: independent agents, captive agents, and registered representatives – Independent agents largest channel They sell: traditional fixed insurance, long- term care, disability. – Some are tax accountants If adopted, they have to become registered representatives Subject to FINRA Rules 3030 and 3040 Sales of insurance products are often a “red flag” – 25% of sales

49. Rule 151A: Other Issues Are fixed annuities securities? – Keyed to performance of underlying securities or indexes – Seems to fit the two prong definition Agents operate through FMOs – May have to become licensed as broker-dealers Super net capital rules – Exchange Act 15c3-1(c)(2)(iv)(C) Registration costs – S-1 does not work (statutory accounting v. GAAP) – SOU v. Prospectus – 25 years for SEC to approve a registration form for variable annuities – Ten years to adopt From N-6 for variable life Other industry issues

50. Discussion and Q&A Session