Good morning and thank you for the kind introduction. It is a pleasure to be speaking with you today. Before I begin, let me remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
Last year, at this conference, I began my remarks by noting some startling events that had taken place as a result of the financial crisis, such as the failures of some prominent financial institutions, the continued turmoil in the credit markets, and a money market fund "breaking the buck." This past year we have seen how the financial crisis has affected life insurance companies. The financial crisis resulted in investment losses on insurers' portfolio holdings. At the same time, insurers' liabilities related to the guarantees offered on their variable annuity products grew. Some insurers raised capital to meet reserve requirements and to strengthen their capital and surplus positions. Two life insurance companies received money from the U.S. government's Troubled Asset Relief Program. Insurers also asked for, and received, a reported $6 billion in reserve relief from state regulators.
On the other hand, for some investors, variable annuities with investment guarantees have served as a "safe port" in the recent financial storm. Although such guarantees have received their share of criticism over the years, they have effectively protected the contract value of investors in recent times. According to a Wall Street Journal article, holders of variable annuities with investment guarantees actually saw their account value increase 6% or more in value during the same period the S&P 500 stock index dropped nearly 39%. As I am sure is being discussed and analyzed at this conference, some of the guarantees may have been too generous from the insurance industry's viewpoint. It has been reported that many insurers are "battening the hatches" by way of scaling back on variable annuity guarantees. Other insurers have stopped or suspended sales of some guarantees entirely. Nevertheless, National Underwriter recently reported that variable annuity sales continue to be driven by living benefit guarantees and that those companies offering the most competitive guaranteed living benefits are gaining significant market share.
While I am on the topic of guarantees, let me first address a concern that commands a lot of the staff's attention in connection with variable products, and that is what I sometimes call the "benefit of the bargain" issue. Investors look to variable products, and in particular, the living benefit riders that have become so central to the marketing of these products, to address particular financial objectives. Investors have legitimate expectations that they will get the benefit of the bargain that they struck with an insurer when buying a contract. This is perhaps more important for variable contracts than for other investment vehicles, given the long-term nature of the investment, and the significant surrender charges and tax penalties facing an investor whose expectations have been frustrated and who therefore looks to move on. This is an issue for variable contract investors, particularly with reference to the investment options under a contract, and to the promises underlying living benefit riders as well.
As to the first of these, sometimes insurers have narrowed the range of investment options available within some existing variable insurance contracts to the point that it raises questions whether the contract will deliver the benefit of the bargain. In some cases, the contract was bought — or should I say sold — on the basis of the investment options available under the contract. In those cases, a contract owner has a reasonable expectation that the variety of investment options available under the original contract, or something very much like it, will be available throughout the life of the contract. As you know, a dissatisfied contract owner may be left with no other option than to transfer his or her investment to another variable annuity, likely resulting in the contract owner immediately paying a surrender charge and becoming subject to a second surrender charge in the new annuity.
Secondly, the staff expects that investors who purchase a guaranteed living benefit in order to protect their investment are in fact able to rely on the guarantee as described in the prospectus. Often, however, the investor must adhere to myriad restrictions in order to maintain the operation of the guarantee. For that reason, a contract owner's obligations should be highlighted in the prospectus disclosure and made crystal clear in the marketing of the benefit rider. Unfortunately, there have been reports of cases where contract owners have unwittingly had their guarantees either eliminated or significantly reduced. This can happen when a contract owner fails to follow certain asset allocation requirements or takes so-called "excess withdrawals," or even when a contract owner's account value falls too low to cover the contract's annual fees (due to a combination of poor market performance and withdrawals during the contract's waiting period).
In my view, these scenarios highlight the importance of effective disclosure, and more broadly, clear communications. An investor should not be left wondering if he or she has bought a "pig in a poke" when purchasing a variable insurance contract. To that end, let me address what I believe you can do to avoid confused and disappointed investors in the future.
First, I must stress how important the concept of plain English is in drafting variable insurance disclosure. It is vital that you clearly convey to your customers the costs, risks and benefits of the products you offer. I find disclosure documents to be most helpful when they provide an easy to understand summary and roadmap before launching into the nitty-gritty details. This is critically important when describing guaranteed lifetime benefit riders, which by their nature are complex features. There are too many disclosure documents that are not effective in informing investors in plain English of the risks of losing the benefit of the bargain. In fact, at times, it appears the prospectus is merely a transcription of the contract. The bottom line is that the staff is serious about plain English and effective disclosure. You owe it to your investors to be serious about it as well.
Second, it is important that the essential features of the product, including the costs, risks, and benefits, be conveyed clearly and effectively to investors in marketing materials and during sales presentations made by registered representatives. Regardless of whether the contract is sold through a captive sales force or through independent brokers, insurers can, and should, exercise effective oversight of the marketing of their contracts with a view towards fully informed investors.
Now I would like to spend a few minutes talking about some of this year's developments, including some of the initiatives the Division staff is undertaking in our ongoing effort to enhance investor protection and to update and improve the regulatory environment in which you do business. And by the way, in connection with that last thought, I would like to acknowledge the terrific work being done by Bill Kotapish, as well as branch chiefs Zandra Bailes, Joyce Pickholz, and Harry Eisenstein and their colleagues in the Office of Insurance Products. I am honored to be working with people in the Division of Investment Management who are talented and hard-working investor advocates.
Let me turn now to a matter that, at least in the near term, is most pertinent to underlying funds. I believe one of the most significant recent developments for mutual funds and their investors was the Commission's vote earlier this year to adopt a Summary Prospectus. The Summary Prospectus represents a revolutionary change in mutual fund disclosure, providing fund investors key information they need in a user-friendly format. The Summary Prospectus consists of a brief, plain English synopsis of key information about a fund's investment objectives and strategies, risks, costs, and performance presented in a standardized order. The full prospectus and statement of additional information remain available online or in paper upon request for those who seek more comprehensive information.
The Summary Prospectus may also be used to satisfy a fund's delivery obligations under the Securities Act, so long as it is not bound together with any other materials. However, an insurer may bind the statutory prospectus of a variable insurance contract with the Summary Prospectuses and/or statutory prospectuses of the underlying funds, which will satisfy the prospectus delivery requirements for both a variable insurance contract and the underlying funds. The staff is aware that there may be some interpretive and implementation issues involving these "bundling" requirements. The staff welcomes inquiries and is interested in working with registrants to find workable solutions, consistent with the rule.
Now that the Summary Prospectus is a reality for mutual funds, I think the timing is right to consider a similar disclosure framework for variable insurance products. In fact, the Commission has received a rulemaking petition from the Insured Retirement Institute (IRI) with a proposal specific to variable annuity contracts that follows the same "layered approach" to disclosure followed in the Summary Prospectus for funds. I believe this is a positive step toward the creation of a variable annuity short form disclosure document, consistent with our goal of providing variable annuity investors key information presented in plain English in a standardized format that will facilitate and encourage comparisons among annuities. This is no easy task, given the complexity of these products. It is interesting that the very complexity of these products which makes clear, concise disclosure so important also makes the goal that much more difficult to accomplish. But I am confident that it is doable and I look forward to working with the industry toward that goal.
I would like to now say a word about indexed annuities. As many of you are no doubt aware, earlier this year the Commission adopted a new rule intended to clarify the status under the federal securities laws of indexed annuities, Rule 151A. Rule 151A defines a class of indexed annuities, on a prospective basis, that are not "annuity contracts" or "optional annuity contracts" for purposes of Section 3(a)(8) of the Securities Act, the exemption for annuity contracts. As adopted, Rule 151A provides that an annuity issued by an insurance company would not be an "annuity contract" under Section 3(a)(8) of the Securities Act if the annuity has two characteristics. First, 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. Second, amounts payable by the insurance company under the contract are more likely than not to exceed the amounts guaranteed under the contract.
Following adoption of rule 151A, petitions were filed in the U.S. Court of Appeals for the District of Columbia Circuit for review of the rule. Petitioners included certain major issuers of indexed annuities. The National Association of Insurance Commissioners, an organization of state insurance regulators, also petitioned for review. Section 3(a)(8) of the Securities Act provides an exemption from the federal securities laws for annuity contracts, but does not define the term, "annuity contract." The petitioners argued that the Commission unreasonably interpreted the term "annuity contract" not to include indexed annuities. The petitioners also asserted that the Commission failed to fully consider the effect of the rule on efficiency, competition, and capital formation.
On July 21, 2009, the Court issued its decision on the petitions for review. The Court held that the Commission's interpretation of "annuity contract" was reasonable and denied the petitions with respect to that issue. The Court, however, granted the petitions with respect to the petitioners' alternate ground that the Commission failed to properly consider the effect of the rule on efficiency, competition, and capital formation and accordingly remanded the rule for reconsideration.
The Commission is currently considering the Court's decision and how to proceed with regard to the remand.
Another topic of interest to the life insurance industry is the securitization of life settlements, which some reports indicate may be a growing market. Although securitization plays an important role in the financial markets, the recent experience with securitization in the mortgage markets argues for the careful review and analysis of all developing securitization activities.
In light of the potentially far-reaching consequences of any movement toward securitization of life settlements, Chairman Schapiro has established a Life Settlements Task Force to examine emerging issues in the life settlements market and to advise the Commission whether market practices and regulatory oversight can be improved. The Task Force is considering, among other things, the application of the federal securities laws to life settlements, the emerging role of securitization, the life settlements marketplace (including trading platforms), and market intermediaries. In particular, in light of reported recent efforts to collect and securitize life settlements by some large investment banks, the Task Force is focusing on investors, sales practices and intermediaries.
The Task Force has started researching the issues and has reached out to fellow regulators to obtain a greater overview of the life settlements marketplace and assess any potential regulatory gaps. In addition, the Task Force is reaching out to other interested parties, such as investor representatives and counsel who practice in the area. In light of the recent market turmoil, some investors may be looking for additional investment opportunities, while some holders of life insurance policies may be looking for additional liquidity. However, these individuals may be more vulnerable due to the current environment. The Task Force will consider what role the Commission can play to better inform and protect these individuals.
If any of you are interested in this market, the Task Force would be interested in your input. You can contact the Office of Insurance Products and you will be put in touch with the appropriate staff members on the Task Force.
Now, one more topic and we're done.
This past June, the Commission held a joint hearing with the Department of Labor on the topic of Target Date Funds. Target date funds have become an increasingly popular investment option for investors in retirement plans, including participants in 401(k) plans, and the staff is also seeing them as investment options under variable contracts. These funds are designed to make it easier and less-time consuming for investors to hold a diversified portfolio of assets that is rebalanced automatically among asset classes. As the target date approaches and sometimes continuing for a period thereafter, a target date fund shifts its asset allocation to investments that are intended to be more conservative — usually by decreasing the percentage allocated to stock.
A concern that has been raised is the degree to which communications to investors in target date funds have — or have not — resulted in a thorough understanding by investors of those funds and their associated risks. Losses in target date funds incurred in 2008 raised concerns about the extent to which investors understand the risks of target date funds. Recent variations in returns among target date funds with the same target date also have raised questions about the extent to which differences among target date funds have been effectively communicated to investors.
Marketing materials for target date funds typically portray the funds as offering a simple solution for investor retirement needs. The marketing materials frequently are less nuanced than the disclosures found in target date fund prospectuses. To the extent that an investor relies primarily on a fund's marketing materials, the investor may develop unreasonable expectations regarding target date funds and their ability to provide for retirement. In addition, questions have been raised regarding whether the names of target date funds have contributed to misunderstandings about these funds.
At Chairman Schapiro's request, the Division of Investment Management has undertaken a review of target date funds, with a view to recommending steps that the Commission could consider to address concerns that have been raised. Because many individuals invest in target date funds through 401(k) plans and other defined contribution plans that are not regulated by the Commission, we have been cooperating closely with our counterparts at the Department of Labor.
The Division of Investment Management is focusing on two areas where enhanced regulation of target date funds may be appropriate: fund names and fund sales materials. The staff is examining closely whether there are circumstances where the use of a date in a fund's name should be restricted in any way or prohibited. The Division also is considering whether we should recommend that the Commission amend its rules governing mutual fund sales materials to address issues raised by target date funds. The Division is concerned that target date marketing messages be balanced and that they not suggest a uniformity or simplicity of target date funds where these are not present.
Together with the Commission's Office of Investor Education and Advocacy, the Division is also developing outreach efforts to investors that could help to address potential misconceptions about target date funds.
I want to thank you for listening this morning. It looks like you are in for an interesting program today. Enjoy the rest of conference.