Suitability: The Rules Are Changing

It used to be that the rules governing when an annuity recommendation was considered "suitable" depended upon whether the annuity in question was a variable contract.

Variable annuities, as insurance products, were regulated by state departments of insurance. As securities, VAs were also subject to the rules of the Financial Industry Regulatory Authority, the regulations of state securities offices, and the policies of the seller's broker-dealer.

On the other hand, sales of non-variable annuities–that is, fixed annuities–were regulated only by state departments of insurance (and did not have to be sold through broker-dealers, even when the seller was a registered representative affiliated with a broker-dealer).

The suitability rules applying to VAs were generally stricter than those applying to fixed annuities.

Some of that is still true. Variable annuities are still securities, regulated by FINRA rules; and state insurance regulators still exercise authority over both variable and non-variable annuity sales.

But revisions to the Suitability In Annuity Transactions Model Regulation, approved in late March 2010 by the National Association of Insurance Commissioners, will change things considerably–for agents who sell fixed annuities (in states that adopt this regulation) and for the insurers who offer fixed annuities.

The new rule mandates completion, within six months of its effective date, of a four-hour training course on annuities. Insurers must verify agents' completion of this course before permitting them to sell any annuity, except contracts used to fund individual retirement accounts, qualified plans, deferred compensation arrangements, or structured settlements.

In other words, it applies to nearly all "non-qualified" annuities. It requires that insurers review all annuity transactions, and it makes them responsible for compliance with the regulation, even if they hire a third party firm to monitor compliance.

It specifies 12 factors that must be taken into account by an agent recommending any annuity, prior to making that recommendation. (See box.)

If these factors look familiar to readers who are familiar with FINRA rules governing variable annuity sales, they should. These are the same 12 factors cited in paragraph (b)(2) of NASD Rule 2821 (now FINRA Rule 2330).

The regulation further states that "insurance producers" (agents and brokers) or insurers (where no producer was involved) must have "reasonable grounds" for believing that the annuity buyer has been informed of the features of the annuity–including surrender charges and schedules, potential tax penalties, fees, limitations on investment returns and insurance components, and that "the particular annuity as a whole" is suitable for that buyer, in light of all these factors.

This amounts to a significantly higher standard of "suitability" for fixed annuity sales than is now required in many states, and closely approaches the standard applicable to sales of VA contracts.

Another dimension of change–and one that many producers may not even be aware of–involves the "source of funds" used to purchase an annuity.

In some states, a producer must hold a securities license if he or she recommends that an annuity be funded by a distribution from a security (such as a stock or mutual fund). In at least one state, this is true even if the producer did not suggest that distribution.

And then there's the whole business of index annuities. At present, these products are not securities, because the Securities and Exchange Commission's Rule 151A was rejected by the District of Columbia Court of Appeals for what amounted to a technical flaw. The SEC may or may not cure the defect and reassert this rule. (Two bills before Congress would trump that by declaring that index annuities are not "securities," but they are still only bills.)

In this environment of uncertainty, many broker-dealers now require that their registered reps submit, through the broker-dealer, all index annuity sales, and impose the same compliance rules to those sales that the broker-dealer employs for securities sales.

Simply to avoid the uncertainties, some insurers are registering newly-developed index annuities as securities.

Finally, there is the "F word"–fiduciary. Although the financial services reform bill currently being debated in the Senate does not apply a fiduciary standard to insurance agents, stockbrokers, and others whose advisory activities are "incidental" to the sale of insurance or investment products, there remains considerable interest, in the financial and regulatory communities, in imposing some form of that standard upon product sellers–potentially including annuity producers.

John L. Olsen, CLU, ChFC, AEP, is principal of Olsen Financial Group, Kirkwood, Mo. His e-mail address is [email protected].