No topic is more current in financial circles these days than regulation. Consequently, it is logical for would-be buyers of annuities to wonder how and by whom these products are regulated.
Annuities: Insurance or Investment?
On the one hand, annuities are financial products issued by insurance companies. Insurance companies are regulated by state governments. This suggests that annuities would be subject to state regulation. On the other hand, annuities are intended to help people fund their retirement. This requires the intertemporal redistribution of consumption from the present to the future. The transformation of saving into investment through financial intermediation conducted by banks and securities firms is regulated by the federal government. Among other things, federal securities laws require that securities be registered and accompanied by a disclosure document called a prospectus.
The Basic Facts of Annuity Regulation
In actual fact, the regulatory status of annuities depends on whether they are fixed or variable. Fixed annuities are deemed to be insurance products and are regulated by the individual states. Variable annuities are legally defined as securities; thus, they are subject to federal regulation as well as state regulation. The third general category of deferred annuities is indexed annuities, which contain elements of both fixed and variable annuities but are closer to the former. Most indexed annuities are not considered securities and are state-regulated, but a few are federally-regulated securities. Beginning in January, 2011, however, all indexed annuities will be defined as securities and subject to federal regulation.
The Logic Underlying Annuity Regulation: Risk Assignment
Such are the facts of annuity regulation. Underlying those facts is the definition of a security, which has both a legal and an economic dimension. Modern federal regulation of securities dates back to the Securities Act of 1933. In Section 3(a), a security is defined as a financial instrument evincing either indebtedness (as with bonds) or ownership (as with stocks). In either case, the holder of the security assumes the investment risk associated with fluctuation in its value.
This contrasts with an instrument of insurance, whose inherent purpose is the reduction of risk and which is governed by principles of contract. The issuer makes representations to the purchaser, and the issuer must fulfill the representations while bearing the burden of fluctuations in the contract’s value.
The Difference Between Fixed and Variable Annuities: Investment Risk
A fixed annuity is an insurance product, not a security, because the insurance company must credit the annuity holder’s account with the specified interest rate for the contractually-stipulated time period, regardless of market fluctuations in actual interest rates. It is the insurance company that bears the investment risk, which it does by investing the annuity holder’s purchase proceeds in fixed-income instruments that the company hopes will provide sufficient return to fulfill its contractual representations to the holder.
The interest rate credited to a variable-annuity holder, however, varies according to the market performance of the annuity’s subaccounts, a risk borne by the holder. This makes the variable annuity a security, subject to federal government regulation and accompanied by a prospectus that must be distributed to every willing buyer.
Two Supreme Court decisions affirmed that fixed annuities were exempt from the securities-regulation provisions of the Act of 1933. The rise of variable annuities led the Court to reconsider its view of annuities. In 1986, the Supreme Court established a safe-harbor exemption for insurance companies from federal securities law. An insurance product would be proof against federal regulation if it could satisfy three criteria: its issuer must be subject to state regulation; the issuer must assume the investment risk and the product must not be marketed primarily as an investment.
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The Hybrid Annuity: Indexed Annuities Straddle the Line
Over the subsequent two decades, indexed annuities arrived on the scene. The ambiguous status of the indexed annuity reflects its hybrid composition. The guarantee against (significant) loss of principal is characteristic of insurance products, while the fluctuation of the credited interest rate in line with the performance of the index is characteristic of securities. Because they were closer to fixed than to variable annuities, there was an automatic tendency to classify them as insurance products exempt from securities regulation. Their protection of principal supported this treatment, and the potential variation in credited interest rate felt asymmetric in its impact – the compelling necessity of protecting annuity holders from upside potential in credited interest rates seemed lacking.
Still, federal securities regulators have long yearned to bring indexed annuities under their control. Technically, risk is the variation in expected outcomes, whether upward or downward. Regulators believed that the possibility of income loss from surrender, albeit slight, coupled with the fluctuations in market returns inherent in indexation made indexed annuities investment products rather than insurance products.
Rule 151(a): Change in Regulation of Indexed Annuities
The financial crisis of 2008 provided an environment favorable to enhanced risk aversion and tightened regulation. In December, 2008, the SEC announced that indexed annuities would be treated as securities and regulated as such, effective January 2011. In January, 2009, this policy change became codified in Rule 151(a) of the Securities Act, which declared that indexed annuities could not meet the safe-harbor exemption tests laid down two decades before because holders inevitably assumed investment risk.
Although the SEC expressed disapproval with the way some indexed annuities had been marketed, the statutory basis for the rulemaking was the fact that an indexed annuity contained the inherent possibility for variation in the credited interest rate, over and above that guaranteed in the annuity contract. The fact that this volatility in credited return was likely to work to the benefit of annuity holders rather than to their detriment – because the indexed annuity put a floor under income and returns but no absolute ceiling on them – was beside the point, according to regulators. Risk is defined as variability of possible outcomes and insurance is supposed to reduce risk, not embrace it. Thus, indexed annuities as currently constituted will henceforward be considered securities.
This new rulemaking has proved unpopular with issuers of annuities. There are theoretical grounds for questioning whether investors consider favorable fluctuations to be just as risky as unfavorable ones. Whether annuity holders find the benefits of annuity regulation to be greater than its costs will be determined in time.
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