INSURANCE PRODUCTS: THE RESPONSIBILITIES OF A GROWING INDUSTRY<1> Keynote Address by Barry P. Barbash, Director Division of Investment Management U.S. Securities and Exchange Commission 15th Annual Advanced ALI-ABA Conference on Life Insurance Company Products Washington, D.C. October 22, 1997 Introduction Thank you, Jim, for your kind introduction. The variable insurance industry continues to show the staying power of that pink, battery-powered rabbit that's always on t.v. Despite what seem to be countless attempts to take away its tax benefits, the industry keeps on going, experiencing astounding growth. Variable annuity sales reached over $73 billion last year, a 40% increase over the year before. Assets in variable products have grown from just $30 billion in 1990 to over $300 billion this past June. And if the numbers don't speak for themselves, the Wall Street Journal's introduction earlier this year of a weekly "Annuities Watch" column is a testament to the industry's increasing importance to individual investors. Can the final step into mainstream America be far behind? That final step is, of course, variable insurance making it into the comics. Insurance companies are developing new and innovative products to satisfy ever-increasing demand and to deal with the challenges of ever-intensifying competition in the financial services business. In many ways, the industry is effectively and impressively meeting the changing retirement and other investment needs of millions of Americans. Together with the industry's success, however, comes added responsibility. Responsibility for fairness. Responsibility for honesty. And responsibility for clear and understandable communication with investors. The responsibilities of compliance and disclosure must be borne by everyone in the industry. But they fall most squarely on the shoulders of those on the legal and compliance side of the business. More than anyone else, you have the obligation for seeing that your clients and firms operate within both the letter and spirit of laws that are intended to protect investors and foster the integrity of the markets. Counsel also wield significant influence over the quality of information that investors receive about variable insurance products, helping to ensure that investors understand the products they buy before they buy - - and not in a lawsuit down the road. Meeting these responsibilities is not an easy task. Many investors in variable annuities and life insurance are new to these products. They may not have the background to understand readily the risks involved in the products being sold today. Care is required to make prospectuses, sales materials, and oral presentations clear and succinct, so they will be useful to investors. Take the case of the 86- year old widow, described in this Monday's Wall Street Journal "Annuities Watch" column.<2> Intending to withdraw a lump sum from her annuity, she found that she had inadvertently annuitized. The mistake was corrected, but then she arranged to withdraw her money on an as-needed basis, subjecting herself -- perhaps unnecessarily -- to heavy surrender charges and taxes. More effective disclosure would almost certainly have helped this seemingly inexperienced investor. Indeed, in view of the complexity of variable insurance products, even the most sophisticated investors benefit from efforts to improve and clarify disclosure. In the area of sales practices, firms today are challenged with the need to oversee far-flung sales forces selling an ever-growing number of new and complex products. Whether a life company has a captive or independent sales force, distributes its products through banks or investment advisers, direct marketing, or some other channel, controls must be in place to prevent sales practice problems to the greatest extent possible. When problems do occur, effective systems should be in place to detect and correct them. Firms that carry out their responsibilities well perform an invaluable service for investors. At the same time, they build their own reputations for integrity. Improving disclosure and focusing attention on compliance will build integrity, foster investor confidence, and fuel continued growth. Much in the way the industry is meeting its unique challenges and carrying out its responsibilities is encouraging and positive. There is, nonetheless, considerable room for improvement. Prospectuses still are often murky and filled with jargon and legalese. Sales practices problems such as churning and questionable suitability determinations remain a concern. Supervisory practices and internal controls need to be scrutinized. This morning, I want to focus on three topics that highlight some of the ways that the industry can strengthen its efforts in the areas of compliance and disclosure. The topics are equity index products and how they are marketed, development of a new registration form for variable life insurance products, and sales practices and internal controls. Equity Index Products Equity index products, introduced a mere two years ago, are a prime example of the innovation and remarkable growth in the insurance industry. By the end of 1995 only four insurers offered equity index annuities. A year later, over 30 equity index annuities were available. In 1997, insurers are offering an estimated 45 equity index annuity contracts. Sales have taken off, with 1997 sales projected to be in the $3-5 billion range. Different products have proliferated, with single premium deferred annuities joined by flexible premium deferred annuities, immediate annuities, and life insurance policies. In remarks to another insurance audience just over a year ago, I noted that, on the basis of our then very limited knowledge of equity index annuities, we had not concluded that any of the available products needed to be registered as securities. And when I spoke to this group a year ago, I observed that the challenge for the Commission was to educate ourselves about equity index annuities as rapidly as possible so that we could determine whether or not they are securities. I encouraged the industry to assist us in this process. In the last year, some in the industry have provided us with useful information, and we appreciate those efforts. At the same time, though, our concerns with respect to these products have been heightened. We are concerned that product marketing sometimes may create the misimpression that equity index insurance products are a means for participating fully in upside market returns without any downside risk. It now appears that it may be very difficult to market these products without giving undue emphasis to their investment-related features. We are also concerned that the varied and complicated forms of these products may make it most difficult for investors to understand what they are buying, and perhaps for agents -- particularly agents unfamiliar with the securities markets - - to understand what they are selling. As many, if not most of you know, in seeking broader and more comprehensive information about equity index products, the Commission recently issued a concept release requesting public input on their operation and marketing. The comment period closes in about a month, and we are looking forward to receiving instructive comments. Over the coming months, the Commission staff will do its part in clarifying the regulatory status of these products. The industry also must bear responsibility for ensuring that products that should be registered with the Commission are registered with the Commission. Insurers should take particular care that they are not putting too great a distance between an initial determination that an equity index annuity need not be registered and subsequent attention to the distribution of the product -- how it is advertised and marketed -- in both written and oral sales presentations. N-6 The development of Form N-6 for variable life insurance products, which we all acknowledge has for too long been more of a dream than reality, is beginning to take shape. The staff is hard at work drafting the proposed form, which we expect the Commission will release for public comment late this year or early next year. We believe that Form N-6 will represent a significant improvement, facilitating clearer communications with variable life purchasers. Currently, companies are using forms that were not designed for variable life insurance products. As a result, these forms lack some of the fundamental improvements that the Commission has made over time to other investment company registration forms, such as the N-4 for variable annuities and the N-1A for mutual funds. Like those forms, the new Form N-6 will be an integrated Securities Act and Investment Company Act form, so that contracts will be registered on a single form rather than the two forms now necessary. The new form also will use the two-part format of prospectus and statement of additional information, enhancing investor understanding by moving more technical material to the statement. Our development of the new Form N-6 will profit from our recent experience in improving Form N-1A. We are coming to the end of the process of revising the mutual fund disclosure form, and we have learned much in the process about how to facilitate better, clearer, and more concise disclosure to investors. We will apply those lessons as we move forward with the Form N-6. In developing the form, the staff is wrestling with a number of difficult issues. One such issue concerns how fees should be disclosed. Our goal is that they be described in a format as transparent as possible that facilitates comparisons to the greatest degree possible. The variable insurance industry has argued long and hard for greater flexibility in pricing these products. Now that last year's legislative changes have granted this flexibility, don't abuse it by doing a poor job of disclosing fees. Another thorny issue involves illustrations. Quite frankly, many of the illustrations included in prospectuses today strike us as bad disclosure, confusing at best. The staff is very concerned with the pages and pages of tables that are sometimes included in variable life prospectuses, which in many cases have very little relevance to most of the individuals who receive the prospectus. We are taking a fresh look at this area, hoping to eliminate much of this disclosure shroud. At the same time, we expect that the Form N-6 will provide insurers with the flexibility to design prospectus illustrations that are helpful and to supplement them, as appropriate, with personalized illustrations that are relevant to individual purchasers. Our goal is for insurers to use illustrations that are effective in helping prospective investors grasp the essential characteristics of contracts and to eliminate those that simply clutter the prospectus. Development of Form N-6 is one of many areas in which the Commission is working to improve disclosure. The Commission cannot bring about clear and understandable disclosure on its own, however. The industry also must be fully committed to that goal. Responsibility is again the theme that must guide the industry. No company needs to wait to work on improving disclosure until Form N-6 is completed or proposed Form N-1A is finalized. Insurers should redouble their efforts now to ensure that investors receive the information they need in a way that is understandable. Too many prospectuses continue to be written in highly complex, technical jargon. Prospectuses should be useful to investors, and not viewed as liability protection documents that are ignored and forgotten until a disappointed investor commences a lawsuit. And how can disclosure materials be improved? Prospectuses can be shortened by eliminating unnecessary discussions. In the case of annuity contracts, the statement of additional information should be used for highly technical information that is not needed in the prospectus. As I noted to you, that option will soon be available for variable life insurance contracts as well. Complex or technical terms should be avoided altogether, or at least explained. Tables, charts, and other graphic materials can be an invaluable aid to investor understanding. The Commission staff is committed to these goals and continues to stand ready to assist the industry in reaching them. I submit that our track record in assisting the industry in these efforts to date has been excellent. And in this case, past performance will be predictive of future results. Sales Practices Finally -- a brief word on sales practices. Much has been said on this topic of late, but it is so important that it bears emphasizing. The dramatic growth in sales of variable insurance products over the past few years has heightened the need for firms to police the activities of sales agents. The growth has highlighted the importance of effective internal controls to prevent, detect, and correct misleading or abusive sales practices. The Commission is concerned that sales practices and compliance efforts sometimes fall short of the high standards set by the securities laws and required to inspire confidence among investors. Article after article it seems has been written about the high level of so-called "1035 exchanges" in the industry. A Cerulli-Lipper study estimated that these exchanges constitute 25% to 30% of industry sales. Nothing is inherently wrong with these transactions, some of which may work to the advantage of customers who receive enhanced products. We are concerned, though, that the high incidence of "1035 exchanges" may reflect sales practice problems such as churning of policies to generate commissions and the sale of unsuitable products to unwary investors. The Commission has recently begun to place greater emphasis in its examination program on evaluating sales practices associated with variable products. The inspections staff is focusing on sales and marketing activities of registered representatives and the supervision they receive from branch managers and others. While the Commission is carrying out its responsibilities in conducting its examination program, the variable insurance industry must recognize its responsibility to promote a culture of compliance. The area of internal controls is critical. Effective internal controls help protect a firm from the actions of unscrupulous employees and prevent irreparable damage to the firm's reputation. Conclusion Today the variable products industry is a dynamic, highly successful industry that is providing valuable services for investors across the country. To retain and improve this position, the industry needs a reputation for integrity and fair dealing. The challenge is great, but the dividends in investor satisfaction and business reputation are equally great. Thank you. _______________________________ <1> The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are solely those of the author and do not necessarily represent the views of the Commission or other members of the staff of the Commission. <2> Ellen E. Schultz, "Planning Withdrawals Can Avoid Snafus," Wall Street Journal, October 20, 1997, at C.1.