If industry leaders and insurance company executives don’t show a little more gumption, backbone, creativity, innovation and leadership than they have a history of doing, then the worst of all results could happen.
On June 25, the SEC announced its intent to propose a rule (151A) that will classify many of the annuity products issued by insurance companies as investments. If the ruling is implemented as proposed, then the sale of impacted annuity products will be supervised in exactly the same manner as stocks, mutual funds and bonds. This means that only those who are registered representatives with FINRA broker dealers or Registered Investment Advisors will be able to sell these annuity products. It is more than an understatement to suggest that such a ruling could have a cataclysmic impact on the traditional insurance industry and its distribution system.
However, the logic that led the SEC to such a ruling is so tortured that it strains credibility to imagine it will be implemented as proposed. (But then again, there is no rule of nature that says government bureaucrats must follow the laws of logic.)
For over 70 years the SEC has operated under the fundamental philosophy that an “investment” was identified based upon the “potential” for the consumer to lose money on their purchase. If there was the possibility the consumer would suffer the loss of any principal invested, then the product was, ipso facto, an investment. If the product purchased contained a guaranteed return of principal it was considered an insurance product exempt from securities regulations.
Over time, hundreds of rulings have been offered up to clarify the distinction between an investment and an insurance product, i.e. if an insurance product is sold in a manner that suggests it is an investment product then it will be deemed an investment product. However, the fundamental “risk” versus “guarantee” test has remained the primary determinant in classifying a product as either insurance or investment.
Now, the SEC has changed or at least severely warped these rules. In making its announcement, the SEC creatively and capriciously departed from the traditional definition of investment products to now encompass the sales practices of the individual selling the product. Specifically, the SEC cited instances where annuities had been allegedly improperly sold to senior citizens. The sin of the sale was in not properly disclosing potential charges if the annuity product were surrendered. This created the potential for the annuity buyer to suffer a “loss of principal” if they were to surrender the policy prior to maturity.
The convoluted logic of this approach creates a flawed syllogism:
Investment products have potential for loss of principal.
Surrender charges applied to an annuity create potential for loss of principal.
Therefore: Annuities are investments.
Of course, the fallacy here is that with an investment product the investor has no control over the potential loss of principal. They must accept the risk of what the product does or does not return. However, with the annuity it is the action of the purchaser, not the market, that determines if there is a loss of principal. If the purchaser of the annuity never surrenders the annuity there will never be a loss of principal. (The SEC also did not take note that all annuity surrender charges systematically decline and ultimately disappear. In fact, with most annuities in as short as three years, even if the policy is surrendered, there is no loss of principal.)
Of course, annuity buyers should be made aware of the impact of actions they may take, but the SEC seeks to rectify the “problem” of surrender charge disclosure by having these annuity products sold and supervised by FINA member broker dealers under securities law. To say the least this is the proverbial use of an elephant gun to kill a flea. And besides, when it comes to fraud, failure to disclose and inappropriate sales practices, I would put the record of insurance agents up against stock brokers anytime. Try comparing the total loses consumers have suffered as a result of inappropriate sales of investment products with the total loses from annuities policies and see just which group needs better supervision.
There is no question that there should be clear and full disclosure of all facets of a financial product – investments and annuities alike, however, insurance products such as annuities are better supervised by insurance regulators not the investment community.
So what is going to happen?
Well, it is almost impossible to predict the actions of bureaucrats in power, but it is safe to say this proposed ruling will cause more flinging of mud and feathers than in a mixed martial arts brawl. Lawyers and lobbyists (no strangers to mixed martial arts) are jumping with glee!
The fact is, I am optimistic as to the outcome. I believe ultimately this will serve more as a warning from the SEC to insurance companies to clean up their actions than to actually have annuities declared investments. I come to this conclusion because the SEC proposal is so outrageously flawed that even the SEC has to recognize that, from both a legal and logical standpoint, the ruling cannot be implemented as proposed. In other words, the reaction of “you’ve got to be kidding” is what the SEC expected and wanted.
The SEC has its own politics to deal with – its relationship with the investment community – and this ruling is a way of doing so, while knowing all along it will not be implemented. It is a little like a senator submitting a bill exempting all his state’s citizens from paying income taxes, knowing all along that there is no way it will pass. Yet, he can go back to his state and brag about what he is attempting to do for his constituents.
There will certainly be a fierce fight and changes will be implemented, but the key will be how the insurance companies and industry leaders respond to this proposed SEC rule. If industry leaders and insurance company executives don’t show a little more gumption, backbone, creativity, innovation and leadership than they have a history of doing, then the worst of all results could happen. Much to the surprise of everyone – especially the SEC – this stupid, ill-conceived, ill-logical rule will become a reality.