November 19, 1997 Jonathan G.Katz Secretary Securities and Exchange Commission 450 Fifth Street, N.W. Washington, DC 20549-6009 Re: File No. S7-22-97 Thank you for the opportunity to comment on matters which the SEC should consider in addressing federal securities law issues raised by equity index insurance products. With regard to annuities and life insurance products whose values or benefits may be determined by reference to an outside index, the following observations seem to deserve discussion: 1. Considerations or premiums received on contracts which provide variable benefits or values are usually added to a separate account. Equity index products provide variable benefits or values (i.e., the benefits or values are not determined in advance, as the interest rate is determined in arrears), but no separate account is generally established for these forms. NAIC model and some states' definitions of "variable" contracts seem to depend upon the establishment of a separate account; failure to establish separate accounts seems designed to avoid the "variable" classification, which in turn affects their regulation under state filing, licensing, reserving, nonforfeiture, and disclosure laws. 2. To protect asset adequacy under diverse cash-flow scenarios, insurance contracts with indexed values may need specific matching assets. If assets are purchased to satisfy liabilities for a contract with variable values, it seems most prudent to hold them in a separate account. However, if such assets fit within the legal limits of the general account, some state insurance laws might not require a separate account. This could create inequities among insurers by size; those with more assets could have greater leeway with regard to investing in the types of instruments needed to hedge equity index product risk. 3. These contracts do not appear to qualify under SEC Rule 151 for exemption from Section 3(a)(8) of the 1933 Securities Act. The SEC discussion in its Rule 151 adopting release said, "an insurer which uses an index feature externalizes its discretionary excess interest rate, and thus shifts to the contract owner all of the investment risk regarding fluctuations in the rate. ... The insurer, therefore, would be permitted to specify an index to which it will refer, no more often than annually, to determine the excess rate that it will guarantee under the contract for the next 12-month or longer period." If the insurer fails to disclose the likelihood that this contract is a security, it may deceptively affect the risk purported to be assumed. Virtually all equity index products refer to the index to determine the excess interest rate to be credited for the previous period (often 12 months), not to fix the excess interest rate for the next 12 months. It seems essential to consistent, adequate, and reasonable regulation for the SEC to take a firm stand regarding the securities status of equity index insurance products. Primary responsibility for determining whether an insurance product is a security rests with the insurer. However, many insurers (including those which have obtained opinions from outside counsel) seem unaware of the statements made by the SEC in its Proposing Release as well as the Adopting Release of Rule 151. The following opinion was provided by outside counsel for an insurer in connection with an equity index annuity form recently submitted to a state insurance department for approval: "[T]he current position of the SEC is that index annuities are not required to be registered. Only recently has the SEC begun to ask for comment from the insurance industry on whether index annuities should be registered." This opinion seems typical. 4. Referring to the index to determine the rate credited on existing funds shifts the investment risk away from the insurer, placing it squarely upon the policyowner. Retention of investment risk by the insured appeared to be the linchpin in the federal court decision in Otto v. VALIC (as well as Rule 151), which declared insurance to be a security when the excess interest rate was not guaranteed prospectively for at least 12 months. Virtually no equity index products guarantee the excess interest rate prospectively. 5. To avoid being misleading, deceptive, or false, policy forms and associated marketing, disclosure, and illustration material must adequately disclose important product features. When indexed values are included in an insurance product, marketers are likely to emphasize them in touting product advantages. State insurance departments are not in a position to determine whether such material will satisfy the marketing test of SEC Rule 151. But because the index is an integral part of those products, emphasis on it could violate the marketing test. Furthermore, state disclosure and illustration requirements for nonvariable products may be inadequate to regulate appropriate illustration of equity index features. 6. If product values or benefits are based on an index, it could be misleading to represent the product as nonvariable. Furthermore, issuing an indexed contract as nonvariable may deceptively affect the risk purported to be assumed by the insurer, in that the insured assumes a portion of the investment risk. However, these possible violations of state insurance laws are not generally recognized, in part due to the confusion over whether the SEC views such contracts as transferring investment risk to consumers. 7. The typical equity index contract obligates the insurer to credit excess interest at a nonguaranteed rate from the general account, with the crediting rate being determined at the end of each period. The interest crediting method thus employed pays a share of company surplus, i.e., a dividend. Therefore, if no separate account is established, the contract is a participating contract, and any dividend (excess interest) thus paid must comply with applicable statutes, rules and actuarial standards of practice. It may be difficult for insurers issuing such contracts to comply with participating contract requirements. Most such forms are titled and described as nonparticipating. However, this misrepresents their true nature, makes their provisions misleading, and deceptively affects the risk purported to be assumed in the general coverage of a nonparticipating contract. Sincerely, David J. Hippen, FSA, MAAA, FLMI Actuary hippend@doi.state.fl.us