Variable Insurance Products: Sales Practice Regulation

1. Variable Insurance Products:Sales Practice Regulation Todd Cipperman, Esq. Cipperman & Company November 11, 2008

2. Overview • Suitability • Switching Firms • State Regulation • Sales Literature and Advertising • Indexed Annuities • Non-Cash Compensation • Sales Contests • Recordkeeping • Compliance

3. Suitability: Rule 2310 • “reasonable grounds” • Security holdings; financial situation • “reasonable efforts” to obtain information • Financial/tax • Investment objectives • Other information • See also SEC Rule 10b-5; 17(a)(2); 10b-10 • State securities statutes

4. Suitability: What to Consider • Investment Objectives • Disclosure of risks • Investor’s ability to understand • Influence exerted by broker • Suitability ≠ Prudence • Risk Tolerance • Wealthy ≠ More aggressive • The case of the poor, risk-seeking customer i.e. what are the consequences • Potholes: age, concentration, margin, penny stocks • Investment Costs • See reverse churning cases • Class B shares • Solicited vs. Unsolicited orders • Compensation and conflicts of interest • Susan Merrill (FINRA Chief of Enforcement): target audience is people preparing for retirement without sufficient retirement plans

5. Variable Annuities: Rule 2821 • Rule applies to purchase/exchange of deferred variable annuities and subaccount allocations • Note NTM 97-27: Conduct Rules apply to group variable contracts • Rule does not apply • Reallocations of subaccounts • Follow-on investments • Employer-sponsored benefit plans • No recommendation unless reasonable basis to believe transaction is suitable

6. Rule 2821: Suitability • Customer has been informed of product features • Surrender period and charges • Tax penalties • Fees and expenses • Insurance and investment components • Market risk • Note: Rep must understand the product • Customer would benefit from tax deferral, annuitization, death/living benefits • Note: Customer need not benefit from all features • Deferred variable annuity as a whole (including subaccounts and riders) are suitable

7. Rule 2821: Exchanges • Consider negatives: • Surrender charges • Loss of existing benefits • Increased fees/charges • Customer would benefit from product enhancements and improvements • Previous exchange within 36 months • Must make effort to review exchanges at third party firms

8. Age Annual Income Financial situation Investment experience Investment objectives Intended use Time horizon Existing assets Liquidity needs Risk tolerance Tax status Other information Rule 2821: Suitability Due Diligence

9. Rule 2821: Principal Review • Before submission; within 7 days • Reasonable basis that transaction is suitable • Can follow customer’s express instructions after informed consent • Documentation • Modified Proposal • Only recommended transactions • 7 days runs from date OSJ receives application • Allows firms to forward money to insurance companies during review

10. Rule 2821: Procedure • Document review for Principal • Written Supervisory Procedures • Surveillance procedures to detect high rates or exchanges • Polices/procedures to punish reps engaged in high rates of exchanges • Training programs • Effective May 5

13. Variable Life: NTM 00-44 • Suitability • Need for life insurance • Ability to assume investment risk • Can afford premiums • Establish target ratios • Older customers • Document customer information • Familiarity with product features/clearly explained • Use case studies • Product brochures • Replacements • Fees, taxes • Get written consent • Financing with cash value • Marketing Materials: don’t over-emphasize investments vs. insurance

14. Switching Firms: NTM 07-06 • Surrender charges and loads without benefit • See also “churning” • Assess suitability • Surrender charges • Comparative fees/expenses • May be the right thing: • Client Service • Notify customer that new firm can’t service • Better product • Not motivated by compensation • Bonus variable annuity may not be enough • Privacy: See In re Next Financial (using customer data without consent)

15. State Regulation • E.g. Regulation 60 of NYS Insurance Department • Replacement sales of annuity contracts • Document 2 separate interactions • Pru fined $9.5 Million in 2004 • National Assn of Insurance Commissioners model regulation to protect seniors (July 2003) • Suitability: See In re Cantella (MA suit re structured products) • Do-Not-Call Statutes: See In re Morgan Stanley (using CareerBuilder list) • What you say can be used against you. • See Betz vs. Trainer Wortham: tolling statute of limitations for re-assuring clients

16. Sales Literature & Advertising(IM-2210-2 and NtM 08-39) • NtM 08-39: Aggregate and clear guidance summarizing past interpretations • Can’t imply that VA is a mutual fund or is a short-term, liquid investment • Full disclosure on Riders and Guarantees • Can’t exaggerate ins. co.’s financial strength • Explain costs and features • Note that Rider is optional • Performance rules same as mutual funds • 1, 5, and 10 year performance • Compare to index • Impact of fees, expenses, etc. • “Past performance is no guarantee of future results.” • Can show predecessor and combined historical performance so long as limits on performance are fully described • When investment option became available • No significant changes to investment objectives • Illustrations • Must show 0% and no more than 10% • Must use real tax rates when showing benefits of tax deferral and compounding • Show deduction of charges

17. Indexed Annuities • SEC proposal to treat Indexed Annuities as securities • Primary risk of return on the purchaser • Effect • Licensing of Reps. • Disclosure, antifraud, sales practices • Comments pending

18. Non-Cash Compensation: Rule 2820 • No paying or receiving gifts > $100 • Occasional Meals/sporting events/entertainment: can’t raise question of “propriety” • But see IM 3060 requiring specific policies and procedures to include dollar limits, prohibitions on quid pro quos • Business development tools permitted • Lead lists • Software • Reimbursement of travel expenses for sales • Training and education meetings • Logo gifts ok • Personal gifts (e.g. wedding gifts) ok • Recordkeeping requirements • Sales Contests

19. Non-Cash Compensation: Training and Education Meetings • Paid by “Offeror” • Home office permission • No sales targets • Can recognize performance in selecting attendees • Appropriate location: no golf resorts • No payment for spouse expenses, unless within firm • Can play golf; just can’t pay for it

20. Sales Contests: Total Production and Equal Weighting • Total production of all variable contracts distributed • Can include non-insurance products • Can’t separate out variable products into multiple contests • Can’t have single product contests • Can limit to a division or department • Can apply to proprietary funds or one contract, if that’s all firm sells • Equal weighting of credit • No limits on award • Can contribute to third party’s sales program

21. Recordkeeping • Numerous Rules (e.g., NASD Rule 2210 (Sales Materials), 3010 (Supervisory Records), 3060 (Non-cash compensation), 3110 (General Books and Records) • SEC Rules 17a-3 and 17a-4 • Electronic storage must be non-rewriteable, non-erasable format, aka WORM ("Write Once, Read Many”) • All communications related to your securities business, “even those cute little instant messages” • Financial records, shareholder account ledgers, agreements, board meeting minutes, brokerage reports • May be different time requirements for each type of record • SEC access upon request • Third party service providers may hold records • Advisers Act requirements (generally 5 years) • Compound Effect: Most other violations are accompanied by (and possibly sparked by) one or more recordkeeping violations!

22. Compliance • Firm must adopt and implement policies and procedures reasonably designed to prevent violations of the securities laws • Consult your policies and procedures manual • Written supervisory procedures • Desk procedures • Compliance manual • Consult your legal and compliance department(s)

23. Final Thoughts • Regulatory attention to variable insurance products • Treating Reps as fiduciaries • Exam priority • Higher standard of care with unsophisticated clients • Seniors • Military personnel • Clear Rules More certainty Fewer problems

24. Cipperman & Company is a unique law firm devoted exclusively to the investment management industry. Our lawyers have spent their careers in the investment management industry, including significant experience at major industry players. Our shared heritage and experience make our lawyers unique and creative industry partners who can give you practical, real-world advice for making informed business decisions and controlling your legal risk. We have worked on a wide range of transactional and regulatory matters, but we concentrate on three core areas - Distribution, Technology and Fund Formation: Distribution: Broker-Dealer Regulatory Matters, Dealer, Solicitation, and Referral Agreements, Asset-Gathering Strategies and Structures, Wrap Programs, Marketing Materials Technology: Licensors and Licensees, Installed and ASP, Portfolio Management Systems, Trading Utilities and Platforms, Compliance Tools Fund Formation: Hedge Funds, Fund-of-Funds, Institutional Products, ETFs, Variable Insurance Products, Cash Sweep Vehicles 150 S. Warner Road, Suite 140, King of Prussia, PA 19406, 610.687.5320, tcipperman@cipperman.com, www.cipperman.com