Swaps Proposal Threatens Annuities’ Insurance Status

July 27, 2011

By Linda Koco
Contributing Editor, InsuranceNewsNet
Several insurance organizations are concerned that a new government proposal regarding swaps could, if adopted, remove certain annuity and life insurance products from state regulation and make them subject to federal regulation.

Offered jointly by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), the proposed rules are designed to define the terms swap, security-based swap, and security-based swap agreement and mixed swaps. The rules can be viewed at the Federal Register as 33-9204
Swaps are derivative financial products. Unregulated use of such products played a key role in the mortgage-backed securities dealings that were central to the financial downturn starting in 2007.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) has now addressed regulatory issues related to swaps. This includes requiring that the SEC and CFTC to “further define” the swap definition that appears in Dodd-Frank’s Title VII. The two federal bodies began work on this directive last year and they issued a Proposing Release in April, with a comment period to end on July 22.
Raising eyebrows
The proposing release includes a definition of insurance that aims to differentiate insurance from swaps. This definition is what is raising eyebrows.

“The proposed rules are pretty good in acknowledging that insurance is not a swap,” says Frederick R. Bellamy, a partner in the Financial Services Practice Group of Sutherland Asbill & Brennan, LLP, a Washington, D.C. law firm. “But if the final version does not come out right, the result could be disastrous, with some insurance and annuity products becoming subject to regulation as swaps.”

Such an environment would not be comparable to the regulatory environment for variable annuities, Bellamy notes. Variable products are subject to both federal and state regulation, but swap products are subject only to federal regulation, he explains. Because of that, insurance products that might be considered swaps would come under federal regulation, and only federal regulation, he says.
The Committee for Annuity Insurers (CAI), The American Council of Life Insurers (ACLI), the National Association for Fixed Annuities (NAFA), the National Association of Insurance Commissioners (NAIC), Metropolitan Life, and Nationwide have all submitted comments on this and related matters. Electronic comments are already posted on the SEC website. Written comments may be posted there later, says Bellamy, who has been representing CAI in proposal-related discussions.

In their proposed rules, the SEC and CFTC acknowledge that some insurance interests are concerned that the swap definition in Dodd-Frank could potentially include certain types of insurance products. (Dodd-Frank defines swap as a contract that "provides for any purchase, sale, payment, or delivery...that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence.”)

But the commissions also indicate that they wrote the proposed rules with another concern in mind as well—namely, that swaps or security-based swaps might be characterized as insurance products in order to evade Dodd-Frank regulations.
Insurance trade groups had suggested that the Commissions resolve the problem by developing a regulatory approach aligned with the existing state insurance regulatory system. That is not what the current proposal does, however, says Bellamy. Instead, the rules attempt to define insurance products that are not swaps, but they do so in a way that raises a number of concerns regarding how certain products, including newer types of insurance products, might be regulated.
“Whether the Commissions will later decide to rely on state insurance regulations, we don’t know,” says Bellamy. “But if they decide to stick with what they have now, we are asking them to adjust the rules to meet the areas of concern.”

Whatever the Commissions adopt, he adds, insurance groups would like there to be a safe harbor from swap regulation for insurance products. This would be comparable to how the Harkin Amendment in Dodd-Frank has created a safe harbor from federal securities regulation for insurance and annuity products, Bellamy says.

Good will but...
“There is definitely good will on the part of the Commissions,” says Bellamy of the SEC and CFTC efforts to draft rules that meet various concerns. “They’ve been willing to take our calls most any time. They are trying to accommodate our concerns with other conflicting or competing concerns, and they are working hard to get it right.”

Furthermore, he stresses that there is no battle between staff and insurance people over whether legitimate insurance products should be treated as swaps. Everyone agrees they should not be treated as swaps. “The issue is how to define legitimate insurance products,” he says.
Excerpts from posted comments:
--Susan E. Voss, president, and Therese M. Vaughan, chief executive officer, National Association of Insurance Commissioners: “The Insurance Product Test in the proposed rule generally states that the term “swap” does not include an agreement, contract, or transaction that by its terms or by law, as a condition of performance on the agreement, contract, or transaction:
1)      requires the beneficiary to have an insurable interest that is the subject of the agreement, contract, or transaction and thereby carry the risk of loss with respect to that interest continuously throughout the duration of the agreement, contract or transaction;
2)      requires the loss to occur and to be proved, and that any payment or indemnification thereof be limited to the value of the insurable interest; and
3)      is not traded, separately from the insured interest, on an organized market or over-the counter.

“However, most insurance products would not qualify under this three-prong test. Therefore, the proposed new requirements are not effective criteria for determining whether a product is insurance.”

Stephen E. Roth, James M. Cain, and W. Thomas Carter, Sutherland Asbill & Brennan LLP, on behalf of the Committee of Annuity Insurers: “The Proposing Release recognizes that swaps and insurance products are subject to fundamentally different and inconsistent regulatory regimes, and that nothing in Title VII suggests that state-regulated insurance products should instead be regulated as swaps; the Committee agrees entirely with these basic concepts.
“The actual Proposals themselves, however, are not consistent with these basic concepts, since the Proposals, in effect, seem to be based on the assumption that insurance products are swaps unless they fit within the exclusions in the Proposals. That is clearly not what Congress intended. ...
“The Committee realizes that a principal concern addressed by Title VII of the Dodd-Frank Act is the largely unregulated market for credit default swaps. We understand that the proposed rules may have been designed with that concern in mind, and the proposed rules may address that concern.
“However, outside of that particular arena, and especially with regard to annuity products, both the proposed rules and the proposed interpretive guidance have very serious flaws in that both aspects of the Proposals are simply too narrow and would not properly recognize that there are other types of insurance products that, while they may not meet the specific conditions of either the proposed rules or interpretive guidance, nevertheless very clearly are insurance products that are not swaps and are not intended to be and should not be removed from insurance regulation and instead regulated as swaps.”

--Kim O’Brien, president and chief executive officer, National Association for Fixed Annuities:  “The Commissions’ approach in the proposed rules is basically to treat an insurance or annuity product as a ‘swap’ unless it can come within the exclusions set forth in the proposed rule. NAFA believes that the proper approach, which is consistent with Congressional intent, is to treat such products as insurance that are not swaps unless they fail to meet criteria set forth in Section 3(a)(8) of the 1933 Act.
“Simply put, instead of the ‘you are a swap until proven insurance,’ the operative presumption should be ‘you are insurance until proven a swap.’…

“Many of the tests or criteria in the proposed ‘swaps’ definition as to whether an insurance or annuity product is to be excluded from this definition are written so that they improperly exclude a wide range of insurance products—including in particular many key annuity products—that are regulated by the states and that Congress never intended be deemed swaps….
“NAFA also has a serious concern regarding, and objection to, a criterion that the Proposing Release says the Commissions may add to the proposed rules. This additional possible criterion would require that any payment under the contract not be based on the price, rate or level of a financial instrument, asset, interest or any commodity. NAFA strongly opposes adding any such criterion because it would prevent many annuities from being excluded from the definition of ‘swap’ as Congress clearly intended. For example, fixed indexed annuities, a very popular and important retirement product, typically base interest payments on positive changes to a popular index (e.g., S&P 500).”

--Nicholas D. Latrenta, executive vice president and general counsel-legal affairs, Metropolitan Life Insurance Company:  “As proposed, neither the ‘product test’ [in the Proposing Release] nor the interpretive guidance specifically addresses group annuities. In addition, the fact that the only annuity contracts identified in the interpretive guidance as excluded from the definition of a swap are annuities ‘the income on which is subject to tax treatment under section 72 of the Internal Revenue Code’ could be read to suggest that group annuity products issued to retirement plans are not excluded.”

--Mark R. Thresher, executive vice president and chief financial officer, Nationwide: “The Commissions commentary clearly indicates their recognition that swaps and insurance products are fundamentally different contract and are regulated through different frameworks. Nationwide believes the Commission's rules and definitions should reflect the understanding in the commentary. An abundance of existing federal laws, regulatory guidance, and judicial decision clearly define products, complete with mechanisms for identifying new products, under the jurisdiction of state insurance regulators. Instead of trying to craft a new definition of properly excluded insurance products, annuities and retirement products, etc., Nationwide recommends that the Commissions look to current federal law to differentiate between swaps and state-regulated insurance and related products.”
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