SEC and NASD issue joint report on examination findings regarding broker-dealer sales of variable insurance products; NASD proposes variable annuity sales practice rule

July 01, 2004

The Securities and Exchange Commission ("SEC") and the National Association of Securities Dealers ("NASD") recently issued a joint staff report on the findings of their examination of broker-dealer sales of variable insurance products.1 At the same time, the NASD proposed a new rule tailored specifically to address sales of deferred variable annuities.2 Both the report and the proposed rule arrive at a time when firms involved in sales of variable insurance products face increasing regulatory scrutiny and enforcement actions.3

SEC/NASD Joint Report

The report's findings focus on sales practices in several key areas, including: suitability, sales practices, and conflicts; supervision; disclosure; books and records; and training. The report identifies weaknesses and "sound" sales practices in the key areas.4 The obvious message is that broker-dealers need to employ sound practices in selling variable products.

Suitability, Sales Practices, and Conflicts

The report reviewed broker-dealer sales practices involving variable product recommendations to customers.5 The examination considered suitability practices in terms of product recommendations, switching or replacements, policies and procedures, and supervisory reviews. Some weaknesses in firms' suitability practices identified in the report were:6

  • Broker-dealers made unsuitable variable product recommendations without a reasonable basis despite customer information that was available to make a suitability determination;
  • Examiners found unsuitable switching or variable product replacements. Registered representatives gave "false and misleading justifications" for switches and replacements;
  • Procedures did not require documentation of the suitability analysis or that registered representatives collect all information required to conduct a suitability analysis; and
  • Some firms did not require supervisors to review the suitability of recommendations or sales.

The examiners identified, among others, the following sound practices regarding suitability:

  • Firms required registered representatives to document each sale with a suitability checklist that evidenced the suitability determination;
  • Suitability determinations were made on two levels—the contract level and the underlying fund level;
    Firms implemented procedures to screen for specific suitability issues and to prevent unsuitable sales of variable annuities in an IRA, 1101(k), or other tax-qualified accounts; and
  • Firms implemented an automated system to facilitate a comparison of sales recommendations, including the underlying funds, to the client's suitability profile to ensure that sales were consistent with the client's investment objectives and risk tolerance.

Supervision

The report identified inadequacies and sound practices regarding supervision by broker-dealers of their employees and associated persons in variable product sales.7 Inadequacies regarding supervision noted in the report were:

  • Written supervisory procedures did not adequately address a firm's variable product business, nor were the procedures updated to address a firm's growing variable product business;
  • Customer files lacked evidence of supervisory review and approval, such as a principal's signature on new account forms, order tickets, and other documents that require supervisory review and approval; and
  • Firms did not employ systems to ensure enforcement of their written supervisory procedures and did not monitor variable product sales activities of registered representatives through use of exception reports.8

Sound business practices identified by the examiners include:

  • Supervision in which, among other things, supervisors reviewed every sale of a variable product to ensure that it was appropriate and hypothetical illustrations to ensure assumed rates of return were indicative of current markets and reflective of appropriate assumptions; and
  • Implementation of automated systems that could detect and prevent improper replacement sales of variable insurance products, and that could produce comprehensive and tailored exception reports, which identified potential problems involving sales of variable products.

Disclosure

The report noted weaknesses where firms failed to provide certain disclosures to customers in connection with sales of variable products, among them:9

  • Firms failed to disclose variable contract fees, risks associated with investment in the product, and the lack of liquidity of variable products;
  • Firms failed to disclose the tax implications of investing in variable products;
  • Firms failed to disclose the potential consequences of financing a variable product, such as the interest rate risk associated with any variable rate loan, that borrowing against cash value in an existing policy or annuity will deplete the cash value, and that a new policy will lapse if premiums are not paid; and
  • Examiners found undisclosed conflicts of interest. For example, investment advisers were recommended for asset allocation services with wrap or managed account programs based on affiliations with or expected payments to broker-dealers, which were not disclosed.

Sound business disclosure practices identified in the report were:

  • Firms made specific disclosures about fees, risks, and tax implications;10
  • Customers were directed to information about investment in variable products located on the SEC and NASD websites; and
  • Firms used a form to disclose to customers in full, clear, and balanced terms the features, benefits, fees, risks, surrender periods, and financing risks of variable product transactions.

Books and Records

The report noted weaknesses in broker-dealers making and keeping certain records and obtaining current information about their customers." Weaknesses noted in the report include:

  • Customer information that was required for a suitability analysis was missing from customer files;
  • Documents related to an exchange or replacement analysis did not include an explanation about the benefits of replacing one policy with another, did not document the reasons for the replacement, or did not require the customer's signature; and
  • There was little or no documentation of disclosure to customers about variable product fees, risks, or expenses.

Sound books and records business practices identified in the report were:

  • Firms obtained updated client information on a regular basis;
    Firms maintained a new account form on file for each customer, along with the application or order forms for each transaction;
  • Firms used forms to document the customer's reason for switching that required the customer to write the reason and then sign the form; and
  • Firms maintained full and complete documentation of written disclosures made to customers.

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