MR. WATSON: Let's do a quick question and answer session as a review....

A fixed dollar annuity guarantees a fixed minimum dollar amount for each annuity payment and it guarantees the principal and minimum interest rate. Despite these guarantees, a risk is still assumed by the annuity buyer. What is this risk?

The risk assumed by the fixed annuity buyer is that the fixed dollar guaranteed payments will maintain their purchasing power through time. In this regard, many people fear that fixed dollar investments for building and liquidating retirement funds are obsolete in an economy that is geared to continued inflation.

What does the insurer guarantee in a traditional variable annuity ?

A traditional variable annuity guarantees the amount of the contracts death benefit if the owner were to die prior to contract maturity. Recent VA designs can offer additional guarantees for an increased cost.

Why was the variable annuity developed?

The variable annuity was developed to overcome the "purchasing power" shortcomings of fixed annuities. This is accomplished by the payment of annuity income that fluctuates with changes in the investment performance of a portfolio of equities.

What is the basic risk insured against by a life insurance company annuity contract, including a variable annuity?

The risk of living too long. An annuity is called the "opposite side of the coin" of a life insurance policy (risk of dying too soon).

What is the basic character of a variable annuity that allows the annuity income to fluctuate through time?

The variable annuity is an investment contract in which the purchaser's retirement fund and benefits increase or decrease according to the investment performance of an underlying portfolio of equity investments"primarily common stocks.

Why are common stocks and other equity investments used in the investment portfolio underlying variable annuities?

The basic tenet of the investment base of variable annuities is that as common stock price levels fluctuate with general price levels, the annuity payments, which are determined by the common stock performance, will provide an effective long-run inflation hedge.

Has a consistent correlation between stock prices and general price levels always been maintained?

No. Even though the long-run correlation between stock portfolio performance and general price levels has been significant, short-run inconsistencies in their patterns have occurred. Thus, variable annuities are not a perfect inflation hedge during all economic periods.

What are the structural components of a variable annuity?

The values in a variable annuity are expressed in terms of units rather than dollars. There are two types of units: accumulation units and annuity units . The value of each type of unit is subject to periodic adjustment based upon the performance of the underlying common stock portfolio.

With the economic future always in a state of uncertainty, was the variable annuity concept originally developed to provide the sole source of retirement income for annuitants?

No. The variable annuity was originated as a supplement to fixed dollar annuities, to provide a balance between fixed and variable income.

List the features of a variable annuity plan.

A variable annuity offers a plan:

1. for lifetime annuity income;
2. that should be undertaken only as a long-term program;
3. based primarily on equity investments;
4. to provide payments that change monthly in dollar amount

Does the variable annuity have a loan value?

Yes. Some companies include a loan provision; however, depending on tax qualifications, some group contracts do not permit a loan provision.

Can the variable annuity contain such features as waiver of premium or term insurance riders?

Yes, it can. Obviously, the provisions apply only to the accumulation period of a deferred variable annuity.

In determining what portion, if any, of a fixed dollar life annuity payable to a retired employee is taxable, an "exclusion ratio" is established. What is the ratio and how does it operate? (Previous chapter...amount invested divided by the expected return)

The basic theory underlying annuity taxation is that a taxpayer should be able to get back, free of income tax, the amount that he put into the annuity contract. Generally, this is accomplished by spreading the tax-free return over the anticipated life of the annuitant. A portion of each payment is considered to be a return of investment and the rest is taxable income. The actual mechanics of determining the tax-free portion is by use of an exclusion ratio . The exclusion ratio is the ratio the total premiums paid by the annuitant over his or her lifetime. This ratio is applied to each payment to determine the tax-free portion. The balance is included in gross income.

How is the capital gains tax determined for an individual during (1) the accumulation period of a variable annuity, and (2) the payout period?

1. There is no capital gains tax to the individual during the accumulation period of a variable annuity.
2. The amount of each annuity payment, including capital gains appreciation in excess of the tax-free return, is taxed as ordinary income during the period of payout. (Taxed like your income.)

What are the characteristics of common stocks that make them a suitable form of investment for variable annuities?

Common stocks represent shares of business ownership, and they tend to change in value with changing economic conditions.

What determines the market value of a common stock that is freely traded in the market?

The market value of a stock freely traded in the market is determined solely by what the buyer is willing to pay and what the seller is willing to accept.

What are the principal differences between common stocks and bonds?

Common stocks represent ownership in the companies that issue them. They promise no fixed rate of return on investment. If the company prospers, its shares of common stock will increase in value; if the company does not prosper, its shares will generally decrease in value arid may even become worthless.

Bonds, however, are instruments reflecting a debtor relationship. They carry a fixed coupon, or rate of return on investment, and generally have a fixed maturity date on which the principal amount will be repaid. The business success of the issuing company will have no effect on the value of its bonds so long as it is able to pay the fixed rate of interest and is able to repay the principal amount of the bond when due.

What is "dollar cost averaging"?

It refers to applying equal amounts of money at regular intervals regardless of market levels. In a variable annuity operation, because the dollar amount of monthly or annual premiums is fixed, this means more units would be credited to the contract for each premium payment when stock market levels are low and less when they are high, thus tending to average out the cost of the units during the pay-in period.

What is the purpose and function of the prospectus?

Before selling a variable life insurance policy or variable annuity, the agent must furnish the prospect with a prospectus. This document is prepared and furnished by the insurance company and reviewed by the SEC. A prospectus contains information about the nature and purpose of the insurance or annuity plan, the separate account and the risk involved. It is a primary source of information for the prospect. All other materials, such as direct mail letters, brochures and advertising also must have prior approval by the SEC.

How are accumulation units acquired?

Prior to retirement the purchaser of a variable annuity pays an agreed periodic premium amount. When these periodic premiums are paid, the purchaser is credited with a number of accumulation units, the actual number of units determined by the current value of one unit relative to the amount of premium paid.

Explain the methods used by a company to apply a given percentage of premiums toward accumulation of annuity units.

Upon payment of premiums, a percentage of each premium, as provided in the policy, is used to purchase accumulation units. When annuity benefits begin, the accumulation units are converted to a fixed number of annuity units. The number of annuity units paid each month never changes, the value of each unit will change according to the stock market, thus producing variable monthly payments. Note, the terms accumulation units vs. annuity units

How does the value of an accumulation unit affect the number of units for which the purchaser gets credit?

The set periodic premium will buy more units when unit values are low and less units when unit values are high. Thus, as periodic premiums continue to be paid, the purchaser acquires an increasing number of accumulation units. The total value of the accumulation units depends upon the investment performance of the portfolio.

Are the investment gains (losses) reflected in the accumulation unit values subject to current income taxation?

No. As in fixed annuities, the investment experience on funds invested in a deferred annuity is not currently taxable to the purchaser.

How is the policy-owner informed of the accumulated value of the contract during the premium payment period?

Most state laws provide that at least once each year the insurer must provide the policy-owner with a report on an approved form that states the number of units credited to the contract and the dollar value of a unit as of a date not more than two months prior to the date the report is mailed.

What are annuity units?

Annuity units are the basic measure and method by which the purchaser's annuity income is determined.

Once the accumulation units are converted to annuity units will the number of annuity units credited to the purchaser change through time?

No. Once converted, the number of annuity units credited to the purchaser is fixed. The purchaser's periodic annuity income is stated in terms of the number of units with which the purchaser is credited. For example, Mr. Doe's variable annuity income for life will be 100 units per month.

How is the actual dollar amount of periodic annuity income a purchaser receives determined?

The two factors that determine the participant's dollar income are the number of annuity units and the dollar value of each unit.

What determines the dollar value of an annuity unit and does the value change through time?

The value of an annuity unit fluctuates according to the earnings of the equity portfolio supporting the annuity. In some plans, the mortality and expense experience of the annuity participants also affects the value.

How could one summarize the mechanical aspects of how a deferred variable annuity works?

The variable annuitant is credited with accumulation units upon payment of each premium. The number of credited accumulation units purchased by each premium depends upon the current value at the time the premium is paid, and that value is determined by a formula specified in the contract. The value of accumulation units is governed by the value of the equity investment portfolio supporting the variable annuity. At retirement total accumulation units are converted to annuity units. The annuitant then receives a constant number of annuity units per period. The annuity unit value, and thus the actual periodic dollar annuity payment, fluctuates with experience according to a formula specified in the contract. The formula might be restricted to investment experience only, or it may be extended to reflect mortality and expense experience.

REGULATION & LICENSING

The company that actually issues the variable annuity may be chartered as a life insurance company or a variable annuity company and authorized to do business in the state. Either way, such a company comes under the supervision of the state.

Agents who want to sell VAs must be licensed by the state, which includes examinations in life insurance and variable annuities. No one may sell VAs in unless he or she is duly licensed and appointed as a life including variable annuity agent, representing an insurer as to life insurance and annuity contracts.

Government regulation of annuities business takes place in two spheres. Although the United States had reserved insurance regulation as a matter for the states, variable annuities raised the question of whether a VA is an insurance contract or a security, similar to shares in a mutual fund. The Supreme Court in 1959 held that federal law applied to insurers selling VA contracts. Thus, these insurers are subject to federal regulation by the SEC and by the states.

This dual regulation means that insurers selling VA are still subject to regulation by the states, but the annuity itself is regulated as a security. The common stock accounts backing VAs as open-end investment companies and the sales personnel as security broker-dealers all fall under the purview of the SEC.

Are variable annuities regulated solely by the state Office of Insurance Regulation?

No. While federal statutes have reserved the regulation of the insurance business to the states and exempted them from SEC jurisdiction by the federal Securities Act of 1940, the origination of the variable annuity raised questions in this regard. The question was whether the variable annuity was an insurance contract or a security similar to shares in a mutual fund. In 1959 the Supreme Court held that the federal statutes applied to insurers selling variable annuities. Thus such insurers are subject to dual regulation by the SEC and the states.

What does dual regulation imply?

It implies insurers selling variable annuities are still subject to regulation by the states, but the annuity itself is regulated as a security. The common stock accounts backing variable annuities as open-end investment companies and the sales personnel as security broker-dealers are all under the regulatory control of the SEC.

What are the variable annuity licensing requirements?

Agents who want to sell variable annuities must be properly licensed by the state after examination in both the life and variable annuity areas, and be appointed as a life including variable annuity insurance agent by the insurance company underwriting the risk.

Are variable annuities only a product of a life insurance company?

No. The company that issues the variable annuity may be chartered as a life insurance company or a variable annuity company and authorized to do business in this state.

Is a company licensed to sell variable annuities under the same state supervision as a company licensed to sell life insurance?

Yes. It is under the supervision of the state Office of Insurance Regulation.

Can a person be licensed only as a variable annuity agent?

No. No person may sell variable annuities unless first duly licensed and appointed as a life including variable annuity agent. A life including variable annuity agent is one representing an insurer as to life insurance and annuity contracts.

 

MARKETING PRACTICES & SUITABILITY

Explain the statute regarding an agent’s identification on annuity contracts annuity contracts.

Existing law requires that an application for an insurance policy or an annuity contract display the name of the insuring entity prominently on the first page of the application. In addition, the law states:

• Such applications shall also disclose the name and license identification number as shown on the agent's license issued by the Department, which information may be typed, printed, stamped or handwritten if legible.

Must an agent report any changes in his or her residence?

• Every licensee shall notify the state, in writing, within 30 days after a change of his or her name, his or her residence address, his or her principal business street address or mailing address, contact telephone numbers (including a business telephone number), or e-mail address.
• Agents are required to provide notice of change to phone numbers and e-mail addresses. Failure to comply with this 30-day rule can result in monetary penalties and/or result in the suspension or revocation of the license. (See law chapters)

Are there certain standards and procedures that must be followed in order to make recommendations for annuity products to consumers?

Yes. With regard to the sale or exchange of a fixed, equity indexed, fixed equity indexed, or variable annuity, to a senior consumer (age 65 or older), an agent is required to have an objectively reasonable basis for believing his or her recommendation is suitable for the senior consumer based on facts provided by the senior consumer. The facts that must be collected from the senior consumer are:

1. Personal information, including the age and sex of the parties to the annuity and the ages and number of any dependents;
2. Tax status of the consumer;
3. Investment objectives of the consumer;
4. Source of funds being used to purchase the annuity;
5. The applicant’s annual income;
6. Intended use of the annuity;
7. The applicant’s existing assets, including investment holdings;
8. The applicant’s liquid net worth and liquidity needs;
9. The applicant’s financial situation and needs;
10. The applicant’s risk tolerance; and
11. Such other information used or considered to be relevant by the insurance agent or insurer in making recommendations to the consumer regarding the purchase or exchange of an annuity contract.

This information must be collected on a form adopted by the Department and signed by the applicant and agent. If the senior consumer does not wish to provide all this information, the agent must obtain from the senior consumer a signed verification form that he or she refuses to provide the requested information and may be limiting protections regarding the suitability of the sale.

An agent's recommendations must be recorded, and an agent must have a reasonable basis to believe that the consumer has been informed of relevant information, included annuity features, potential future tax penalties, applicable fees, features and charges for any riders, the annuity's insurance and investments components and market risk. Where the consumer is exchanging or replacing an existing annuity, an agent must specifically consider whether the consumer will incur a surrender charge, be subject to commencement of a new surrender period, lose existing benefits, be subject to increased fees, benefit from product enhancements, or has recently had another annuity exchange or replacement.

An annuity policy sold to a senior (older than 65) consumer may not include a surrender charge or deferred sales charge for a withdraw of money from an annuity in excess of 10% of the amount withdrawn with certain exceptions.

An agent is prohibited from dissuading or attempting to dissuade a consumer from truthfully responding to the insurer's request for suitability information, from filing a complaint, or cooperating with the investigation of a complaint.

In the event that the consumer declines to follow an agents advise, the agent must obtain a signed statement from the consumer acknowledging that the annuity transaction was not recommended.

What additional information must an agent provide with regard to the replacement or exchange of an annuity contract?

In transactions involving the replacement or exchange of an annuity contract, the agent must provide, on a form, information concerning differences between the existing annuity contract and the one being recommended, including:

1. A comparison of the benefits, terms, and limitations;
2. A comparison of any fees and charges;
3. A written basis for the recommended exchange, including the overall advantages and disadvantages to the consumer;
4. Such other information considered relevant by the agent or insurer in making recommendations to the consumer.

Before the purchase or exchange of an annuity contract, an agent must also disclose that there may be tax consequences as a result of the purchase or exchange and that the applicant should consult a tax advisor for more information.