Source of Funds Looms on Horizon
November 9, 2010 by Steven A. Morelli
By Steven A. Morelli
InsuranceNewsNet
Nov., 5 2010 — While many in the insurance industry warily watch the developments in fiduciary and suitability standards and how they relate to insurance, particularly for annuities, another area of government oversight has some in the annuity distribution channel even more concerned.
The other issue is source of funds, which is percolating in a few states but threatens to blow up into new legislation and regulations that could fundamentally change annuity distribution, according to some insurance marketing organizations (IMOs). One of the key concerns is a notice issued by Arkansas that could serve as a model for other states, particularly if the National Association of Insurance Commissioners (NAIC) uses it for model legislation.
According to Arkansas Bulletin No. 14-2009: “The recommendation to replace securities such as mutual funds, stocks, bonds and various other investment vehicles defined as securities under the Arkansas Securities Act is the offering of investment advice. It is unlawful to offer investment advice unless one is registered (licensed) with the Arkansas Securities Department as an investment adviser or investment adviser representative.”
The penalties for violations are steep. Producers can lose their licenses. They can also be charged $5,000 per violation by the Insurance Department. The securities commissioner can also issue fines of $10,000 per violation or an amount equal to the money received in connection with the violation. If the violation involves someone at least 65 years old, the fine can be $20,000 or twice the amount of money received per violation.
Although Arkansas is in the forefront on source of funds, the Financial Industry Regulatory Authority (FINRA) is looking at its oversight in transactions, said Donald J. Walters, general counsel of Insurance Marketplace Standards Association (IMSA). (Walters is expected to be the leader of the new association to replace IMSA — see this month’s Perspectives for details on IMSA.)
“I am not sure that [Arkansas’ view] is the majority view within the state insurance regulatory community, but I think that they would want to monitor those types of transactions,” Walters said. “It does speak to a need to try to coordinate the examination activities of the states and FINRA as well.”
Fiduciary standards have overshadowed other concerns because of the Dodd-Frank financial regulation law, which strengthens the Securities and Exchange Commission (SEC) and its enforcement arm, FINRA. The Dodd-Frank legislation also requires federal agencies to devise, by some estimates, 500 new rules by year’s end, with the SEC responsible for dozens of them along with a study by January identifying regulatory gaps followed by a new standard-of-care rule. The new Federal Insurance Office established by the law is required within 18 months to issue a study on how to modernize and improve insurance regulation in the United States. Any and all of these things could have an effect on insurance regulation, particularly with fiduciary standards. That could lead to greater SEC authority over transactions and allow for rules such as Arkansas’ directive.
Much of this is still up in the air, but what it is clear is that the SEC and FINRA have had annuities in their sights for years. The SEC’s attempt to regulate indexed annuities and FINRA’s Notice 05-50, an indexed annuity order that is still on the books, are evidence of the federal agencies’ drive to extend their reach to annuities. SEC Chairwoman— and former FINRA chairwoman — Mary Schapiro has said the federal government should oversee all annuities.
The industry’s experience with the SEC and FINRA is what has some IMOs concerned about what might happen with source of funds.
“It’s alarming,” said Brian Williams, chief financial officer of Financial Independence Group, Scottsdale, Ariz. “[Source of funds] is a larger issue that is going to build up to a crescendo … the way 151A built itself up and suddenly we were looking at a proposed rule by the SEC. Right now we’re seeing some foundations of something larger that may happen in our industry regarding source of funds.”
Mark Lindsey, CEO of The Revolution, Canoga Park, Calif., sees source of funds as the next logical step after the SEC’s failed Rule 151A.
“That’s what they are going to be looking at,” Lindsey said. “All regulators are going to want to know where the money is coming from. Is it coming from a securities product? Is it coming from annuities? Is it coming from life insurance? Is it coming from a check? I also think it is critical to your business. You need to be on top of that.”
Being on top of and more aware of source of funds can only help a producer, said Michael Brandone, division manager of financial products at Insurance Network America, Boise, Idaho.
“The real key here is that agents offer only products that they are licensed or registered to sell,” Brandone said. “They need to get away from offering or giving advice on things that they have no involvement with, they have no license to sell. If they do that, then they are going to be fine. It’s very difficult for agents, though. You get into a situation with the client and the client is going to ask you specific questions, and sometimes the client is going to ask you very difficult questions. And sometimes you may have to back away. As much as you want to say do this or do that, if you’re not registered or you are not licensed to offer that product, you just have to be very, very careful.”
Chuck Lucius, CEO of Gradient Financial Group, Shoreview, Minn., echoed that admonition to be careful about advice.
“The definition of an investment advisor is a person who causes the purchase or sale of securities, either directly or indirectly, receives compensation and does that on a regular basis,” Lucius said. “That’s what creates this question on source of funds when money is moved to an insurance product. So, if you are talking to somebody about mutual funds and you indicate risk [of keeping the funds], and they’re somehow induced to get rid of those funds and buy an annuity that you get a commission on, that’s the compensation — and if you do it regularly, which almost all insurance agents would do, you are acting as an investment advisor.”
Many states are very firm in those instances and consider them an improper use of funds, Lucius said, particularly in the post-151A environment.
“But in some states they don’t really reinforce this definition,” Lucius said. “They don’t regulate it until there’s an issue. When the client says, ‘Well, I don’t like what happened. I dropped my variable annuity or my mutual fund or investments from my 401(k) and bought this annuity, and I really didn’t understand what I bought,’ that’s when the state and then the regulators invoke the definition, after the fact.”
An insurance company vice president said he agreed that the source of funds issue could be substantial, not just to producers but to the industry as a whole.
“At some future point, and that could be weeks, months, you know, certainly within the next 12 to 24 months, [source of funds] could become very important,” said Paul Garofoli, vice president of marketing at National Western Life Insurance Co., Austin, Texas. “And depending upon how expansive this whole issue of source of funds becomes, how an agent can engage the customer in repositioning assets and how those assets are defined can be real critical to our ability to fund our products and any insurance company’s products, for that matter.”
