A Challenge To The SEC’s Claim of Jurisdiction Over Index Annuity Contracts

A group of insurance companies has filed a petition challenging the SEC’s recently enacted Rule 151A regarding indexed annuities. At issue is whether the SEC overstepped its authority in enacting a rule which permits the Commission to assert jurisdiction over certain index annuity contracts or whether those contracts are exempt from the provisions of the Securities Act. American Equity Investment Life Ins. Co. v. SEC, (D.D.C. Filed Jan. 16, 2009).

Section 3(a)(8) of the Securities Act provides an exemption from its provisions for certain annuity contracts. Specifically, the Section provides an exemption for “[a]ny insurance or endowment policy or annuity contract or optional annuity contract, issued by a corporation subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia.” Previously, the Commission promulgated Rule 151, which provided a safe harbor for certain annuity contracts that are not deemed subject to the federal securities laws and which can rely on Section 3(a)(8). That safe harbor essentially applies to guaranteed investment contracts issued by a state regulated insurance company where “the insurer assumes the investment risk” in a manner described by the rule.

New Rule 151A deals with indexed annuity contracts. This product is a “contract issued by a life insurance company that generally provides for accumulation of the purchaser’s payments, followed by the payment of the accumulated value to the purchaser,” according to the Commission’s Release on the rule. Prior to the pay out under the contract, the insurer credits the purchaser with a return that is based on changes in a securities index such as the Dow Jones Industrial Average.

The Rule provides essentially that the contract is not exempt within the meaning of Section 3(a)(8) if the “amounts payable by the issuer under the contract are more likely than not to exceed the amounts guaranteed under the contract.” The SEC adopted, this test based primarily on investment risk. According to the SEC, at the time Section 3(a)(8) was adopted, the annuities that were typically offered and were thus exempt involved no investment risk to the purchaser. Thus, the protections of the securities laws were not necessary for the purchaser.

In contrast, under Rule 151A where “the amounts payable by an insurer under an indexed annuity contract are more likely than not to exceed the amounts guaranteed under the contract, the purchaser assumes substantially different risks and benefits. Notably, at the time that such a contract is purchased, the risk for the unknown, unspecified, and fluctuating securities-like portion of the return is primarily assumed by the purchaser,” according to the SEC’s Release. Under these circumstances, the purchaser can benefit from the protections of the securities laws.

Commissioner Tory Paredes apparently disagreed with the SEC’s position on Rule 151A, dissenting from its adoption. Essentially, Commissioner Paredes argued that Rule 151A exceeded the Commission’s jurisdiction. First, Commissioner Paredes claimed that in adopting the Rule the Commission did not properly characterize investment risk as the concept applies to Section 3(a)(8). In this regard, Rule 151A denies an exemption to an indexed annuity when it is “more likely than not” that the performance of the linked securities index amounts payable to the purchaser of the contract will exceed the amounts the insurer guarantees. This approach ignores the central insurance component of the product, according to Commissioner Paredes.

Second, Commissioner Paredes noted that the position taken by the SEC is inconsistent with its prior position on this issue. In an amicus brief, the Commission argued that a Section 3(a)(8) exemption applies when the “insurance company, regulated by the sate, assumes a ‘sufficient’ share of investment risk and there is a corresponding decrease in the risk to the purchaser.” This position differs from the SEC’s current position.

The petition challenging the rule is pending.