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94-36 SEC Approves Communication Guidelines For Variable Products

SUGGESTED ROUTING

Senior Management
Advertising
Legal & Compliance
Mutual Fund

Executive Summary

On March 21, 1994, the Securities and Exchange Commission (SEC) approved amendments that provide guidelines for communications with the public about variable life insurance and variable annuities (Guidelines). The Guidelines govern the preparation of, and communication with the public through, advertising and sales literature of variable products. The Guidelines are intended to provide a level of disclosure sufficient to assist in making fair and informed investment decisions. The text of the amendment, which is effective March 21, 1994, follows the discussion below.

Background And Description Of The Amendment

As the number of variable life insurance and annuity products has increased substantially in recent years, so has the variety of ways in which information about such products is communicated to the public. Because the use of such communications is proliferating, and because what is being described in such communications is, in some cases, a complicated hybrid product containing both insurance and securities elements, the NASD has determined to provide guidance by adopting a comprehensive set of Guidelines for the preparation and use of communications with the public regarding variable life insurance and variable annuities. The Guidelines, approved by the SEC on March 21, 1994, incorporate past positions on variable products communications taken by the NASD, as well as certain positions taken by the staff of the Securities and Exchange Commission.

The Guidelines govern the preparation of, and communication with the public through, advertising and sales literature of variable products. The Guidelines are intended to provide a level of disclosure sufficient to assist investors in making fair and informed investment decisions.

The Guidelines set forth standards that must be considered, along with the standards set forth in Article III, Section 35 to the Rules of Fair Practice, in the preparation of advertising and sales literature about variable life insurance and annuities. For the purposes of these Guidelines, the terms "advertisements and sales literature" includes not only the definitions of those terms as found in Section 35, but also individualized communications such as personalized letters and printed or on-screen computer illustrations.

General Considerations

In light of the complexities and unique nature of variable products, it is essential that potential investors understand what they are being offered. Consequently, the Guidelines require that communications concerning variable products must clearly identify the product. Where product type is identified in a proprietary name, it is not necessary to include a generalized statement identifying product type. In order to prevent confusion in variable product sales material, no statement or presentation may indicate or imply that the product offered or its underlying account is a mutual fund. Although variable product separate accounts may ultimately be invested in mutual funds, there are significant material differences between a variable product investment and a direct mutual fund investment.

As products with potentially substantial tax penalties and charges for early withdrawal, variable products must not be presented by members as short-term, liquid investments. Any discussions or presentations concerning liquidity or accessibility to investment values must be balanced by disclosure of the impact of early withdrawal, such as sales loads, tax penalties, and potential loss of principal. Additionally, regarding the liquidity of variable life insurance products, a balanced presentation requires a discussion of the impact of loans and withdrawals on cash values and death benefits.

Guarantees by insurance companies, such as a minimum death benefit, a schedule of annuity payments, or a fixed return on the investment account, all depend on the claims-paying ability of the issuing insurance company, and thus must not be exaggerated. Members are prohibited from representing or implying that the investment return or principal value of the separate investment account is guaranteed, or that an insurance company's financial ratings apply to the separate account.

Specific Considerations

Prior Fund Performance

The guidelines allow variable product communications to contain the historic performance of an existing fund that pre-dates the fund's inclusion in the variable policy or annuity, provided no significant changes occurred to the fund at the time of, or after, the inclusion. A variable product that contains a new, or "clone," fund as the underlying investment vehicle is prohibited from using communications with the public that promote the performance history of the existing fund on which the new, or "clone," fund is modeled. All historic performance in communications to the public must conform to applicable NASD and SEC standards, including, in particular, all elements of return and deduction of applicable charges and expenses.

Product and Performance Comparisons

Product comparisons that are fair may help investors to make informed investment decisions. Article III, Section 35(d)(2)(M) of the NASD Rules of Fair Practice requires that a member who makes investment comparisons directly or indirectly, in a communication with the public, must ensure that the purpose of the comparison is clear and that the comparison is fair and balanced, including any material differences between the subjects of the comparisons. The Guidelines permit a comparison using variable products so long as the comparison meets the standards set forth under Subsection (d)(2)(M).

Variable Life Products

Variable life insurance allows purchasers to combine life insurance coverage and tax-deferred accumulation of excess premium payments in one contract. Because such products are designed to serve both insurance and investing needs equally, communications with the public on behalf of variable life insurance products must provide a balanced discussion of these features. However, since single premium variable life insurance is predominantly designed to meet investment needs, communications with the public regarding single premium variable life insurance may emphasize the investment features of the product so long as an adequate explanation of the life insurance features is given.

Hypothetical and Personalized Illustrations of Variable Life Products

Hypothetical illustrations of variable life insurance products using assumed rates of return are permissible to show how performance of the underlying investment accounts could affect the policy cash value and death benefit, but may not be used to predict or project investment results. Such illustrations must follow the methodology and form requirements for such illustrations in the prospectus.

All illustrations must show a hypothetical zero percent gross rate of return, and may show any additional combinations of rates of return up to and including a gross rate of 12 percent, though members are cautioned to choose a rate that is reasonable given current market conditions. All illustrations of rates of return must reflect maximum charges, though illustrations may reflect current charges in addition to maximum charges.

Sales literature that contains hypothetical illustrations may also provide a personalized illustration reflecting factors relating to the circumstances of an individual customer.

The Guidelines require clear disclosure to precede any illustration that explains the purpose and hypothetical nature of the illustration. It is generally inappropriate and potentially misleading to compare a variable life insurance policy with another product, including a variable annuity, since the purpose of such a comparison would exceed the purpose of illustrating how underlying investment account performance affects the policy cash value and death benefit. However, it is permissible to use a hypothetical illustration comparing a variable life policy to a term policy with the difference in premium invested in a side fund, where the sole purpose of such a comparison would be to demonstrate the concept of tax-deferred growth as a result of investing in the variable product. In order for such a comparison to be balanced and complete, the comparative illustration must: use a rate of return no greater than 12 percent; use the same rate of return for the variable product and the side fund; deduct the same fees as those deducted from the required prospectus illustration; illustrate the side fund product using gross values that do not reflect the deduction of any fees; and, not characterize the side product as any specific investment or investment type.

Questions regarding the Notice may be directed to Robert J. Smith, Attorney, Office of General Counsel, (202) 728-8176, or R. Clark Hooper, Vice President, Advertising/Investment Companies Regulation, (202) 728-8325.

Guidelines For Communications With The Public About Variable Life Insurance And Variable Annuities

(Note: New language is underlined.)

The standards governing communications with the public are set forth in Article IP. Section 35 of the NASD Rules of Fair Practice. In addition to those standards, these guidelines must be considered in preparing advertisements and sales literature about variable life insurance and variable annuities. The guidelines are applicable to advertisements and sales literature as defined in Section 35. as well as individualized communications such as personalized letters and computer generated illustrations, whether printed or made available on-screen.

I. GENERAL CONSIDERATIONS
A. Product Identification

In order to assure that investors understand exactly what security is being discussed, all communications must clearly describe the product as either a variable life insurance policy or a variable annuity, as applicable. Member firms may use proprietary names in addition to this description. In cases where the proprietary name includes a description of the type of security being offered, there is no requirement to include a generalized description. For example, if the material includes a name such as the "XYZ Variable Life Insurance Policy." it is not necessary to include a statement indicating that the security is a variable life insurance policy.

Considering the significant differences between mutual funds and variable products, the presentation must not represent or imply that the product being offered or its underlying account is a mutual fund.
B. Liquidity

Considering that variable life insurance and variable annuities frequently involve substantial charges and/or tax penalties for early withdrawals, there must be no representation or implication that these are short-term, liquid investments-Presentations regarding liquidity or ease of access to investment values must be balanced by clear language describing the negative impact of early redemptions. Examples of this negative impact may be the payment of contingent deferred sales loads and tax penalties, and the fact that the investor may receive less than the original invested amount.

With respect to variable life insurance, discussions of loans and withdrawals must explain their impact on cash values and death benefits.
C. Claims About Guarantees

Insurance companies issuing variable life insurance and variable annuities provide a number of specific guarantees. For example, an insurance company may guarantee a minimum death benefit for a variable life insurance policy or the company may guarantee a schedule of payments to a variable annuity owner. Variable life insurance policies and variable annuities may also offer a fixed investment account which is guaranteed by the insurance company. The relative safety resulting from such a guarantee must not be overemphasized or exaggerated as it depends on the claims-paying ability of the issuing insurance company. There must be no representation or implication that a guarantee applies to the investment return or principal value of the separate account. Similarly, it must not be represented or implied that an insurance company's financial ratings apply to the separate account.
II. SPECIFIC CONSIDERATIONS
A. Fund Performance Predating Inclusion in the Variable Product

In order to show how an existing fund would have performed had it been an investment option within a variable life insurance policy or variable annuity, communications may contain the fund's historical performance that predates its inclusion in the policy or annuity. Such performance may only be used provided that no significant changes occurred to the fund at the time or after it became part of the variable product. However, communications may not include the performance of an existing fund for the purposes of promoting investment in a similar, but new, investment option (i.e., clone fund or model fund) available in a variable contract.

The presentation of historical performance must conform to applicable NASD and SEC standards. Particular attention must be given to including all elements of return and deducting applicable charges and expenses.
B. Product Comparisons

A comparison of investment products may be used provided the comparison complies with applicable requirements set forth under Article III. Section 35 of the NASD Rules of Fair Practice. Particular attention must be paid to the specific standards regarding "comparisons" set forth in subsection (d)(2)(M).
C. Use of Rankings

A ranking which reflects the relative performance of the separate account or the underlying investment option may be included in advertisements and sales literature provided its use is consistent with the standards contained in the Guidelines for the Use of Rankings in Mutual Fund Advertisements and Sales Literature*

* Guidelines for the Use of Rankings in Mutual Fund Advertisements and Sales Literature, have been filed with, and are currently awaiting approval by, the Securities and Exchange Commission in rule filing SR-NASD-93-69.
D. Discussions Regarding Insurance and Investment Features of Variable Life Insurance

Communications on behalf of single premium variable life insurance may emphasize the investment features of the product provided an adequate explanation of the life insurance features is given. Sales material for other types of variable life insurance must provide a balanced discussion of these features.
E. Hypothetical Illustrations of Rates of Return in Variable Life Insurance Sales Literature and Personalized Illustrations
(1) Hypothetical illustrations using assumed rates of return may be used to demonstrate the way a variable life insurance policy operates. The illustrations show how the performance of the underlying investment accounts could affect the policy cash value and death benefit. These illustrations may not be used to project or predict investment results as such forecasts are strictly prohibited by the Rules of Fair Practice. The methodology and format of hypothetical illustrations must be modeled after the required illustrations in the prospectus.

An illustration may use any combination of assumed investment returns up to and including a gross rate of 12%. provided that one of the returns is a 0% gross rate. Although the maximum assumed rate of 12% may be acceptable, members are urged to assure that the maximum rate illustrated is reasonable considering market conditions and the available investment options. The purpose of the required 0% rate of return is to demonstrate how a lack of growth in the underlying investment accounts may affect policy values and to reinforce the hypothetical nature of the illustration.

The illustrations must reflect the maximum (guaranteed) mortality and expense charges associated with the policy for each assumed rate of return. Current charges may be illustrated in addition to the maximum charges-Preceding any illustration there must be a prominent explanation that the purpose of the illustration is to show how the performance of the underlying investment accounts could affect the policy cash value and death benefit. The explanation must also state that the illustration is hypothetical and may not be used to project or predict investment results.
(2) In sales literature which includes hypothetical illustrations, member firms may provide a personalized illustration which reflects factors relating to the individual customer's circumstances. A personalized illustration may not contain a rate of return greater than 12% and must follow all of the standards set forth in Section II.E.1.
(3) In general, it is inappropriate to compare a variable life insurance policy with another product based on hypothetical performance as this type of presentation goes beyond the singular purpose of illustrating how the performance of the under lying investment accounts could affect the policy cash value and death benefit. It is permissible, however, to use a hypothetical illustration in order to compare a variable life insurance policy to a term policy with the difference in cost invested in a side product. The sole purpose of this type of illustration would be to demonstrate the concept of tax-deferred growth as a result of investing in the variable product. The following conditions must be met in order to make this type of comparison balanced and complete:
(a) the comparative illustration must be accompanied by an illustration which reflects the standards outlined in Section II.E.1:
(b) the rate of return used in the comparative illustration must be no greater than 12%:
(c) the rate of return assumed for the side product and the variable life policy must be the same:
(d) the same fees deducted from the required prospectus illustration must be deducted from the comparative illustration:
(e) the side product must be illustrated using gross values which do not reflect the deduction of any fees: and,
(f) the side product must not be identified or characterized as any specific investment or investment type.

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