Sec. 1035 Scrutiny Reflects Industry's Growing Pains

By Rick Carey

The rapid growth of the variable products industry over the past five years has brought with it the expected level of growing pains--from focus on fees, to issues concerning Revenue Ruling 81-225, to the current Securities and Exchange Commission examination of 1035 exchange activity.

An industry in the spotlight can expect no less. A review of past headlines shows there are paradigms. In the late 1970s, similar scrutiny hit the money market fund industry; and in the 1980s, the mutual fund industry.

Although we can accept the paradigms, there is an important caveat: We are living in a much different world from that of 1980 or 1985, so the issues are not identical. Today's investor is the beneficiary of living in an information age where in-depth analysis is an expected outcome. Therefore, the investigative process is now a regular part of our personal, economic, and political lives.

This is important to keep in mind when considering the growing attention being given to 1035 exchanges by regulators. The scrutiny is both expected and, in the modern sense, quite normal.

The privilege of making policy exchanges under Section 1035 of the Internal Revenue Code has always enjoyed a favorable connotation, and its preservation is certainly a common goal shared by both the public and the industry. It assures that consumers will have freedom of choice and preservation of capital, by allowing tax-deferred exchanges of non-qualified funds between life policies, between annuities, and from life insurance to annuities.

The continued well-being of the 1035 privilege, to a large degree, is dependent upon maintenance of that favorable connotation. Meanwhile, any abuse of it will lead to disintermediation of capital, which will affect a company's bottom line, its ability to recoup acquisition costs, and ultimately its ability to meet its customers' financial needs.

To preserve this special feature, it is critically important that the industry maintain the variable product's identity as an insurance contract with unique attributes. It is the ability to insure against the risk of never outliving one's retirement capital that sets VAs and VLs apart from other mainstream investment products.

Granted, as more variable products are sold, the more mainstream they become. But they must always be mainstreamed as insurance products, not investments. To do otherwise could lead to detrimental results.

Because variable products have attracted so many well-known fund management groups, constant reference to the mutual fund industry is inevitable. This means that when integrating the best and the brightest of the mutual fund management groups into insurance products, insurers must conduct a continual reality check on the direction of the product line.

Those who are concerned about the attention being given to the appropriateness of 1035 exchanges should keep in mind that the issue is an outgrowth of the evolution of the VA industry.

This evolutionary process is being accompanied by several other trends: the advent and popularity of trail commissions, which bring benefits to consumers and issuers alike; the enhanced performance of variable subaccounts in comparison to their mutual fund counterparts, due in large part to low turnover in those subaccounts; and the growing prevalence of enhanced death benefits and other special features.

So many changes have occurred in variable products, in fact, that it's quite possible today's higher-than-normal level of transfer activity has been driven by consumer desire or need to take advantage of the enhanced fund groups and special features.

However, current 1035 exchange levels may prove to be short-lived. That's because, as the majority of all new and existing contracts adopt these new features, the need to transfer assets from older policies to the modern versions will no doubt decline.

Hence, concerns over 1035 exchanges may well evaporate, or at least, shrink, over time.

Meanwhile, in a manner similar to that used by the Investment Company Institute--which aided the mutual fund industry through its evolution--the National Association for Variable Annuities has developed recommendations designed to encourage companies to be proactive in creating an environment that will foster favorable marketing practices within the industry.

Additionally, it is my opinion that the industry will take advantage of enhanced sales reporting activities to track contract sales, including and excluding 1035 exchanges, with special focus on VA to VA exchanges and net redemptions. This will produce new benchmarks that will become important components in following the growth of annuitized products, and monitoring policy exchanges.

Looking to the future, the need for retirement income insurance will only grow more important, for the real growth of the annuitized products is yet to be fully realized. As such, the evolution of the variable products industry will continue for years to come, and it will experience more growing pains along the way. As noted earlier, "...an industry in the spotlight can expect no less."

Mr. Carey is editor and publisher of The VARDS Report, a Roswell, Ga. publisher of variable product statistics.

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