May 10, 2004
Dear Mr. Katz:
This is to provide you with comments regarding proposed Securities and Exchange Commission SEC Rule 22c-2 under the Investment Company Act of 1940 Proposed Rule. As you know, the Proposed Rule would apply to life insurance companies that issue variable annuity contracts and variable life insurance policies variable insurance contracts or contracts since these companies function as intermediaries through which purchasers of variable insurance contracts can allocate annuity payments and life insurance premiums payments to separate accounts that invest in specific mutual funds. The SEC has long recognized that people can market time purchases and redemptions of mutual fund shares through transfers into and out of the sub-accounts that underlie variable insurance contracts. This is because life insurance companies that issue variable insurance contracts establish accounts with mutual funds that make their shares available as investments for the insurers sub-accounts. These accounts enable life insurance companies to maintain the values of the sub-accounts units by purchasing and redeeming shares of the underlying mutual funds in response to corresponding transactions in the sub-accounts units.
All purchases and redemptions of a sub-accounts units are aggregated and netted at the separate account level on a daily basis and converted by the life insurance company into an order to purchase or redeem the underlying mutual funds shares. These orders to purchase or redeem shares are transmitted to the mutual fund and are recorded in the companys account with the fund.
While the Proposed Rule is a well-intended effort to deter short-term trading strategies that harm long-term investors in mutual funds, its regulatory scheme overlooks important fundamental differences between the structure and operation of mutual funds and variable insurance contracts. Because of this, the Proposed Rule would require life insurance companies and/or mutual funds to impose redemption fees in situations where transfers into and out of sub-accounts were wholly unrelated to market timing. Furthermore, the Proposed Rule could require life insurance companies to file endorsements with state insurance departments to amend the existing forms for their variable insurance contracts before they would be allowed to impose the redemption fee required by the Proposed Rule. And, there is no guarantee that all or even a majority of the states insurance departments would consent to the imposition of this fee with regard to contracts that have already been issued. As a result, life insurance companies could be caught in the middle of this jurisdictional conflict. These and other concerns regarding the Proposed Rule are set forth below.
Five-Day Holding Period
The Proposed Rule is intended to deter short-term trading in mutual fund shares by persons who are trying to time the market or otherwise take advantage of pricing inefficiencies. To accomplish this, the Proposed Rule requires that mutual fund shares be held for a minimum period of five business days after they are purchased to avoid the imposition of a fee on their redemption. However, in the case of variable insurance contracts it is not as clear as to when the five-day holding period should begin as it would be in the case of mutual fund shares. Should the five-day period begin when a variable insurance contract is purchased and the initial payment is allocated to one or more sub-accounts that were pre-selected on the application, or should it begin when the first elective transfer out of a sub-account occurs?
Also, many transfers into and out of the sub-accounts that underlie variable insurance contracts occur automatically and are not the result of any market timing strategy. For example, transfers between sub-accounts can occur automatically because of account rebalancing or because the reallocation period provided for in the contract expired and the life insurance company reallocated the initial payment out of the money market sub-account and into the sub-accounts that were pre-selected on the application or were otherwise selected by the contract owner. Also, transfers into sub-accounts can automatically occur because of dollar cost averaging, and transfers out of sub-accounts can automatically occur because of deductions for monthly premiums, income payment withdrawals, guaranteed benefit transfers, and loan repayments. Under the Proposed Rule, any automatic transfer into or out of a sub-account could inadvertently set up the imposition of a redemption fee. Even if the Proposed Rule was intended to apply to such automatic transfers, the systems modifications that would have to be made to calculate the holding periods of the sub-account units that were automatically purchased or redeemed would be complex, time consuming, and costly to implement.
However, we do agree that the five-day holding period should be calculated on a first-in, first-out basis, since calculating it on a last-in, first out basis would only exacerbate the above-mentioned issues.
Method of Assessing the Redemption Fee
The Proposed Rule would give mutual funds that enter into participation agreements with life insurance companies the option to choose between two different methods to assess the redemption fee. Depending on the method chosen by a mutual fund, a life insurance company would be required to either i at the time of any transaction within the account set up by the insurer with a mutual fund, provide the mutual fund or its transfer agent with the contract owners account number that was used by the insurance company to identify the transaction so as to permit the mutual fund or transfer agent to make a determination of whether a redemption fee is applicable or ii enter into an agreement with the mutual fund under which the life insurance company would agree to monitor transactions within its account with the mutual fund to identify redemptions that would trigger the application of the redemption fee, and then transmit holdings and transaction information to the mutual fund or transfer agent to enable them to assess the applicable redemption fee.
In the alternative, life insurance companies may agree, subject to the supervision of the mutual fund, to impose redemption fees on contract owners that effect transfers between sub-accounts that result in transactions within the companies accounts with the fund that trigger the application of the fee. They will be required to remit the fee to the mutual fund.
It is unlikely that the various mutual funds that enter into participation agreements with life insurance companies would select the same method by which the life insurance companies would transmit transaction information to the funds. Thus, these life insurance companies would be required to have systems and procedures in place to support all of the methods set forth in the Proposed Rule and would be required to keep track of the particular methods selected by the various mutual funds. This would impose an undue hardship on these companies.
Potential Conflict With State Mandated Free-Look Periods
All of the states have enacted laws that mandate a free look period when an annuity contract or life insurance policy is purchased. Depending on the length of the free look period, during the first several days after an annuity contract or life insurance policy is delivered, the owner is entitled to a return of the purchase payment or premium or a return of the contract or policy account value without any deductions if the owner surrenders the contract or policy. If transfers between the sub-accounts underlying a variable insurance contract triggered a redemption fee during the free look period, there would be a conflict between the Proposed Rule and the states free look law if the owner surrendered the contract before the end of the free look period. This could restrain contract owners from transferring account values among sub-accounts during the free look period, which would delay their participation in their desired investment portfolios and conflict with the SECs policy of fostering transparent participation in the securities markets.
Providing Confidential Customer Information to Mutual Funds
The Proposed Rule could require life insurance companies to provide confidential information about contract owners to mutual funds and thereby expose these companies to potential liability for violating the non-disclosure provisions of the Gramm-Leach-Bliley Act and/or the states privacy laws.
Need to Amend Contract Forms
As already noted, life insurance companies could be required to file endorsements with state insurance departments to amend existing forms for their variable life insurance contracts before they would be allowed to impose the redemption fee required by the Proposed Rule. It is unlikely that state insurance departments would be compelled by federal preemption to agree to the imposition of the redemption fee. Therefore, it is possible that several of the states insurance departments might not allow life insurance companies to unilaterally amend in-force contracts to enable them to impose the new redemption fee. If this were to occur, life insurance companies would be caught in the middle of a conflict between state insurance laws and the Proposed Rule.
Unfair Financial Burden on Life Insurance Companies
To comply with the Propose Rule, issuers of variable insurance contracts would incur significant administrative costs in monitoring transactions within their accounts with mutual funds to detect redemptions of mutual fund shares that trigger the application of the redemption fee. These costs would include, but would not be limited to, modifying their existing administrative systems and procedures to identify related purchases and redemptions of sub-account units that led to the application of the redemption fee at the fund level. But, while life insurance companies would bear the entire cost of this effort, the redemption fees would be paid to the underlying mutual funds without any portion being remitted to the life insurance companies. Thus, life insurance companies would not be able to recoup the expenses that they would incur in regard to contracts that were already priced and issued, even though the Proposed Rule would apply to these contracts. This would impose an unfair financial burden on life insurance companies.
Expanding Hardship Exemption
The hardship exemption should be expanded to include transfers out of any sub-account when the underlying mutual fund in which the sub-account is invested is in financial trouble and the contract owner is in imminent danger of financial loss if the owner cannot redeem the sub-accounts units as soon as possible.
I hope that the above comments are helpful and I appreciate the opportunity to provide them to you.
Very truly yours,
Robert W. Armstrong
Assistant General Counsel
Transamerica Occidental Life Insurance Company