Adoption of Form N-6: Registration Form for Variable Life Insurance

Transcription

1 Legal Alert Adoption of Form N-6: Registration Form for Variable Life Insurance As part of its long-standing commitment to improve the quality of disclosure available to investment company investors, on April 12, 2002, the Securities and Exchange Commission (the Commission ) adopted Form N-6, a new integrated disclosure form with a prospectus format tailored specifically for variable life insurance, and amended Form N-1A, the registration form for mutual funds. 1 The amendments to Form N-1A require the prospectuses for mutual funds that offer their shares as investment options for variable life insurance and variable annuities to include a fee table. In a companion release, the Commission also proposed amendments to Form N-4, the registration form for variable annuities funded by unit investment trust separate accounts, to conform the format for the disclosure of fund expense information in the Form N-4 fee table with the Form N-6 requirements. 2 Form N-6 becomes effective on June 1, Insurers are permitted to conform their variable life insurance registration statements to Form N-6 on or after that date. 3 Compliance with Form N-6 becomes mandatory for new registration statements and post-effective amendments that are annual updates filed on or after December 1, 2002, essentially requiring most insurers to transition to Form N-6 by May 1, The final compliance date for filing post-effective amendments to conform to Form N-6 is December 1, Insurers can continue to use Form S-6 after the final compliance date for policies that are no longer sold to new purchasers. Compliance with the amendments to Form N-1A becomes mandatory for new registration statements and post-effective amendments that are annual updates filed on or after September 1, Investment Company Act Release No (Apr. 12, 2002) (the Adopting Release ). Investment Company Act Release No (Apr. 12, 2002). The Commission staff has stated that it is not receptive to compliance prior to the effective date. The Commission staff also stated that it is not receptive to the use of a statement of additional information ( SAI ) with financial statements in a variable life insurance registration statement on Form S-6.

2 FORM N-6 Form N-6 has an overall three-part structure similar to Form N-4. 4 Form N-6 consists of a simplified prospectus, an SAI containing more detailed and technical information that investors can obtain upon request, and a Part C. It replaces both existing registration statement Forms S-6 and N-8B-2 that are currently used for variable life insurance under the Securities Act of 1933 (the Securities Act ) and the Investment Company Act of 1940, respectively. Form N-6 requires the use of plain English principles in drafting variable life insurance prospectuses, which means the information must be presented in an easily readable format, using everyday language that investors can easily understand. The Commission adopted Form N-6 in substantially the same form as proposed with changes that reflect suggestions from commentators. A description and explanation of each item in Form N-6 is set forth in the enclosed Commission release. Below is a brief summary and analysis of the more significant aspects of Form N-6, including some noteworthy changes made by the Commission in the Adopting Release. Risk/Benefit Summary: Benefits and Risks As described in the Proposing Release, Form N-6 requires a variable life insurance prospectus to include a risk/benefit summary that provides narrative information about policy benefits and risks at the beginning of the prospectus. However, in the Adopting Release, the Commission made the following significant changes to the requirement as originally proposed. Non-required information may be included. Required information is not required in any specific sequence. Disclosure of the allocation of premium to insurance coverage, investments and charges is no longer required. Underlying portfolio information may be included in the risk/benefit summary. If a risk/benefit summary includes information about underlying portfolios, an insurer may be able to modify or omit the discussion of underlying portfolios later in the prospectus. 4 Investment Company Act Release No (Mar. 13, 1998) (the Proposing Release ). 2

3 Notably, to ensure the prominent disclosure of policy costs, Form N-6 requires the fee table to precede the narrative risk/benefit summary where the summary exceeds five pages in length. Fee Table Form N-6 requires that all variable life insurance prospectuses include a standardized fee table. In retaining the standardized fee table requirement, the Commission was not persuaded by arguments that the fee table would not provide useful disclosure to investors because of the complexity of variable life insurance fees and charges. Instead, the Commission agreed with those commentators who felt the standardized fee table would facilitate comparisons among variable life insurance policies and bring variable life insurance fee disclosure into general parity with variable annuities and mutual funds. The Commission noted that the complexity of variable life insurance charges, particularly in light of the increased flexibility to structure charges after the adoption of the National Securities Markets Improvement Act of 1996, increases the need for investors to receive clear and understandable disclosure. Clearly, the Commission views the use of a standardized fee table as an important step in meeting that goal. Although the Form N-6 fee table requirements are substantially similar to those described in the Proposing Release, the fee table requirements reflect a number of significant changes made by the Commission. Those changes and other important aspects of the fee table are described below. Fee Table Format. The Form N-6 fee table retains the three-part structure described in the Proposing Release that includes: (1) policy owner transaction fees (such as sales loads, surrender charges and transfer fees); (2) annual charges (other than underlying portfolio charges); and (3) underlying portfolio charges. Form N-6, however, has a three column format for policy charge disclosure, instead of the proposed four column format. The Commission eliminated the proposed fourth column agreeing with those commentators who questioned the need for identifying whether a charge is deducted from all policies or only certain policies. The Commission also modified the format of the underlying portfolio operating expenses section of the Form N-6 fee table to more closely resemble the presentations required by Forms N-1A and N-4. As originally proposed, portfolio expenses would have been disclosed in the same column format prescribed for policy charges. The Commission modified the format, in part to emphasize the non-contractual nature of portfolio expenses, and because of its general belief that the format used in Forms N-1A and N-4 provided uniformity, simplicity and comparability in fund fee disclosure. 3

4 Disclosure of Guaranteed and Current Charges. Form N-6 permits, but does not require, insurers to disclose current charges in the fee table so long as the current charge disclosure is not more prominent than, and does not obscure or impede understanding of, required maximum guaranteed charges. This represents a significant departure from the Proposing Release that relegated the disclosure of current charges, except for cost of insurance, to footnotes. In making this modification, the Commission implicitly recognized that the disclosure of guaranteed charges alone in the fee table could significantly overstate charges. Cost of Insurance Charge. Form N-6 requires the disclosure of a minimum and maximum cost of insurance charge, or range, in the fee table. In response to uniform opposition from commentators who questioned the relevance of such numbers for investors, Form N-6 also requires in the fee table the cost of insurance charge that would be paid by a purchaser with characteristics (e.g. sex, age and rating classification) that are fairly representative of actual or expected purchasers of the policy. The characteristics of the representative policy owner would be described in a sub-caption for the charge in the fee table. Form N-6 also requires narrative disclosure identifying the limitations of cost of insurance charge fee table disclosure and disclosure informing policy owners of how they can obtain information about charges that would apply to them. Insurers may supplement required cost of insurance charge disclosures with narrative information and tables showing the cost of insurance for a spectrum of representative policy owners. Disclosure of Rider Charges. Form N-6 requires the disclosure in the fee table of all fees and charges, including all rider charges, whether or not a specific caption is provided for the charge. In requiring the disclosure of rider charges, the Commission expressed some concern that investors could be overwhelmed by information of limited relevance. Notwithstanding that concern, the Commission rejected the recommendations of commentators to limit the disclosure required in the fee table to fees and charges that are relevant to most policies or charged to a typical investor. The Commission found that selection to be problematic, particularly given the industry trend toward the unbundling of product features and charges. The Adopting Release, however, does note that insurers can disclose rider charges at the end of the second section of the fee table, under a caption that indicates rider charges are for optional features, to ensure that disclosure does not overwhelm the disclosure of base policy charges. 4

5 Portfolio Fees and Charges. Form N-6 retained the proposed requirement that, for variable life insurance prospectuses that offer multiple underlying portfolios, the fee table disclose the range of expenses for all underlying portfolios. To address the concerns of some commentators that the particular fees and charges of specific underlying portfolios are more important to investors than the range of fees and charges for all underlying portfolios, Form N-6 permits, but does not require, the disclosure of the fees and expenses for each underlying portfolio, in addition to the disclosure of the range of expenses for all underlying portfolios. As noted above, the Commission also adopted amendments to Form N-1A to impose a fee table requirement on variable insurance funds. The amendments to Form N-1A are intended to ensure that all variable life insurance investors have access to complete information about underlying portfolio fees and expenses. For insurers who choose not to disclose the fees and expenses for each underlying portfolio in their variable life insurance prospectuses, one effect of the new disclosure regime may be to place a greater emphasis on the delivery of each underlying fund prospectus with the annual prospectus update. Form N-6 also follows the modified Form N-1A approach for the disclosure of portfolio expenses. Form N-6 requires the disclosure of underlying portfolio expenses on a gross basis, before any expense reimbursements or waivers. Expenses after reimbursement or waiver can be disclosed in a footnote. Consistent with Form N-1A, Form N-6 permits the disclosure of net expenses in the fee table if a contractual reimbursement or waiver arrangement is in place. In that case, Form N-6 would permit the addition of one line to the fee table showing the range of net total underlying portfolio operating expenses after taking into account contractual limitations that require reimbursement or waiver of expenses. A footnote should describe the contractual arrangement. Observations Regarding Fee Table Requirements. Over the months and years ahead, the variable insurance industry will need to grapple with a number of difficult disclosure, actuarial and business issues raised by the fee table requirements of Form N-6. The requirement to disclose the cost of insurance charge for a fairly representative policy owner presents the industry with a new standard that was not the subject of much attention and analysis when Form N-6 was subject to industry comment. The disclosure of a cost of insurance charge for a representative policy owner that in many cases may not be representative of a majority of policy owners will test the sales and compliance procedures of insurers to ensure that policy owners understand their actual cost of insurance. For insurers who choose to disclose charges on a current basis in the fee table, the disclosure of charges on both a current and guaranteed basis will challenge the creativity of those insurers to draft disclosures that are at the same time accurate yet not so unwieldy so as to 5

6 obscure their meaning. The challenge becomes even greater when one considers the number and variety of riders (and rider charges) that are available with variable life insurance policies. Charges Form N-6 requires insurers to describe all charges deducted from premiums, cash value, separate account assets, or any other source (e.g., sales loads, premium and other taxes, etc.). As originally proposed, Form N-6 would also have required insurers to explain what is provided in consideration for each charge. That requirement has been modified to require an explanation of what is provided in consideration for all charges. Where it is possible to identify what is provided in consideration for a particular charge, that should be separately explained. Financial Statements As originally proposed, Form N-6 allows insurers to remove the financial statements from the prospectus. The full financial statements of the separate account must be in the SAI. For the insurer, the SAI must include at least comparative balance sheets for the last two years and, in certain cases, a more current interim balance sheet. Other insurer financial statements (statement of operations and statement of changes) can be in Part C rather than the SAI. Form N-6 generally requires insurer financial statements to be prepared in accordance with generally accepted accounting principles ("GAAP"), except where the insurer would not have to prepare GAAP financial statements for any purpose other than registration statements for variable insurance products. In a tightening of this rule, Form N-6 also requires GAAP financial statements where the parent of the insurer prepares GAAP financial statements, and the insurer prepares either partial GAAP financial statements or a GAAP reporting package to be used by the parent in its consolidated financial statements. However, Form N-6 does not require the use of GAAP when an insurer prepares GAAP financial statements solely for internal purposes. Performance Data Form N-6 does not require disclosure of any historical performance information nor prohibit the presentation of such information in a variable life insurance prospectus, provided the information is not incomplete, inaccurate or misleading and does not obscure or impede understanding of required information. The SAI, however, must include (i) an explanation of how an insurer calculates performance data used in advertising, including how charges are 6

7 reflected in the data, and (ii) a quotation of performance for each sub-account for which performance data is advertised. In adopting the proposed requirement, the Commission noted that at the present no method of measuring variable life insurance performance has been devised that is useful enough to be required. In not prohibiting the use of performance information, the Commission acknowledged that each category of performance information (underlying portfolio performance, portfolio performance adjusted for separate account asset-based charges, and individual policy owner illustrations), may provide useful information to investors. The Commission did caution that performance information that does not reflect all charges should be accompanied by information about omitted charges so it is not misleading. The Commission also reiterated its belief that underlying portfolio performance data is most appropriately included in the portfolio prospectus. Hypothetical Illustrations As described in the Proposing Release, Form N-6 permits, but does not require, the inclusion of hypothetical illustrations in either the prospectus or SAI. However, a number of the requirements originally proposed by the Commission to place reasonable limits on the assumptions used in hypothetical illustrations have been changed in response to recommendations from commentators. Those requirements are described below. Narrative Information. As adopted, Form N-6 clarifies the proposed requirement that a clear and concise explanation of hypothetical illustrations immediately precede the illustrations. Specifically, Form N-6 identifies a number of items that must be addressed in the narrative preceding the illustrations. Those items include, among other things, a description of the expenses reflected in the illustrations, a statement that illustrations are based on assumptions about investment returns and policy owner characteristics, and a description of the circumstances under which actual results for a particular policy owner would differ from the illustrations. Assumed Rates of Return. In a significant departure from the Proposing Release, Form N-6 requires the use of gross rates of return of 0%, 6% and one other rate not greater than 12%. Additional gross rates of return no greater than 12% may also be used. In modifying its original proposal of requiring only two rates of return, the Commission agreed with commentators who asserted that the use of three rates of return more effectively demonstrates the operation of variable life insurance policies and the effect returns have on cash values and death benefits. In addition, the Commission was persuaded that illustrations using a 12% gross rate of return should not be prohibited, based on historical stock market returns. That said, an insurer must determine for itself whether the use of a 12% gross rate of return is appropriate and not 7

8 misleading under its particular facts and circumstances, including the historical returns of available underlying portfolios and the actual and expected allocations of policy owners. Premium Amounts. In the Adopting Release, the Commission modified the language of the proposed requirement that premium amounts used in hypothetical illustrations reflect actual or expected average policy size. The Commission noted that policy size meant premium amount not policy face amount. As adopted, Form N-6 also provides greater flexibility to determine the actual or expected typical premium amount by allowing insurers to use an average or median premium amount or some other basis that results in a typical premium amount representative of sales or expected sales. Rating Classification. As adopted, Form N-6 modified the proposed requirement that illustrations be shown for the rating classification with the greatest number of outstanding policies. Specifically, if that rating classification is not representative of actual or expected policy sales, illustrations should be shown for a commonly used rating classification that is representative of actual or expected sales. Portfolio Charges and Expenses. Form N-6 requires the use of an arithmetic average of underlying portfolio fees and expenses for all available portfolios in hypothetical illustrations, based on the most recent fiscal year, absent expense reimbursements or fee waivers. However, consistent with the approach taken by the Commission staff with the expense example of Form N-1A, illustrations may reflect underlying portfolio operating expenses after taking account of contractual reimbursements or waivers of expenses, but only for the period of contractual limitation. While Form N-6 explicitly requires illustrations with both current and maximum guaranteed charges, it appears from both Form N-6 and the Adopting Release that the same approach is not taken in the case of underlying portfolio operating expenses. In the Adopting Release, the Commission stated that it would not object if personalized illustrations were provided to an investor based on a weighted average of expenses of the underlying portfolios in which the investor invests or expects to invest, provided those illustrations are not otherwise misleading. Hypothetical Illustrations Based on Historical Rates of Return These are illustrations based on actual historical rates of return for one or more underlying portfolios. Although the Commission identified a number of limitations on their usefulness in the Adopting Release, it did not prohibit their use in the prospectus or SAI, provided the illustrations were not incomplete, inaccurate, or misleading and do not, because of 8

9 the nature, quantity, or manner of presentation, obscure or impede understanding of required information. Form N-6 does not address hypothetical historical illustrations. Personalized Illustrations In the Adopting Release, the Commission declined to take the opportunity to propose standards for personalized illustrations. Notwithstanding that decision, the Commission did express concern over the practice of marketing a variable life insurance policy based on illustrations that reflect assumed rates of return and fees and charges of a single underlying portfolio, rather than the arithmetic average of fees and charges for all available underlying portfolios. The Commission suggested that it may find that practice per se misleading, where the investor does not invest or expect to invest, exclusively in that underlying portfolio, particularly when the portfolio has lower expenses relative to other portfolios. Form N-6 does not address personalized illustrations. Exhibits In transitioning variable life insurance registration statements to Form N-6, insurers will need to consider the inclusion of certain new exhibits to their registration statements. Described below are certain Form N-6 exhibit items insurers should consider. Actuarial Opinion. Form N-6 requires an opinion from an actuarial officer if illustrations are included in the registration statement. As originally proposed, Form N-6 would have required the second prong of the actuarial opinion to indicate that the rate structure of the policies and the assumptions selected for the illustrations do not result in an illustration of the relationship between premiums and benefits that is materially more favorable than for a substantial majority of other prospective policy owners. In response to objections from commentators who asserted that the proposed second prong would require difficult judgments for which there are no established standards, the Commission replaced the second prong as a requirement of the actuarial opinion. The new second prong would require the actuary to opine that the policy has not been designed, and the assumptions had not been selected, to make the relationship between premiums and benefits, as shown in the illustrations, appear to be materially more favorable than for any other prospective purchaser with different assumptions. Calculation. If illustrations are included in a variable life insurance registration statement, one sample calculation should be provided for each item illustrated (e.g., cash 9

10 surrender value, cash value and death benefits), showing illustrated values for the fifth policy year. Redeemability Exemption. This exhibit item requirement essentially preserves the requirement to provide a memorandum on issuance, transfer and redemption procedures. Transition Filing Insurers who transition their existing registration statements on Forms N-8B-2 and S-6 to Form N-6 will be deemed to be filing a post-effective amendment to Form N-6. That posteffective amendment should be filed under paragraph (a) of Rule 485 under the Securities Act. Funds filing annual updates to comply with the amendments to Form N-1A may file under paragraph (b) of Rule 485, provided the post-effective amendment otherwise meets the conditions for immediate effectiveness under the rule. If you have any questions about Form N-6 or the amendments to Form N-1A, please call your contact at the firm. *Sutherland Legal Alerts are intended to provide clients with information on recent legal developments, not to render legal advice.