STATE OF CALIFORNIA DEPARTMENT OF INSURANCE 45 Fremont Street, 21st Floor San Francisco, California INITIAL STATEMENT OF REASONS

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1 STATE OF CALIFORNIA DEPARTMENT OF INSURANCE 45 Fremont Street, 21st Floor San Francisco, California INITIAL STATEMENT OF REASONS Date: March 11, 2011 REG SUITABILITY IN ANNUITY TRANSACTIONS INTRODUCTION The Life and Annuities (A) Committee of the National Association of Insurance Commissioners (NAIC) in 2008 formed the Suitability of Annuity Sales Working Group, which was charged with reviewing and considering improvements to the then-existing Suitability in Annuity Transactions in order to better protect annuity consumers from unsuitable sales and abusive marketing practices. The working group received comments from interested parties, including insurance industry representatives and consumer representatives. Successive revised drafts were circulated, and further public comments were received by the working group until December 21, 2009, when the Life and Annuities (A) Committee of the NAIC voted unanimously to adopt the December 17, 2009 draft. During the Spring 2010 NAIC National Meeting, the NAIC voted to adopt the proposed amendments to the NAIC (the NAIC Model or the Model ). Additionally, on July 21, 2010 President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ). Pub. L. No , which at Section 989J promotes the adoption of the NAIC Model by the States in order to preserve the sole authority in state insurance regulators to regulate fixed ( non-variable ) annuities. The Commissioner believes that the proposed regulations are necessary to carry out the purpose set forth in the Model: to require insurers to establish a system to supervise recommendations and to set forth standards and procedures for recommendations to consumers that result in transactions involving annuity products so that the insurance needs and financial objectives of consumers at the time of the transaction are appropriately addressed. The Commissioner further believes that the proposed regulations are also necessary in order to meet the requirement of section 989J of Dodd-Frank, which encourages the States to adopt suitability regulations by June 16, 2013 in order to avoid the Security Exchange Commission s gaining dual authority with the states to regulate fixed annuities. The preservation of the current exemption from federal regulation of fixed annuities benefits both consumers and the insurance business of this State. For the most part, the text of the proposed regulations copies the language of the verbatim, with nonsubstantive changes in grammar, format and numbering. In instances where a substantive change has been made, in each case identified and discussed separately below, the change was necessary in order to comply or avoid conflict with California law, to resolve ambiguities present in the and/or to make explicit an underlying principle of the. #640310v1 1

2 To the extent that the proposed regulations contain the provisions of the Model, they are reasonably necessary in order to achieve uniformity in regulation across the states and facilitate an efficient and consistent regulatory framework governing sales of annuities to senior citizens on a nationwide basis. Many insurers write annuity contracts in multiple states. As of January 2011, two States had adopted some form of the Model, and more States plan to do so by year s end. It can be beneficial to both insurers and consumers when administrative costs related to compliance with multiple, inconsistent regulatory requirements imposed by different states are reduced. The proposed regulations tend to serve this purpose by ensuring that California s regulatory requirements in this area are as consistent with those of other states as is possible under California law and consistent with the Commissioner s mandate to protect consumers. To the extent that insurers and producers, operating in compliance with California law, are able to devote additional resources resources which could otherwise be devoted to satisfying multiple, inconsistent regulatory regimes to improving their financial stability or providing better products to consumers, everyone stands to benefit. The proposed regulations are reasonably necessary to the degree to which they help to achieve progress toward this goal. SPECIFIC PURPOSE AND REASONABLE NECESSITY OF REGULATION The specific purpose of each adoption and the rationale for the Commissioner s determination that each adoption is reasonably necessary to carry out the purpose for which it is proposed are set forth below. SECTION : PURPOSE This section states the purpose of the Model: To require insurers to establish a system to supervise recommendations and to set forth standards and procedures for recommendations to seniors that result in transactions involving annuity products so that the insurance needs and financial objectives of seniors at the time of the transaction are appropriately addressed. This provision is reasonably necessary for uniformity of regulation across the states. This section further states that nothing stated in these regulations shall be construed to create or imply a private cause of action for violating these regulations. Section is substantially identical to the corresponding section of the ; this section is therefore reasonably necessary in order to carry out the purpose of the Model. SECTION : SCOPE This section limits the applicability of the proposed regulations both in terms of the range of insurance products to which they apply: annuities and to recommendations to purchase, exchange or replace an annuity made to a consumer by an insurance producer, or if there is no insurance producer involved, by an insurer. In a departure from the model, this section limits the applicability of the proposed regulations to situations where the consumer is a person aged 65 or older and a sale occurs. #640310v1 2

3 By limiting the scope of the regulations to sales made to consumers who are aged 65 or older, the Department has made a substantive change to the language of the corresponding section of the Model. A large proportion of Consumer Requests for Assistance received by the Department of Insurance which allege abuses in the sale of annuities are sent by or on behalf of consumers aged 65 and older. For this reason the proposed regulations focus on this age group. These complaints often contain allegations of marketing abuses, including that the consumers have been sold unsuitable annuities. For example, one senior consumer complained that the annuity was unsuitable because he needed ready access to his money and the annuity tied up those funds for too long a time a period of time, resulting in the senior s being forced to pay a substantial surrender charge in order to withdraw his money, thus significantly reducing his principal. Many seniors believe or are lead to believe that they will have ready access to their money as they need it, and do not realize the significance of the surrender charge provision or the limitations of the "free withdrawal" provisions. In another case, the heir of the senior consumer complained that the surrender charge applied upon his parent s death unless he, the beneficiary, agreed to receive the annuity over a five-year period, thus thwarting the intent of the senior who had purchased the annuity. Many of these types of annuities are sold to older seniors, who intend to leave the money in the annuity to their beneficiaries as a lump sum. Additional complaints involve an insurance producer inducing the senior consumer to replace an existing annuity with a new annuity that is a significantly less beneficial investment. In one case, the replacing annuity had a first-year bonus that was presented to the senior as desirable, but in fact, the surrender of the existing annuity resulted in the senior s being assessed significant surrender charges that exceeded the amount of the bonus paid by the replacement annuity. It is often the case that the replacing annuity does not contain terms that are more advantageous than the existing annuity. Accordingly, this amendment is necessary to make clear that it is these sales that are affected by the regulation. Section is otherwise substantially identical to the corresponding section of the ; this SECTION : EXEMPTIONS In conformity with the Model, this section lists certain transactions that are exempt from the substantive prohibitions announced in the Model. Section is otherwise substantially identical to the corresponding section of the ; this section is therefore reasonably necessary in order to carry out the purpose of the Model. SECTION : DEFINITIONS This section defines technical terms used in the proposed regulations. The proposed regulation amends Model s definition of the term "Annuity" so that it refers to "California" law instead of #640310v1 3

4 "State" law. This non-substantive amendment was reasonably necessary to make clear that the term annuity as defined in these regulations is one that is an insurance product under California law. The proposed regulation amends the Model s definition of the terms Continuing Education Credit or CE credit so that it means one continuing education credit hour rather than "one continuing education credit" because this concept is referred to as "one continuing education credit hour" in subdivision (i) of existing Section of the Department s regulations. Therefore, this amendment was necessary in order to avoid a violation of the consistency standard of the Administrative Procedure Act (the APA ). Similarly, the proposed regulation amends the NAIC Model s definition of "continuing education provider" or "CE provider" by deleting the word "approved" and instead, inserting the word "certified. This amendment was made because Section 2188 and subdivision (b) of Section use the term "certified" rather than the term "approved. Accordingly, this amendment was necessary in order to avoid a violation of the consistency standard of the APA. The proposed regulation deletes from the NAIC Model the definition of the term "FINRA, which refers to the Financial Industry Regulatory Authority or a succeeding agency, because, unlike the, this term is not used in the proposed regulations. This substantive amendment is necessary because the in the section entitled "Duties of Insurers and of Insurance Producers," provides a "carve out" from the for "FINRA broker-dealer sales of variable and fixed annuities if the suitability and supervision is similar to those applied to variable annuity sales." This regulatory scheme would result in these types of sales not being subject to the regulations. As will be explained again below, it would violate the consistency standard of the APA to enact this portion of the. Insurance Code section requires that the Commissioner enforce the provisions of the Insurance Code and other laws regulating the business of insurance in the state. Insurance Code section states that the Commissioner must require from every insurer compliance with all provisions of the Insurance Code. The Insurance Commissioner is prohibited from exempting a particular group of licensees from compliance with the Insurance Code or the regulations governing insurance. Accordingly, this amendment was necessary in order to comply with the consistency standard of the APA. The proposed regulation amends the definition of "Insurer" by adding the phrase "and/or hold a certificate of authority. This amendment was made because Insurance Code section 700 requires that an insurer obtain from the Commissioner a certificate of authority in order to transact insurance business in California. Since there are other entities that transact annuities which are required to obtain a license from the Commissioner prior to transacting annuities, the term "license" has not been deleted from this section. Accordingly, this amendment was necessary in order to avoid a violation of the consistency standard of the APA. Additionally, the word "state" has been capitalized to make clear that it refers to the laws of the State of California. This is a non-substantive change for clarity. Section is otherwise substantially identical to the corresponding section of the ; this #640310v1 4

5 SECTION DUTIES OF INSURERS AND OF INSURANCE PRODUCERS This section of the proposed regulations is for the most part substantially identical to the corresponding section of the NAIC Model. As such, it is therefore reasonably necessary in order to carry out the purpose of the Model. However, we have added a sentence which does constitute a substantive amendment, at the end of subdivision (c). Insurance Code section defines an "unnecessary replacement" as: the sale of an annuity to replace an existing annuity that requires that the insured will pay a surrender charge for the annuity that is being replaced and that does not confer a substantial benefit over the life of the policy to the purchasers so that a reasonable person would believe that that purchase is unnecessary. The amendment is necessary in order to comport with the consistency standard of the APA. The requirements set forth in Insurance Code section is absolute; there are no exceptions to those requirements. However, if the Model were promulgated unaltered in this respect, subdivision (d)(1) of Section would waive the requirement of Insurance Code section in the event any of the circumstances identified in subparagraphs (d)(1)(a) through (d)(1)(d) of the proposed regulations applied. For this reason it was necessary to recite the language of Insurance Code section in the proposed regulations and to indicate that that language is binding on insurers and producers, regardless of other provisions in the regulations which might suggest otherwise. Further, Insurance Code section requires that the Commissioner enforce the provisions of the Insurance Code and other laws regulating the business of insurance in the state. Insurance Code section states that the Commissioner must require compliance from every insurer with all provisions of the Insurance Code. The Insurance Commissioner is prohibited from permitting "unnecessary replacements" of annuities to occur. At paragraph (d)(1), using the words "arising from" rather than "related to" more precisely describes the extent of the stated exemption. The use of the phrase related to here would result in a degree of vagueness which may violate the clarity standard of the Administrative Procedure Act. Additionally, at the second sentence of paragraph (f)(2), we have arguably made a substantive change by adding the words "for the consumer. This was necessary to cure an ambiguity that would have constituted a per se violation of the APA clarity standard. It was unclear whether the insurer was required to take "appropriate corrective action" as to a third party that the insurer contracted with to perform a function required by Section or whether the insurer was required to take "appropriate corrective action" for the consumer. We determined that the most logical interpretation of the was that it required this corrective action be taken for the consumer. This is true in part because in Section (a)(1), the same language is used, and it requires that an insurer take appropriate corrective action for any consumer harmed by the insurer's or by its insurance producer's violation of this article. #640310v1 5

6 As was discussed above in connection with the deletion of the definition of the term "FINRA from the "Definitions" section, the Department has deleted Section H of the from our Section This substantive amendment is necessary because the provides an exemption from the requirements of the for "FINRA broker-dealer sales of variable and fixed annuities if the suitability and supervision is similar to those applied to variable annuity sales." Since the proposed action implements, in part, various provisions of the Insurance Code, it would violate the consistency standard of the APA to enact this portion of the Model, which would in effect waive those provisions of the Code in certain circumstances not specified in the Code. Insurance Code section requires that the Commissioner enforce the provisions of the Insurance Code and other laws regulating the business of insurance in the state. Insurance Code section states that the Commissioner must require from every insurer compliance with all provisions of the Insurance Code. The Insurance Commissioner is prohibited from exempting any licensees from compliance with the Insurance Code or the regulations governing insurance. Accordingly, this substantive amendment was necessary in order to comply with the consistency standard of the APA. Section is otherwise substantially identical to the corresponding section of the ; this SECTION INSURANCE PRODUCER TRAINING Subdivision (b) contains both non-substantive amendments which have been made in order to comply with the APA s clarity standard and substantive amendments which are necessary in order to avoid violating the consistency standard of the APA. Paragraph (b)(1) has been amended to require that the insurance producer complete an eight (8) credit hour annuity training course prior to commencing to transact annuities. This substantive amendment is necessary because Insurance Code section requires that insurance producers satisfactorily complete eight hours of training prior to selling annuities to individual consumers. The permits insurance producers to complete a single four (4) hours training requirement within six months after the effective date of this regulation. To enact this subdivision of the without revision might cause producers to inadvertently violate Insurance Code section Therefore, this subdivision has been appropriately amended so that it reflects the requirements of Insurance Code section , thereby avoiding violating the consistency standard of the APA. Additionally, in order to remain consistent with the requirements of Insurance Code section , paragraph (b)(2) has been added to set forth the requirement that every producer who transacts annuities in the State must satisfactorily complete four (4) continuing education hour credits prior to license renewal every two years. This continuing education requirement is absent from the NAIC Model. To omit this legal requirement from this section of the proposed regulations could incorrectly suggest to producers that the initial training in annuities comprises all the training that producers transacting annuities in California are required to take. Paragraph (b)(3) has also been substantively amended at subparagraphs (b)(3)(f) through (H). Whereas the NAIC Model, at subparagraph (b)(3)(f) lists "Appropriate sales practices, replacement and disclosure requirements," we have amended that subparagraph by replacing the word "Appropriate" with the word "Prohibited" because Insurance Code section (c) #640310v1 6

7 requires, among other things, that one of the topics required in the training must be "prohibited sales practices" (emphasis added). Similarly, the topics described in subparagraphs (b)(3)(g) and (b)(3)(f) are also required to be included in this training pursuant to Insurance Code section (c). We have also added to subparagraph (b)(3)(f) the phrase "including but not limited to sales of annuities to persons aged 65 and older, under California law, including but not limited to this article." This phrase was added because California has a number of laws that apply to sales of annuities to and disclosure requirements for senior citizens, which are inapplicable to annuity sales made to other consumers. For example, Insurance Code section requires that the producer provide a notice to the senior 24 hours before the producer's initial meeting in the senior's home; Insurance Code section (a) and (b) specifically address replacement sales made to senior citizens. Similarly, Insurance Code section requires that a thirty (30) day free look notice be set forth on the cover page or policy jacket of individual annuities; and Insurance Code section requires that information regarding the surrender charge be located on the cover page or policy jacket of all individual annuities sold to seniors. Our substantive amendments make clear that the training must cover requirements that apply not only to all purchasers of annuities but also to senior citizens in particular. Subsection (8) of the, which states that the satisfaction of the training requirements of another State shall be deemed to satisfy the corresponding training requirements in California, has been deleted. Insurance Code section 1749 requires that the Insurance Commissioner approve the course of study for both the eight hour and four hour courses. Therefore, to permit the satisfaction of the training requirements of another State to satisfy the training requirements for California producers would violate the consistency standard. Section is otherwise substantially identical to the corresponding section of the ; this SECTION COMPLIANCE; MITIGATION; PENALTIES Subdivision (b) contains substantive amendments which have been made in order to comply with the APA s consistency standard. This subdivision of the Model, which sets forth the circumstances in which penalties for violations of the regulation may be reduced or eliminated, has been made applicable only as to producers; it has been deleted as to insurers. Instead, with regard to insurers, subdivision (b) states that any applicable penalty under the cited Insurance Code sections "shall be determined pursuant to Article 19 of Subchapter 3 of this Chapter 5, commencing at Section 2591." Section 2591 et seq. were promulgated as mandated by Insurance Code section (a)(7), which required that the Commissioner promulgate enforcement guidelines that set forth appropriate for violations based on the nature, severity, and frequency of the violations." It would violate the consistency standard of the APA to include in section a provision providing that an applicable penalty assessed against an insurer might be reduced if the insurer takes prompt corrective action for the consumer, since the issue of determining penalties to be paid by insurers subject to penalties under Insurance Code sections 783.5, 789.3, or is already addressed in Section 2591 et seq., which #640310v1 7

8 provide rules that are potentially at odds with the stricken language. For instance, Section (a) indicates that absence of harm shall not mitigate the effect of other relevant considerations. Section is otherwise substantially identical to the corresponding section of the ; this SECTION RECORD KEEPING Subdivision (a) has been substantively amended to state the time period during which records of the transaction must be maintained: five years after the insurance transaction is completed by the insurer. This is the minimum length of time for record retention required by Insurance Code section Therefore, this amendment is necessary so as to not violate the consistency standard of the APA. Section is otherwise substantially identical to the corresponding section of the ; this IDENTIFICATION OF STUDIES There are no specific studies relied upon in the adoption of this article. SPECIFIC TECHNOLOGIES OR EQUIPMENT Adoption of these regulations would not mandate the use of specific technologies or equipment. ALTERNATIVES The Commissioner has determined that no reasonable alternative exists to carry out the purpose for which the regulations are proposed. Performance standards were considered but were rejected as an unreasonable and impracticable alternative in the context of regulations that seek efficiently to define specific rules for the protection of senior citizens who are being sold annuity contracts. ECONOMIC IMPACT ON SMALL BUSINESS The Commissioner has identified no reasonable alternatives to the presently proposed regulations, nor have any such alternatives otherwise been identified and brought to the attention of the Department, that would lessen any impact on small business. Although performance standards were considered as an alternative, they were rejected, in part, because the kind of risks from which the regulations seek to protect consumers cannot practicably be gauged by means of a performance standard. PRENOTICE DISCUSSIONS #640310v1 8

9 The Commissioner has not conducted prenotice public discussions pursuant to Government Code Section , because the many of the affected parties who would have been invited to participate in such discussions primarily insurers have been offered and, in some cases, have taken advantage of the opportunity to participate in the public comment process afforded by the NAIC in the drafting of the Model. Additionally, it is unlikely that the interested parties will find the modifications made by the Department to the language of the Model to be too complex or multifarious to be reviewed easily during the comment period. #640310v1 9