On September 27, 2017, members of the securities industry gathered in New York for the Practising Law Institute (“PLI”) Securities Arbitration Forum. While a variety of topics were discussed, this Alert focuses on one of the panels at the Forum, titled “Lifting the Veil: A Practicum on Insurance Issues in Dispute Resolution.”

The panelists, Tracey Salmon-Smith, a Principal at Bressler, Amery & Ross, P.C., Darya Geetter, an Executive Vice President and Deputy General Counsel at LPL Financial, James Yellen, President at Yellen Mediation Services, and Glenn Gitomer, Litigation Chair at McCausland Keen & Buckman, discussed several key topics regarding insurance issues in securities arbitration, including securities claims arising from insurance products such as variable annuities, variable life insurance and variable universal life insurance.

Variable annuities are hybrid investments containing securities and insurance features. Variable annuities allow you to select from a menu of investment choices, typically mutual funds, and allow you to receive tax deferred treatment of earnings, a death benefit, and a payout option. Variable life insurance offers fixed premiums and a minimum death benefit to policy holders while the cash value is invested in a portfolio of securities. Variable universal life insurance combines features of universal life insurance and variable life insurance. It offers flexibility in premium payments and insurance coverage, as well as an investment account that also varies with a menu of investment choices.

General Requirements

During the panel, Salmon-Smith reminded FINRA member-firms that brokers have a duty to (1) understand the insurance product, and (2) accurately explain the nature and risk of holding the long-term investment. Salmon-Smith’s views echoed FINRA’s recent attention to firms’ disclosure communications. For example, in Regulatory Notice 17-06 FINRA proposed amendments to Rule 2210 which governs broker dealers’ communications with the public, retail and institutional investors. Rule 2210 provides that communications may not predict or project performance, imply that past performance will recur, or make any exaggerated or unwarranted claim, opinion or forecast.

The proposed amendments to Rule 2210 identify a few exceptions to the general admonition, and provide examples of hypothetical illustrations which will be permissible. For instance, the proposed rule amendments would provide an exception to the prohibition of projections for a customized hypothetical investment planning illustration. If approved, the amendments will permit illustrations which project an asset allocation or other investment strategy, but not the performance of an individual security. The proposal includes a “reasonable basis” requirement for all assumptions, conclusions and recommendations. Further, brokers must “clearly and prominently” disclose that the illustration is hypothetical and that there is no assurance that the investment performance demonstrated will occur.

Proper Disclosures

With variable insurance products, it is incumbent on brokers to make the necessary disclosures regarding the maintenance of the product and the volatility of the subaccounts. Amendments approved or not, FINRA prohibits misrepresentation or omission of material facts concerning these products under FINRA Rule 2211. That Rule provides additional requirements for communication disclosures specifically relating to variable annuities and variable life insurance, to avoid common misrepresentations as to these products including:

  1. Misrepresenting the product as a short-term liquid investment;
  2. Misrepresenting the product as a retirement plan or mutual fund;
  3. Misrepresenting an insurance premium obligation, i.e., that the policy needs adequate funding and the premiums do not “vanish;”
  4. Misleading illustrations – illustrations are intended to predict the future performance of the product, but if the illustration is not appropriately explained, it can become a misrepresentation.

Firms should also carefully review their jurisdiction’s insurance regulations for further guidance. For example, New York State Insurance Department Regulation 60 permits illustrations to show up to a maximum 12% annual return. Brokers are required to balance the expectations by accompanying the 12% return illustration with an illustration showing what can happen in the worst-case scenario – a 0% investment return.

Suitability and Avoidance of “Twisting” Claims

Firms were also reminded by the panel that the variable insurance product must be suitable. With variable annuities, FINRA Rule 2330 provides specific requirements pertaining to principal review, supervision, training and suitability of purchases and exchanges of deferred variable annuities. Rule 2330 requires firms to have written policies and procedures in place for surveillance of brokers’ recommending, purchasing or exchanging of deferred variable annuities. Brokers are required to have a reasonable basis to believe that (i) the customer is informed about the terms and features of the annuity; (ii) the customer will benefit from the annuity features, such as deferred growth and annuitization; and (iii) the annuity and subaccounts are suitable for the customer.

This is in addition to FINRA Rule 2111 suitability requirements, which require customer suitability for sales of any investment, including variable insurance products. Suitability extends past the purchase of the insurance product to encompass the underlying securities within the subaccounts. Suitability may not be an issue at the initial purchase of the product but may ripen into an issue when a broker recommends surrendering a policy in exchange for a new policy. The practice of knowingly making a misleading representation or fraudulently omitting facts about an insurance policy to induce the customer into surrendering an existing policy for a new policy with a new insurer is commonly referred to as “twisting.”

The panel specifically discussed the serious concerns surrounding twisting claims. Surrendering an existing policy can lead to an early termination penalty which results in the customer losing money while the broker earns a new commission. Commissions associated with life insurance policies are heavily scrutinized by regulators. As discussed in FINRA’s 2017 Regulatory and Examination Priorities Letter, excessive and short term trading of long-term products is at the top of FINRA’s regulatory priority list because of the increased costs, i.e., commissions, leading to diminished investment returns to the customer.

Further, twisting carries more than just regulatory ramifications. Twisting can lead to criminal fraud charges. In 2016 the U.S. Attorney’s Office, with the investigative assistance of the IRS and the Oklahoma Insurance Department, brought an action in the Northern District of Oklahoma against an agent who owned an insurance and financial company. The agent ultimately pled guilty to fraud after admitting that he lied to clients to convince them to surrender existing annuities to immediately purchase new ones and failed to disclose early termination penalties as part of his twisting scheme. The investigation revealed that one of the agent’s clients lost nearly $14,000 after surrounding one policy while the agent gained more than $17,000 on the commission for the new policy. The court sentenced the agent to 27 months in federal prison. The State’s insurance commissioner reminded industry professionals, “it is imperative that consumers be able to trust their insurance agent or broker.”

The Bottom Line

Firms should confirm that brokers are making the necessary disclosures when recommending variable insurance products to customers. The product and underlying subaccounts’ investments must be suitable for the customer. Firms are well-advised to have a supervisory system and infrastructure that adequately detects, monitors, and prevents twisting, and carefully scrutinizes switches among product holders.