On March 11, 2020, the Securities and Exchange Commission (“SEC” or “Commission”) adopted a new prospectus disclosure framework, including new rules, rule amendments and registration statement form amendments, for SEC-registered variable annuity contracts and variable life insurance policies (together, “variable contracts”). The changes, which reflect more than a decade of major insurance industry and SEC staff effort and collaboration, are wide-sweeping and bring a host of much needed and very welcome disclosure improvements, as well as critical technical modernizations to the manner in which variable contract investors receive and can review prospectus information.
The adopting release, which is 713 pages long, may be found here (the “Adopting Release”). In the accompanying SEC press release, which can be found here, the SEC announced that the changes will streamline and simplify critical disclosures for investors in variable contracts. SEC Chairman Jay Clayton stated that "with today's technology and the benefits of layered disclosure, investors should not have to work through hundreds of pages of disclosure to understand these products' risks, fees, and features in order to make informed investment decisions…”
KEY HIGHLIGHTS:
- The heart of the new disclosure framework is new Rule 498A under the Securities Act of 1933 (“1933 Act”), which substantively mimics the layered disclosure approach that has been successfully in place for mutual funds since 2009, finally placing variable products and mutual funds back in parallel disclosure frameworks.
- An optional variable contract summary prospectus will serve as the cornerstone of the new layered disclosure framework, providing investors with important information relating to the contract’s key terms, benefits and risks, in a concise and more reader-friendly presentation, with access to more detailed information available online, or delivered in paper upon request.
- In a groundbreaking approach to prospectus delivery, the SEC will permit insurers and their selling firms to satisfy their obligations to deliver underlying mutual fund prospectuses if such fund summary prospectuses (and other materials) are posted online at the website address specified in the variable contract summary prospectus. This delivery method will only apply to mutual funds that are available through variable contracts.
- Effectively eliminating an obstacle that has long vexed the variable contract industry, insurers and selling firms will not need to obtain investors’ consent in connection with the use of a summary prospectus, nor do they need consent for online delivery of underlying fund prospectuses.
- Background: The Old Variable Contract Disclosure Regime was “Broken”
In order to fully appreciate this watershed moment, it is important to understand the increasingly unworkable pre-Rule 498A disclosure regime for variable contracts.
Variable contract prospectuses are frequently longer than 100 pages. Variable contract prospectuses have become far too lengthy and difficult for investors to navigate. This length is attributable to several factors, including the disclosure related to variable contracts’ novel and sometimes complicated feature functionality: death protection and retirement income benefit features. In addition, in catering to the diverse needs of variable contract investors, many insurers offer not just one or two of these features but a panoply of optional insurance benefits, each with its own terminology. It is also not uncommon for insurers to layer multiple variable contract iterations sold over time into a single variable contract prospectus, so one prospectus can describe both the terms of the variable contract that the insurer is currently offering as well as its predecessor versions, adding even more pages for investors to sift through. In turn, variable contract prospectuses are typically bound with, or accompanied by, prospectuses for the underlying funds that are available for investment, adding still more pages. Some insurers offer 100 or more such funds. Indeed, today’s variable contract prospectus packages have become so voluminous that they are often humorously referred to as “phonebooks.”
Variable contract prospectuses are delivered to existing contract owners annually, despite the fact that very little information changes. Insurers or their financial intermediaries deliver a variable contract prospectus to each new investor prior to or upon the completion of a variable contract purchase. In addition, existing contract owners receive an updated variable contract statutory prospectus each year, as arguably a subsequent purchase payment, or even a transfer among underlying fund options, constitutes a new purchase triggering the need for an up-to-date prospectus. This typically happens on or about May 1st each year -- simultaneous with insurers’ annual obligation to update variable product registration statements with current financial statements. With little exception, however, the information in variable contract statutory prospectuses does not change from year-to-year, as a variable contract’s features and terms are generally “locked-in” when the insurance contract is issued. Accordingly, insurers print and mail virtually the same prospectus year after year. The underlying fund prospectuses are also delivered every year.
| As a result, variable contract investors have been bombarded, both at the point of sale and annually, with lengthy and non-navigable prospectuses, and existing contract owners who receive the current prospectus annually have no easy way of evaluating what information has been updated or changed in the overwhelming sea of repetitive information. |
With these challenges at the forefront, variable contract insurers and selling firms for years have been advocating for disclosure reform and modernizations. These advocacy efforts intensified in the wake of the SEC’s 2009 adoption of Rule 498, which left the insurance industry and mutual funds operating in very different prospectus disclosure regimes – one that has subsisted for years.
- Summary Prospectuses as Part of a Layered Disclosure Framework
The focal piece of the new variable contract disclosure regime is the optional summary prospectus, which builds on more than 20 years of experience with the use of the internet as a medium for delivering information to investors, as well as the success of the mutual fund summary prospectus. Indeed, the SEC estimates that approximately 93% of mutual funds and ETFs use summary prospectuses. In a departure from the mutual fund summary prospectus regime, however, and in deference to the unique nature of variable contracts, Rule 498A provides for the optional use of two different forms of summary prospectuses, as follows: an Initial Summary Prospectus (“ISP”) for new investors at the time of the initial purchase; and an Update Summary Prospectus (“USP”) for in-force variable contract owners on an annual basis.
| The optional use of a summary is intended to give the variable contract industry a period of time to transition to the new regime, given the diversity of variable contracts and their disclosures and the fact that the variable contract disclosure regime will differ from the mutual fund disclosure regime in several ways. |
Regardless of whether an insurer uses an ISP or a USP for a particular contract or all their variable contracts, insurers will be required to update all their contract’s statutory prospectuses and registration statements in accordance with the applicable amended registration form, which include Forms N-3 and N-4 (for variable annuity contracts) and N-6 (for variable life policies). These revised prospectuses and amended registration statements, along with all ISPs, are subject to SEC staff review and comment. A definitive form of the USP must be filed with the SEC and is not subject to stand-alone staff review.
| The SEC believed it was important for staff to review the ISP prior to its first use. Unlike the USP and the mutual fund summary prospectus, where the content is virtually identical to certain portions of the statutory prospectus, the ISP --because it is specific to a single (or a single class) of contract offerings -- will typically vary somewhat from its statutory prospectus. |
ISP. An ISP may cover only a single contract described in the related statutory prospectus (but may describe multiple “classes” of the same contract). The SEC defined “class” to be a class of contracts that vary principally with respect to distribution-related fees and expenses.
| The SEC adopted this requirement for ISPs because aggregating disclosure for multiple contracts, or currently offered or no longer available features of a single contract, can hinder investor understanding of what they are purchasing. |
The ISP must contain the following disclosure sections in the following order: (i) cover page; (ii) important considerations; (iii) overview (iv) standard death benefit (for variable life only); (v) benefits available under the contract; (vi) buying the contracts; (vii) lapse information (for variable life); (viii) withdrawals/accessing your money; (ix) additional information about fees; and (x) an appendix containing specified underlying mutual fund information.
USP. The USP is designed to focus existing contract owners’ attention on new or updated information, as well as to remind them of the key features of their variable contract. The SEC premised this disclosure approach, in part, on its belief that highlighting “important” changes will provide the information investors need in considering whether to continue making additional purchase payments and/or to reallocate contract value (and even surrenders and exchanges).
The USP must contain a subset of the ISP’s sections and one additional section, in the following order: (i) cover page; (ii) updated information about the contract; (iii) important information to consider; and (ix) an appendix containing specified underlying fund information.
Information relating to any changes to the following is required: (i) the availability of portfolio companies; (ii) statutory prospectus disclosure relating to the Fee Table; (iii) the standard death benefit; (iv) the other benefits available under the contract, and (v) any other changes to disclosure items that are included in an ISP. The USP may also include a concise description of any other changes to the contract that the registrant wishes to disclose, provided they occurred within the same time period.
A USP may cover one or more contracts (and more than one class of contract) described in the related statutory prospectus. Given the limited information in the USP, the SEC believed that permitting the inclusion of multiple contracts in a USP would not lead to investor confusion in the same way that doing so might in an ISP.
ISP and USP Highlights: The Key Information Table (“KIT”) and the Fund Appendix. Perhaps the two most novel and somewhat controversial components of the new disclosure regime are the so-called KIT and the Fund Appendix.
KIT. The “Important Considerations” section, required in both the ISP and USP (and also the statutory prospectus), will contain a contract summary table and is largely viewed as one of the primary lynchpins of Rule 498A. The SEC intends for the KIT to highlight, in a consolidated location, important purchase considerations, including some unique aspects of variable contracts that might not otherwise be familiar to investors who have experience with mutual funds or other types of investments. In this sense, it is intended to provide a contextual baseline to help form investors’ understanding of more detailed disclosure that comes later in the ISP.
The KIT includes several prescribed sections in the following order: (i) fees and expenses; (ii) risks; (iii) restrictions; (iv) taxes; and (v) conflicts of interest. It will also include cross-references to the locations in the statutory prospectus where further information on each item can be found.
| The KIT represents another key variation from the mutual fund layered disclosure regime in that the variable contract disclosure regime will not only layer disclosure between documents, e.g., from the summary prospectus to the statutory prospectus, but it also will layer disclosure within the summary document itself – for example, fee and expense information in both the KIT and the fee table. |
Fund Appendix. A Fund Summary Appendix is required in the ISP and USP (and statutory prospectus). Its inclusion, which is intended to foster fund comparisons, is based on the SEC’s premise that variable contract investment experience will largely depend on the mutual funds selected, and, following the decision to purchase a variable contract, information about the mutual funds is the most important ongoing information needed in terms of where to allocate contract value and/or new purchase payments. In addition, the Fund Appendix provides a foundation for the new optional online delivery of underlying mutual fund prospectuses. Its content complements the mutual fund prospectus, and it allows the investor to decide the amount and type of fund information he wishes to review – either by stopping at the Fund Appendix or going further and reviewing the mutual fund prospectuses.
The Fund Appendix is comprised of a table summarizing the mutual fund portfolios available under the variable contract, as follows: the portfolio type or investment objective; the name of the portfolio company and its adviser(s); the portfolio company’s expense ratio; and its average annual total returns over the past 1-year, 5-year, and 10-year periods. In addition, if the availability of one or more portfolio companies varies by benefit offered under the contract, insurers would be required to indicate which portfolio companies are available under each such benefit.
| While the variable contract industry is fully supportive of the option to deliver fund prospectuses online, the information required in the variable contract Fund Appendix will require an enormous amount of time-sensitive coordination between insurers and mutual fund sponsors, and includes the inclusion of fund performance that will be out of date as of the date of the first use of the variable contract prospectus. |
Website Posting & Prospectus Delivery: New Rule 498A will permit insurers and selling firms to satisfy their prospectus delivery obligations under the 1933 Act for variable contracts by giving a paper summary prospectus to investors and making the statutory prospectus and other disclosure documents available online. The delivery of summary prospectuses must comply with certain binding and prominence requirements. Insurers that use summary prospectuses are required to make publicly accessible the related variable contract statutory prospectus, as well as the contract’s statement of additional information (and the summary prospectus), free of charge, at a website address specified on the cover of the summary prospectus. An investor who receives a contract summary prospectus may request the statutory prospectus and SAI in paper or electronically, at no cost to the investor.
Inline XBRL. When the requirement to use XBRL (eXtensible Business Reporting Language) was first proposed and implemented for financial statements in registration statements almost ten years ago, variable contract registration statements were exempted. Now, however, in the SEC’s ongoing efforts to modernize the manner in which investors can review the information in variable contract prospectuses, the Commission is requiring the use of the Inline XBRL format for certain disclosures in the variable contract statutory prospectus. XBRL also will enable SEC staff and other data users to analyze and compare the information about variable contracts efficiently. The Commission has previously amended its rules to require operating companies, mutual funds, and ETFs to submit certain required information in Inline XBRL.
The SEC is requiring insurers to tag the following prospectus disclosure items using Inline XBRL: (a) the key information table, (b) fee table, (c) principal risks of investing in the contract, (d) benefits available under the contract, and (e) investment options available under the contract.
| XBRL will only be required in connection with variable contracts that currently are being offered, which means that insurers generally are not required to go through the rather laborious “tagging” process required to implement XBRL with regard to its “closed” books of business. |
Statutory Prospectus. The SEC has also adopted major changes to the full statutory prospectuses and SAIs for variable contracts through amendments to SEC registration Forms N-3, N-4 and N-6. The changes will significantly alter the format and content of statutory prospectus disclosure that insurers must provide for variable contracts, again, regardless of whether the insurer chooses to utilize the option to use summary prospectuses.
Many of the form amendments are directly in line with the summary prospectus framework, i.e., all information items required in the summary prospectus are also new information items required in the statutory prospectus. Other changes enhance current disclosure requirements and/or require new disclosure. A number of the changes simply provide greater consistency among the registration forms for variable contracts with the SEC relying on Form N-6, its most recently adopted variable contract form, as a model for many of the proposed amendments to Forms N-3 and N-4, e.g., Forms N-3 and N-4 will now require a summary of the principal risks of purchasing a variable annuity contract.
| One of the most notable and welcome changes is the SEC’s removal, in its entirety, of the requirement to include accumulation unit value (“AUV”) tables in the statutory prospectus and SAI. For many insurers, the AUV tables included thousands and thousands of numbers, and spanned dozens of prospectus and SAI pages. |
| Insurers should not underestimate the time that will be required to transition their variable contract prospectuses to the new format. Compliance with the form amendments will entail significant rewriting of and additions to variable contract statutory prospectuses. |
- New Online Option to Satisfy Underlying Fund Prospectus Delivery Requirements
Building on the momentum of Rule 30e-3 (which permits insurers and mutual funds to deliver mutual fund shareholder reports online), Rule 498A will permit an optional method for satisfying underlying mutual fund prospectus delivery obligations by making fund summary and statutory prospectuses available online. Online delivery of fund prospectuses will be available if: (1) an ISP is used for each currently offered variable contract under a registration statement; (2) the fund uses a summary prospectus; and (3) the fund’s current summary prospectus, statutory prospectus, SAI, and most recent shareholder reports are posted online in accordance with certain specified conditions. These conditions, in part, are designed to encourage the use of summary prospectuses. The online delivery option will be available for variable annuity contracts and variable life insurance policies registered on Form N-4 and N-6, respectively. It generally will not be available for contracts no longer being offered.
If the conditions for use of the online delivery option are met, insurers would no longer face the prospect of binding fund prospectuses to variable contract prospectuses. Nor would they need to provide fund prospectuses upon initial allocation to an underlying fund or send them on an annual basis.
| The online delivery option for satisfying underlying fund prospectus delivery obligations represents the SEC’s most innovative step to date in adopting an access equals delivery model for investment company prospectus delivery and a significant opportunity for insurers and underlying funds to embrace a disclosure regime that on its face appears more rational and efficient for individual investors. |
- The Withdrawal of the Great-West No-Action Letters & “Grandfathering” Options
Perhaps the most controversial subject in the evolution of this rulemaking was the viability of the “Great-West” line of no-action letters providing relief from registration statement updating requirements for small closed blocks of business, and whether there would be any form of going-forward relief for closed contract blocks under the new disclosure regime. Ultimately, in the Adopting Release, while the SEC is withdrawing the Great-West line of no-action letters, which date back to 1977, it is effectively providing “grandfather” treatment for most small closed blocks. It is not, however, providing any substantively similar forward-looking relief.
Background. Based on the “Great-West” line of no-action letters (“Great-West Letters”), under certain prescribed conditions, many insurers have stopped maintaining registration statements and delivering updated prospectuses for variable contracts that are no longer being offered for sale and that have relatively few contract owner investors (typically fewer than 5,000 contract owners, with certain no-action letters permitting substantially more). The Great-West Letters have been elemental in helping insurers manage the internal resources needed to support the legions of registration statements and full-length prospectuses that they maintain, on a new and existing contract owner basis, by helping insurers address the increasingly disproportionate costs associated with diminishing blocks of discontinued variable contracts and the assets associated with those contracts.
Great-West is particularly critical to insurers because unlike mutual funds, where any change made to the mutual fund’s operations apply to all its investors, whether they purchased ten years ago or yesterday, once an investor purchases a variable contract, no changes can be made unless such changes are expressly permitted by the terms of the insurance contract, and very few changes, in fact, are permitted. Accordingly, with very few exceptions, when an insurer modifies the terms of a current variable contract offering, it is creating a new contract “iteration”, i.e., it is effectively closing one block of business and opening another. The Great-West Letters have helped insurers manage these numerous blocks of contract owners.
This situation is further exacerbated by the fact that, unlike mutual funds and other types of registered investment companies, which are free to unilaterally liquidate when they are no longer economically viable, variable contracts, because they are binding agreements, have no mechanism, under federal or state law, that permits an insurance company to unilaterally terminate a block of variable contracts once the asset base becomes too small to offset the insurer’s costs.
| Indeed, it is arguable that the relief provided by the Great-West Letters has helped insurers manage the price of variable contracts, as well as given them the ability to deploy their human resources more freely to support product innovation. |
Grandfathering. In withdrawing the Great-West Letters in the Adopting Release, the SEC states there will be no basis for an SEC enforcement action against an issuer of a closed block of variable contracts if, as of the effective date of the new rules:
- The contract has a registration statement with fewer than 5,000 investors;
- New contracts are not offered to the public, and there is no contemplated offering in the future;
- Satisfactory “alternative disclosures” are delivered to contract owners, which are all of the materials required to be delivered under the Great-West no-action letters today (e.g., underlying fund prospectuses, financial statements, confirmations and more), although companies may opt to provide certain “modernized” alternative disclosures (see below);
- The company continues to file annual reports on Form N-CEN; and
- The company files the financial statements delivered to contract owners with the SEC.
| Today, insurers only need to send the specified financial statements to Great-Wested contract owners. In order for a variable contract to be grandfathered, insurers now will have to take on the added cost and obligation of filing those financials with the SEC. |
Possible “Great-West” Modernizations. In lieu of providing underlying fund prospectuses and financial statements in paper (or electronically), companies with grandfathered Great-Wested contracts will have the option to provide so-called modernized alternative disclosures. If a company with a grandfathered contract sends variable contract owners an annual “Notice Document” with the same information that is required in a USP, the company may take advantage of the online underlying fund prospectus delivery option, and deliver the applicable financial statements online (both subject to certain requirements), as well as file them with the SEC. The Notice Document would also need to be filed with the SEC.
- Important Dates & Next Steps
Important Dates. The following is the list of the important dates:
Next Steps. The January 1, 2022 Compliance Date will be upon the variable contract industry in a relatively short period of time. Insurance company legal and business teams will need to develop action plans and timelines around both their new business and legacy product lines. Summary prospectuses will need to be drafted, registration statements will need to be amended and multiple SEC filings will be required. Establishing website hosting, in compliance with the new rules, will be critical, as well as coordination with fund partners related to online delivery of fund prospectuses and the robust fund information needed in the Fund Appendices. Insurers will need to determine which variable contracts are eligible for grandfathering treatment under Great-West, and to decide (and plan for) which contracts will maintain the current Great-West disclosure treatment and which will be treated under the modernized approach.
Without question, new Rule 498A (and the related rules and form amendments) represents the most significant advancement in variable contract disclosure since variable contract registration statement forms were originally adopted. The new layered prospectus disclosure regime is a major step forward in modernizing the disclosure requirements imposed by the federal securities laws on SEC-registered variable contracts, and recognizes the pervasive use of electronic media by the investing public. The sheer breadth of the changes represents a very substantial effort by the SEC staff in the Division of Investment Management. They should be highly commended for this accomplishment.
[View source.]
