Regulatory wars: the perfect catalyst for regulatory changes

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Only 5% of the taxes and fees collected by the states (US) or the provinces (Canada) is used to regulate the insurance industry. 95% of what is left goes into general revenue and can be considered as profits to the states or provinces. It is therefore simple to conclude that the states or provinces have no stake into protecting the consumer. The states or provinces profit substantially when the insurance industry succeed at the expense of the consumers.

Considering the lack of resources allocated to the regulation of the insurance industry in both the U.S and Canada, why is there such a difference in the regulatory environment of the two countries? Why does the U.S have a more comprehensive and more advanced regulatory environment? The answer may surprise you. It is because of the conflict between states and federal power which has forced the U.S. states to address the commercial practices of insurers, harmonization and other issues in other to keep the Federal U.S government out of the business of insurance. This conflict between the States and the Feds was and continue to be a catalyst for changes for better regulations. This conflict never took place in Canada and as a result the provinces never had the incentives to address such issues as the sale of Universal Life as an investment. Let’s therefore look at what happened in the U.S…

Paul v. Virginia: the fist challenge to state’s regulation of insurance

Conflict between federal and state powers started early in regards to insurance. In the mid-1800s, an agent with the name of Samuel Paul decided not to get licensed under Virginia laws and was convicted of having sold insurance without a license. This case was used by insurance companies to challenge the power of the states arguing before the Supreme Court that insurance fell under the federal government under the Commerce Clause. The Supreme Court rejected that argument stating that insurance was not a transaction of commerce.

“The industry was not alone in its early preference for federal regulation of insurance. Early state regulators believed that the national nature of the insurance business and considerations of efficiency supported federal regulation. Elizur Wright, known as the “Father of Insurance Regulation,”opined that “insurance, being of widespread interest should be secure against the adverse operation of local causes—that simplicity required a national bureau, and that a state could probably not protect itself as well with reference to insurance of other states as it could be protected by the federal government.” (Susan Randall, INSURANCE REGULATION IN THE UNITED STATES: REGULATORY FEDERALISM AND THE
NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS, Florida State University Law Review)

While the industry and some regulators failed in their attempt in having the insurance industry federally regulated, this still led to the creation of the National Association of Insurance Commissioners (NAIC) and the start of the harmonization of insurance laws and statutes across states jurisdictions. Until the 1900s, there were no more challenges to the states regulation of insurance.

United States v. South-Eastern Underwriters Association

It was all quiet of the regulatory front lines between states and the federal government until Missouri resisted a rate increase requested by insurance companies. The matter went before the court and the difference between current rates and the new rates was deposited into the court until a decision was reached. A settlement was reached between the Missouri Superintendent of Insurance and the insurers where the rate increase was going to be allowed under the provision that Missouri was going the keep 20% of the funds deposited to the court.

This did not go well with the Missouri attorney general Roy McKittrick who viewed this as a bribe and charged those involved with conspiracy. Using the fact that the conspirators were out-of-state insurers, the matter was transferred to the U.S. Department of Justice but it was not a surprise that the district court dismissed the indictment relying on the decision of the Supreme Court in Paul v. Virginia.

The matter went again to the Supreme Court which contrary to what was expected reversed its decision by declaring that insurance was interstate commerce subject to federal regulations under the Commerce Clause. The states through the NAIC responded quickly and a bill was presented and signed into law by President Roosevelt under the name of the McCarran-Ferguson Act which made the business of insurance subject to state laws.

However this act did provide that if the states did not regulate the business of insurance, such business would be regulated by the federal government through the Sherman and Clayton Acts and the Federal Commission Trade Act. This clause was the perfect incentive for the states to ensure that the business of insurance was regulated and NAIC introduced model laws which were quickly adopted by the states.

We could have expected that with the existence of the McCarran-Ferguson Act, there would no more challenges to the rights of the states to regulate the insurance industry. This changed when the insurers decided they were not in the business of insurance but were instead in the business of savings.

A Petition for Issuance and Amendment of Rules and Rulemaking Proceeding Therefor

When insurers decided to move away from traditional fix benefits life insurance products to compete for the savings of American consumers against other investment opportunities, this raised the question of what was the business of these insurers and what were they selling. If these insurers were in the business of investments selling Universal Life with enough inherent investment risk then the consumers needed to be protected under the Securities Act which provided for the disclosure of this risk.

For the Mutual Funds industry, the answer was simple. Since these products were created to compete against mutual funds, then the Universal Life fell under the Securities Act and therefore under federal law despite the existence of the McCarran-Ferguson Act.

This is why the American Life Convention and the Life Insurance Association of America requested an exemption to the Securities Act for these new products through a petition in 1970 arguing that the guarantees offered by the Universal Life put the insurers at risk and therefore these were primarily contracts of insurance which should be exempted from federal securities laws.

Prior to this request for exemption, there already had been decisions by the Supreme Court about what constituted an investment contract. The question had already been addressed for the sale of variable annuities in SEC v. Variable Annuity Life Insurance Company (VALIC) with the court ruling that what constituted insurance is a federal question not answered by what the state had decided and therefore variable annuities were a security contract subject to federal regulation which could not be exempted from the Securities Act. The majority decision was however based on the fact there was no guarantee of fixed income for the variable annuity and therefore there was no risk taking on the part of the insurer. This decision had a big impact on insurance product development and led to the creation of investment /insurance products with guarantees which would provide an exemption to the Securities Act.

Still the issue was not settled and it was revisited with SEC v. United Benefit Life Ins. Co when this company introduced a variable annuity with a guarantee of 100% of net premiums paid if the contract was redeemed for cash. The decision was that a contract could be of insurance and of investment and therefore could be fragmented. Since a potential purchaser would select this type of product because of the capital growth it was offering and not because of the guarantee, this contract was deemed to be a security. Basically the appeal of the investment was added to the tests created by the previous decision of the Supreme Court for Valic.

SEC decision on the petition

It was a strange decision that the SEC made in regards to Variable Life Insurance and specifically Variable Universal Life. This decision represented a surprising compromise. The SEC decision was that variable life insurance contract was a security within the meaning of the Securities Act. However the insurers and agents selling these contracts were exempt from the Investment Company Act and the Investment Advisors Act. This exemption was given in deference to the states which would still be responsible for the supervision of insurers and advisors. One the main effect of this exemption was to remove the limit on any sales loads applied to Variable Universal Life if these two acts had applied. Basically SEC recognized that the states had been efficient in monitoring the solvency of insurers and actions of advisors. However the states had a poor track record in regards to consumer protection from misleading sales practices and as a result, the Securities Act needed to apply to these products to protect consumers.

As a result, in the United States, they would be shocked to learn that in Canada, an advisor can sell Universal Life linked to very risky investments without any disclosure required contrary to the U.S. where a prospectus would be required under the Securities Act.

Conclusion

I believe that the matter of whether Variable Life insurance should be regulated under federal laws to protect consumers because these products contain significant investment risk is far from being a closed issue. But at least in the U.S the dialog is going on while in Canada it has never started. Canadians are sold investment contracts with significant risks offering no guarantees and no disclosure is required on the part of the insurers selling these products. It is therefore not surprising that this situation has been abused by the Canadian insurers. The worst example is software that produces illustrations that have nothing to do with the reality to promote the sale of Universal Life.

This matter in Canada is becoming urgent. Sales of Variable Universal Life will decrease significantly now that the tax payer is not subsidizing the sale of this product anymore. The Canadian insurers will have to introduce a new product to increase sales and will look south of the border for their inspiration. I predict that in 2015/2016, we will see the first Index Universal Life appear in the Canadian market place. However without proper disclosure and regulations the sale of this product will become a second crisis for the Canadian insurance industry. This is why in my next step we will review the particularities of the Index Universal Life.

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5 comments

  1. Ami Maishlish
    President, CompuOffice Software Inc.

    Richard, the consumer is not better protected in the US than in Canada; I’d venture to say that, if anything, the consumer is subject to more exposure in the States than in Canada. “The grass is greener across the fence” as the proverb goes… but: The perceived impression that regulatory protection is greater in the US than in Canada is a mirage, an illusion.

  2. Richard Proteau
    Founder Financial Services Consumer Alliance

    Ami, since you do not provide any facts your statement is unsupported. However I do have facts for you. Since 2002, the NAIC has introduced a model law ” Managing General Agents Act” in 2002. Where are we at in Canada? Well in 2014, for the first time because of an article in the Globe and Mail, regulator were surprised to learn of the existence of the MGA. This means and its even stated in the paper produced by the regulators that the public was left unprotected because MGA were not regulated… Currently in 2014, the NAIC sent a letter to all insurers regarding IUL illustrations and there is currently a big discussion on the appropriate rate of return for an illustration and required disclosure. It is quite an interesting discussion which i will touch on my next text. Where are we at in Canada regarding UL illustrations. Are the insurers and regulators have discussed the subject. In the US, an illustration cannot be done at 12% for example while in Canada it is still an accepted practice by the insurers. So who is protected the most? The Americans or the Canadians. I think the grass is indeed greener south of the border…

  3. Richard Proteau
    Founder Financial Services Consumer Alliance

    Ami I also forgot to mention that the whole purpose of my text was to demonstrate that in the US there has been a long legal discussion about what is Universal Life; is it a security or is it insurance? Therefore there is a legal definition of what constitute a security or what constitute insurance which means that the consumer knows what he is buying.(a TUL and IUL is insurance and a VUL is a security) In Canada, this discussion never happened and our UL is undefined legally…. and can be marketed outside of any regulatory guidelines…

  4. Ami Maishlish
    President, CompuOffice Software Inc.

    Richard, you bring an interesting perspective angle to the subject; however, it’s the practical facts on the ground that count. This is not just for actual practice relating to the sale of various permutations of UL.

    You note in reference to your presentation of facts that:
    “In the US, an illustration cannot be done at 12% for example while in Canada it is still an accepted practice by the insurers.”
    In that regard, I’m not questioning the first part of that statement, “In the US, an illustration cannot be done at 12%”; however, I’d appreciate it if you would substantiate the second part, “in Canada it is still an accepted practice by the insurers.”

    Yes, in the 1990s illustrations of UL at a net 12% regretfully existed and I recall voicing my objections to projection of such rates; however, I haven’t run into any life insurance company illustration having 12% net ROI, set as the default in insurance company illustration software now nor since quite a number of years ago. Likewise, I haven’t seen a single agent illustrating UL at 12 net ROI or anything near that in recent years. So, if illustrations at 12% net ROI on UL “is still an accepted practice by insurers here in Canada, I’m certainly curious to know who such insurers may be.

    You also note that ” our UL is undefined legally…. and can be marketed outside of any regulatory guidelines…” Richard, I appreciate your wealth of knowledge and would appreciate if you would expand on this.

    Thanks.

  5. Richard Proteau
    Founder Financial Services Consumer Alliance

    Ami, first contrary to the US there has been no discussion as to what is a suitable rate for a Universal Life illustration and what process is used to select that rate. I would suggest your read the NAIC paper on rate for IUL that has been produced in 2014. Also for all of the insurers that I have worked with there is absolutely no process to review an illustration. The only check that is done is to ensure the illustration is signed. So an illustration at 12% would not raise any questions from an insurer. In Quebec we have such a case which are the illustration done by Thibault at 11%+. He did this in 2000+. This should have been questioned when you consider that already insurer knew he falsified life insurance applications.

    Is a UL an investment or is it insurance? In the US, you had the regulators looking at this with federal regulators disagreeing with States regulators which meant the issue went into the Court with the Supreme Court creating a 4 test process to determine whether a product is insurance or investment. Again this did not happen in Canada.

    Please note that in the States, recommended illustration max rate for UL is 10% for UL. However in the States policy charges are not linked to high MER and their MER are less than 1% since their policy have a lot more of fixed charges (charges that are reflected in the illustration contrary to MER). For example a 10% maximum illustration rate in the State (when adding up the MER of 1%) is equaled to a maximum projected earned rate of 11%. Now translating this to a Canadian illustration rate based on a 3.5% MER our max rate should be 7.5%… no software should be allowed to illustrate above this rate.

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