A discussion of insurance duty: fiduciary duty, fiduciary standard and suitability Article added by John Olsen on January 29, 2014
SAINT LOUIS, MO
Joined: September 04, 2002
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Scene: The lobby lounge of a hotel. Five people, three men and two women, are seated around a cocktail table. They have just attended a meeting sponsored by a professional association for financial advisors and are discussing the day’s presentations. They are:
Andy: A life insurance agent
Barbara: A fee-based financial planner
Charlie: an attorney, working in the compliance department of a large insurance company
Don: a freelance writer, specializing in "consumerist" articles involving the financial services industry
Ellie: An investigator for the State Department of Insurance
Andy: I don't know about you folks, but I found today's sessions to be very helpful, especially that lawyer's presentation on "standards of care." I was always under the impression that we life insurance agents are obliged to make recommendations that are suitable, but that we are not subject to the fiduciary duty that applies to portfolio managers and investment advisors. Frankly, what I heard is a bit scary.
Barbara: I can relate to that. As a registered investment advisor, I am held to that fiduciary standard when I am acting in that capacity, but, like you, I always thought that insurance agents don't have that burden. Charlie, is that your impression?
Charlie: That's a very interesting question, Barbara. It's an issue that we have been kicking around for some time at my shop. Some of our people are insurance agents without securities registrations, some are both agents and registered representatives, and a few are registered investment advisory associates with the advisory arm of our firm.
We have always taken the position that when our people are acting solely as insurance agents, the "suitability standard" that applies to such agents is the only applicable standard of care, and even when the agent is selling a security and acting as a registered rep, the same is true. But, of course, our advisory folks are held to a higher standard, which is spelled out in the ADV form that they must supply to the client. But we are re-examining this issue, in the light of this whole fiduciary duty debate.
Barbara: Are you thinking about applying the fiduciary standard to everyone?
Charlie: We're giving a lot of thought to that. Frankly, we're just not sure that the rules are clear.
Don: Wait a minute. I'm confused. Aren't all of your people obliged to put the client's interest first? Doesn't everyone who sells
financial products to consumers have to do that?
Andy: Sure. All good insurance agents do that. When we sell something, whether it's life insurance, an annuity, or some other product, it has to be suitable. The client has to be better off by buying that product.
Barbara: Yeah, but that's not the same thing as "putting the client's interest first," is it?
Charlie: Not exactly. Our understanding is that for a sale to be "suitable," it must meet the client's needs. But, if it's an insurance or securities sale made by an insurance agent or registered rep who is not acting as an "investment advisor," that rep doesn't have to disregard his own commission interest. By contrast, the investment advisor must put the client's interest ahead of his own.
Don: Hold on a minute. How is that even possible? Are you suggesting that an insurance agent or registered rep — stockbroker or whatever — can take into account how much money he will make on a sale, but an investment advisor can't do that? Aren't all advisors, no matter how they are designated, in business to make a profit?
Barbara: Sure. I certainly am. But I don't get commissions. I charge a fee for my advice.
Don: So, are commissions different from fees? Are fees treated differently, for purposes of determining the client's best interest, from commissions?
Andy: Uh oh. I saw this coming.
Barbara: It's not that one is better than the other, but they are different. The real distinction is, I think, not in the nature of compensation,
but in what a financial professional does to earn that compensation. Andy is selling products. I sell advice. And, as I understand it, those of us who sell financial advice, who are "investment advisors," for purposes of the 1940 Investment Advisors Act, are held to a higher standard than those who sell financial products for a commission.
Charlie: That's right.
Ellie: If I can jump in, I think the Barbara is right that there are two standards of care involved here. Our department regulates the
sale of insurance products. We do not regulate investment advisors. That's handled by our friends at the State Department of Securities. They regulate both the sale of securities by registered reps, who are compensated by commissions, and the sale of advice by investment advisers, who are compensated by fees. The so-called "suitability standard" applies to registered representatives — and to insurance agents, whom we regulate — and the "fiduciary standard" applies to investment advisors. The suitability standard is not as high. It does not require disclosure of compensation, nor does it require the insurance agent or registered rep to put the client' s interest ahead of his or her own. That said, I'm told that there are elements of the fiduciary standard that do apply to stockbrokers or registered reps in our state, such as the duty to execute trades faithfully and promptly and to maintain proper custody of client's assets.
Don: This is really confusing. How can a consumer know what to expect and which duty applies to the person offering him financial products or advice?
Barbara: That is a question that the SEC has been wrestling with and that Congress specifically addressed in the Dodd-Frank financial reform law. Sections of that law direct the SEC to develop a fiduciary standard that will apply to everyone who gives financial advice.
Andy: Are you saying that the SEC is going to hold me, an insurance agent, to the same standard that applies to you, Barbara, or to a trust officer or portfolio manager? Will those sections of the Dodd-Frank law that you mentioned say that I cannot earn commissions?
Charlie: No, Andy, they don't. One section of that law specifically states that the standard that Dodd-Frank requires the SEC to develop must acknowledge that the receipt of commissions, in and of itself, will not violate that standard, and also that recommending financial products that are proprietary, or that come from only a limited portfolio of products, will, in and of itself, not violate that standard.
Don: But doesn't Dodd-Frank require Andy, or any insurance agent or financial advisor, to sell only the best product? Doesn’t your department, Ellie, impose that requirement?
Ellie: We require sales to be suitable, and we permit the sale of only those products that we have previously approved for sale in our state, but we don't…
Andy: The best product? What do you mean by that, Don? What is the best product and who determines that?
Don: Come on now! Are you saying that you don't have an obligation to sell to a consumer the best product for his or her needs?
Andy: No, Don, I'm simply asking you what you mean by "the best product."
Don: OK, Andy. Wouldn't you agree that some life insurance policies are more expensive than others, but offer the same amount of insurance? If one policy for $100,000 costs $1,000 a year and another, for the same amount, costs $2,000 a year, isn't the second one more expensive?
Andy: Certainly, the premium for the second policy is higher, but does that make that policy "more expensive"? When two life insurance policies, on the same insured, have premiums that are different, there is generally a difference in the coverage. One might have a guaranteed premium while the premium for the other might be subject to change. One may guarantee the death
benefit for a longer period than the other. One may offer a cash surrender value higher than the other. And these are only a few of the differences that might exist between two policy alternatives. Should the amount of the initial premium be the only consideration when one is determining which policy is better?
Don: OK, I see your point. But surely you would agree that some policies are better than others. Don't you have an obligation to sell only those better policies?
Andy: Yes, I do. But you're begging the question of how I, or anyone, can determine "better" or "worse." I'm saying that this can only be done on an individual basis, taking into account a lot of factors, including the required duration of coverage, the client's ability to pay premiums, whether or not cash value is required, and how that cash value should be invested; that is, what kind of growth potential in that cash value is offered by the policy. A good agent will take all of these factors, and others, into account before making a recommendation.
Ellie: It's interesting that you should say that, Andy. As you know, our state recently approved the NAIC Suitability in Annuity Transactions Model Regulation of 2010, which specifies 12 factors that must be taken into consideration prior to the recommendation of any annuity. We have a similar statute that deals with life insurance recommendations. In fact, as of June 16, 2013, all sales of any life insurance or annuity product, made in any state, must conform to the suitability requirements, including considerations of those 12 factors, specified by that model regulation. This was mandated by section 989J of Dodd-Frank.
Charlie: Absolutely. In fact, as you know, Ellie, that section requires those sales to be compliant, not only with that model regulation, but with any successor regulations that the NAIC may adopt. There is some question as to which insurance policies fall within this rule, but insurance companies are scrambling to revise their suitability rules to comply.
In my personal opinion, this is long overdue. The differences in suitability statutes from state to state make it very difficult for an insurer offering products in many states to be confident of what will be acceptable to state regulators. And to how they must disclose the costs and benefits of their policies.
Andy: I was waiting for that. Disclosure requirements are one of my chief headaches. Have you seen an illustration for a universal life policy lately? They are the size of a small novel, written by a very bad novelist. They're not just overly long; they're almost impossible for anyone but a Philadelphia lawyer to understand. Why is this?
Let me ask you, Ellie, why in the world do I need to present a potential insurance buyer with a 50-page document, with endless columns of numbers, and pages of boilerplate that is darn near incomprehensible? How does this help a potential buyer to make an informed buying decision?
Ellie: I feel your pain, Andy. We regulators are acutely aware of this problem. The NAIC has been struggling with it for years. "Fair
disclosure" is a difficult goal to achieve. You've got to include all the factors that are relevant to the costs and benefits of a policy, but you've got to do so in language, and at a length, that is readily understandable for the average consumer. I'm sure you'll remember that policy illustrations produced years ago included "net cost" disclosures that totally ignored the time value of money and that insurers were able to illustrate projected values, including dividends, pretty much any way they wanted. We've tightened
requirements considerably but, I admit, current illustrations are still pretty obtuse.
Barbara: That's putting it mildly, Ellie. I'm not a life insurance expert, but I have to deal with my clients' life insurance needs. Trying to decipher a computerized illustration for a life insurance policy is, for me, a painful process. And it's not just the illustrations. Some product brochures are just as bad. Especially when the product is a deferred annuity with one of those guaranteed lifetime withdrawal benefits. Have any of you ever looked at one of those?
Charlie: I'd rather take a whipping. Some products, like indexed life or annuity contracts, seem to have been deliberately designed to be as complicated as possible.
Don: Good grief! If you, a compliance officer, have trouble deciphering those things, what chance does the average consumer have? The computerized illustrations and product brochures for these products are downright terrible. The illustrations purport to show the future performance — for life insurance products, both the death benefit and the cash value — of the product being recommended, almost always assuming that the policy will earn the same rate of return every year, perhaps for decades. Does that make any sense? Can a reasonable consumer have any confidence in those numbers?
Andy: Surely you jest. The one thing that one can say about the numbers and a computerized illustration for almost any life insurance policy is that the numbers are wrong. Worse, we have no idea how wrong. Some industry experts have called for using stochastic analysis in these illustrations, allowing the numbers to reflect the fact that interest rates — and, perhaps, the pure cost of insurance — may and probably will change over time. But no insurance company produces illustrations on that basis. Why? Is it not possible to produce illustrations that assume changes in those variables?
Charlie: Sure. It's doable. But what insurance company wants to be the first to do that? For one thing, switching to that kind of illustration would be an implicit acknowledgment that your earlier illustrations, based upon assumptions as to interest and mortality costs that never change, were wrong.
Barbara: Yes, which is why I always say that computerized policy illustrations should be filed under science fiction. But I've got a further gripe with those illustrations, and with almost all point-of-sale product brochures.
They extol the benefits of the product with the unspoken assumption that it's the right product for that client. They don't present alternatives. Of course they don't. Their purpose is to sell that product. But would it not be possible to design point-of-sale materials with a diagnostic focus to help the client assess his or her needs and present a range of solutions? That's what a good financial advisor does anyway. Why not develop materials that would assist us in that process?
To my mind, that would not only provide meaningful disclosure (of whatever product is eventually recommended) but would go a long way toward meeting appropriate standard of care requirements.
Andy: Wonderful idea, Barb! But how do we get there?
Charlie: I love it! My editor will love it. Consumers will love it. Heck, they might even understand it.
Dick: Barb, you're a compliance officer's dream. And, probably, a marketing officer’s worst nightmare.
Ellie: Admirable. But is it practical? Assuming that insurers and regulators could be persuaded to attempt this, who would start the process?
Who, indeed? That is the question — not merely for five fictional characters gathered in a hotel lobby, but for our industry and for
those we serve.
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