Agents Selling LIIS Should Be Required to Act in the Best Interest of the Consumer, including an Obligation to Sell Only Policies that Are Suitable for the Consumer

           Agents selling LIIS are generally not subject to suitability requirements (or to the higher obligations imposed by fiduciary or “best interest” standards).  Suitability requirements are imposed, however, when the policy being sold is a variable universal life policy.  With a variable universal life policy, the consumer is actually buying the mutual funds or other securities that underlie the policy and comprise its value.  Because the sale of a variable universal life policy involves the sale of securities, agents selling such policies have been subject to FINRA Rule 2111 imposing a requirement the recommendation be suitable.    And the SEC recently adopted a final rule (17 CFR 240) that imposes an obligation on broker-dealers selling securities (including those selling variable life) to act in the best interest of the consumer  See SEC Regulation Best Interest:  The Broker-Dealer Standard of Conduct.  The SEC standard, while a step in the right direction, is inadequate to protect consumers, as the California Department of Insurance has pointed out and is discussed below.

By contrast, buyers of indexed universal life policies -- policies indexed to the S&P 500, for example -- are not buying a mutual fund but only a promise by the insurance company to credit interest to the policy based in part on the performance of an Index such as the S&P 500™.   Agents selling such policies are considered to be selling general account policies and not securities, and therefore even suitability requirements are largely non-existent.

This makes no sense.  Although it is true that LIIS and mutual funds represent different asset classes, the fact is that consumers purchasing LIIS need even more protection than consumers purchasing mutual funds because purchasing an LIIS policy is a much more complex transaction than purchasing a mutual fund or a stock.  The concept of buying a mutual fund or a stock is not difficult to understand, but understanding how any particular LIIS policy works is very difficult, as the policies are opaque to most consumers, and the illustrations require a great deal of study and sophistication to understand.  See, for example, an illustration for the PacLife Discovery Xelerator IUL 2 – GPT.

If a consumer buys an S&P 500 index fund, at least the consumer can understand the cost of the transaction.  But the cost of a universal life policy tied to the same index is very difficult for a consumer to understand – all the more difficult because most insurers do not require their agents to include fee and expense information in policy illustrations.  LIIS policies are so complex that most consumers buy them on faith – faith in what the agent is telling them about the policy and the illustration – and faith that the insurance company will reasonably perform on the (consumer-perceived) “promises” of the illustration.  Some insurers capitalize on this tendency of consumers to buy on faith by marketing to particular ethnic groups using agents of the same ethnicity to mine their communities.

Agents selling LIIS must be required to recommend only policies that are suitable for the consumer and must be required to act in the best interest of the consumer, i.e. without regard to their own interests, which are often in conflict with the consumer’s.

New York recently adopted a regulation (11 NYCRR 224 – Insurance Regulation 187) that requires agents to recommend only policies that are suitable for the consumer, where “suitable” means “in furtherance of a consumer’s needs and objectives under the circumstances then prevailing, based upon the suitability information provided by the consumer and all products, services, and transactions available to the producer.”  The agent must further act in the best interest of the consumer, where best interest of the consumer  means that “the producer’s or insurer’s recommendation to the consumer is based on an evaluation of the relevant suitability information of the consumer and reflects the care, skill, prudence, and diligence that a prudent person acting in a like capacity and familiar with such matters would use under the circumstances then prevailing.  Only the interests of the consumer shall be considered in making the recommendation.  The producer’s receipt of compensation or other incentives allowed by the Insurance Law and the Insurance Regulation is permitted by this requirement provided that the amount of the compensation or the receipt of an incentive does not influence the recommendation.”  Other states are considering similar rules for their licensed insurance producers.

A New York court recently struck down Regulation 187 as "unconstitutionally vague."  Matter of Independent Ins. Agents and Brokers of New York, Inc. v. New York State Department of Financial Services, 65 Misc. 3d 562 (April 29, 2021).

The court's opinion is only two pages and contains no analysis of the terms of the regulation.  The court states that "the guidelines with respect to the suitability information that producers must obtain from the consumer and the suitability considerations that must necessarily be disclosed are inadequate to the extent that they rely upon subjective terms that lack long-recognized and accepted meanings and provide insufficient guidance with respect to how producers must conduct themselves in order to comply with the amendment."  But the court fails to identify even a single term in the regulation that the court finds vague or subjective.

New York regulators are appealing the decision, and they should prevail.  Not only are the detailed terms of the regulation reasonably clear, but the New York Department of Financial Services did not need to provide even the guidance that it did provide.  A state is free to impose fiduciary duties on persons who engage in certain transactions without any such guidance.  For example, California imposes a common law fiduciary duty on stockbrokers providing advice to clients.  Twomey v. Mitchum, Jones, and Templeton, Inc., 262 Cal. App. 2d 690 (1968); Duffy v. Cavalier, 215 Cal. App. 3d 1517, 1530 (1989) (reaffirming Twomey).  Such a duty should apply to an agent selling a LIIS policy because LIIS policies are at least as complicated as stock, bond, and mutual fund transactions.  Even a financially literate consumer has essentially no chance of assessing whether a LIIS policy is a good investment, and so the consumer invariably relies on the agent.  California should adopt a "best interest" standard that is equivalent to a fiduciary standard.  While guidelines similar to New York's may be helpful to the industry, such a standard can and should be adopted without guidelines if industry groups wish to oppose guidelines, as they apparently have in New York.

California has not yet adopted suitability and best interest standards for LIIS, but in its February 5, 2018 Comments to the NAIC Annuity Suitability (A) Working Group, the California Department of Insurance took the position that suitability and best interest standards should apply to sales of both annuities and “life insurance products that have an investment component.”  The California DOI reiterated that position in its June 12, 2019 comments on the NAIC’s November 24, 2017 Draft Amendments to the Suitability in Annuity Transactions Model Regulation (#275).  Among other things, the California DOI believes that the agent, or insurer if there is no agent, must consider only the interests of the consumer in making a recommendation to purchase annuity (or a life insurance policy with an investment component).   Further, the DOI expressed the concern that the SEC’s best interest standard “states that a best interest standard is required but actually requires a standard of care that is not a true best interest standard:  while the broker-dealer cannot put his/her own interest first, the consumer’s interests are not required to be put first.”  This “may cause producers to tell their clients that they are required to sell annuities that are in the consumer’s best interest” and may cause consumers to “incorrectly believe that the producer is putting the consumer’s interest first.”

The California Department of Insurance has also recommended a prohibition on cash or non-cash compensation that depends on the producer's having reached a target sales level.  See California DOI Comments of July 15, 2019 to NAICCalifornia DOI Comments to NAIC 5.7.18  We agree with the DOI's position since compensation that depends on the producer's having reached a particular level can exacerbate the inherent conflict of interest that a producer faces in making a recommendation for a particular policy.

In the Spring of 2020, the National Association of Insurance Commissioners adopted the Suitability in Annuity Transactions Model Regulation (No. 275), which purports to adopt a best interest of the consumer standard but actually adopts a much weaker standard that does not require the agent to put the consumer's interest first.   The Model Regulation suffers from the same problem as the California DOI described (above) regarding the SEC's "best interest" standard -- it is not a true best interest standard but may mislead consumers into believing that the agent is required to put their interest first.  (See the News Section of this site for a more detailed discussion of some of the problems with the NAIC's new Model Regulation.)

Potential Public Policy Approach:

We believe that it is imperative that agents selling LIIS policies (or insurers where there is no agent involved), be subject to suitability and best interest standards.  We understand the best interest standard to be essentially equivalent to a fiduciary standard.  We prefer the “best interest” nomenclature because it is more easily understood by consumers.   We would favor adoption of rigorous suitability and best interest guidelines for producers that reflect, at a minimum, the requirements proposed by the California DOI to the NAIC in the annuity context.  See DOI Letter of June12, 2019; DOI Letter of July 15, 2019.