A variable universal life insurance policy (“VUL”) is a policy in which the cash value of the policy is segregated into one or more separate accounts, rather than in the carrier’s general account. Typically, policy owners have the choice to select from a wide range of separate account investment options (fixed-income investments, stocks, mutual funds, bonds, money market funds, etc.), and earnings from, and changes in value of, those investments adjust the policy’s cash value.
It has become accepted wisdom in the life settlement industry that a VUL must be treated as a security when purchased and sold in the secondary market for life insurance. Indeed, in its Notice to Members 06-38, the Financial Industry Regulatory Authority, Inc. (“FINRA”) stated, “A variable life insurance policy is a security, and the sale of such product in the secondary market is a securities transaction subject to [FINRA] rules.”
On its face, this position appears unassailable. To sell VULs, an agent must have a life insurance license and an appropriate securities license, and the product must be sold through a broker-dealer and delivered with a prospectus. How, then, can an argument be made that a VUL is not a security in the context of a life settlement transaction?
The answer lies in the nature of the product itself. A VUL is a life insurance policy with an investment account “bolted” onto it. Under the terms of Section 3(a)(8) and Rule 151 of the Securities Act of 1933 (the “Act”), insurance policies issued by a state-regulated insurance company are exempt from regulation under the Act, assuming certain conditions are met. Even when funds are allocated to the separate account, the reason a VUL is considered a security is not the underlying insurance policy, but the policy’s link to accounts that clearly are securities under the Act. The question, then, is whether a VUL is still a security for purposes of the Act if all cash value is moved from the separate account to the carrier’s general account.
As a general matter, when one security is exchanged for another security, the Securities and Exchange Commission (“SEC”) views this as the redemption of one security and the purchase of another security; and, unless an exemption is available, the SEC requires that the security to be acquired must be registered under the Act and a prospectus delivered, because the purchaser is making a decision to invest in a new security. When a VUL owner redeems funds from the separate account and moves those funds to the carrier’s general account, is an investment decision being made? The answer likely is no.
Nothing under federal securities laws, or current court or SEC interpretations of the Act, suggest that a VUL must be treated as a security after all of the funds have been redeemed from the separate account and transferred to the carrier’s general account. A policy owner is not making a decision to purchase a “security” when the redemption and transfer occurs and, therefore, is not entitled to the protections afforded by the Act.
Nor does anything under federal securities law, or current court or SEC interpretations of the Act, suggest that once funds have been transferred to the carrier’s general account, the VUL must still be considered a “security” simply because the policy owner has the right to transfer funds back to the separate account at some future date. This option is distinct from a typical option, which is a security, because the underlying instrument, a life insurance policy, is not itself a security.
Does this mean that the participants in a life settlement transaction can simply ignore securities laws by moving funds from the separate to the general account? The answer is no. Each case must be looked at individually, and each player in the transaction must assess their role and the potential risks associated with their decisions. Brokers that solicit VULs for sale, unless the funds have already been moved to the general account, are clearly soliciting the sale of a security. And, even if the broker facilitates the movement of any cash value from the carrier’s separate account to its general account, the transaction could be re-cast as an attempt to do in two steps what cannot be done in one.
Providers and financing entities interested in purchasing a case should also look at each policy carefully, but if the funds are moved to the general account prior to the purchase of the policy a strong argument arises that no investment decision is being made (vis-à-vis the separate account). And, assuming funds are not thereafter moved to the separate account, it can be argued that securities law, and hence FINRA rules and other securities regulations, would not be applicable to any subsequent re-sales of a VUL in the tertiary market.
The most conservative (and hence safest) course is to treat VULs as securities, whether or not any cash value resides in the separate account, and to make payments to broker-dealers pursuant to FINRA regulations. However, under the circumstances noted above, it may be that VULs are not securities for purposes of the Act and, therefore, it is not necessary to comply with FINRA rules or securities regulations when purchasing and selling these policies.
James W. Maxson is Of Counsel in the firm’s Insurance Practice and co-chair’s the firm’s Life Settlement Practice. Mr. Maxson concentrates his practice in corporate and regulatory matters for the life settlement industry, as well as focusing on mergers and acquisitions and securities transactions. Jim received his bachelor’s degree from Denison University and law degree from the Ohio State University School of Law.