Separate Account

The Statutory Definition

Section 2(a) of the Investment Company Act of 1940 introduces its definitions with the words "When used in this subchapter, unless the context otherwise requires". Paragraph (37) of that subsection defines the term separate account.

The definition has five parts. The first is that the account is established and maintained by an insurance company. The second is that the account is established and maintained pursuant to the laws of any State or territory of the United States, or of Canada or any province thereof. The third is that the income, gains and losses, whether or not realized, from assets allocated to the account are credited to or charged against the account. The fourth is that the crediting or charging is in accordance with the applicable contract. The fifth is that the crediting or charging occurs without regard to other income, gains, or losses of the insurance company.

Variable Contracts and Separate Accounts

FINRA Rule 2320 is titled Variable Contracts of an Insurance Company. Rule 2320(b)(2) provides that the term variable contracts shall mean contracts providing for benefits or values which may vary according to the investment experience of any separate or segregated account or accounts maintained by an insurance company.

The variable life release describes the difference between a traditional life insurance policy and a variable life policy. Variable life insurance is similar to traditional life insurance, except that the cash value and/or death benefit vary based on the investment performance of the assets in which the premium payments are invested. Under a traditional life insurance policy, premium payments are allocated to an insurer's general account and invested, consistent with state law requirements, to enable the insurer to meet its death benefit and cash value guarantees. Premium payments under a variable life policy, in contrast, are invested in an insurance company separate account, which generally is not subject to state law investment restrictions.

The variable annuity release describes the position under a variable annuity contract. Under a variable annuity contract, purchase payments are invested in an insurer's separate account created under state law and legally segregated from the assets of the insurer's general account. The separate account offers the contract owner a number of investment options, which generally consist of mutual funds.

The FINRA annuities page describes variable annuities as sometimes compared to mutual funds because they offer similar investment features, including investment choices, called subaccounts, that resemble mutual funds. In general, variable annuities have two phases: the accumulation phase, when the premiums paid are allocated among investment portfolios, often referred to as subaccounts, and earnings on these investments accumulate; and the payout phase, when the insurance company guarantees a minimum payment based on the principal and investment returns (positive or negative). The SEC releases spell the word sub-accounts, and the FINRA page spells it subaccounts.

Separate Accounts Registered as Unit Investment Trusts

Section 4(2) of the Investment Company Act, in a section titled Classification of investment companies, provides that unit investment trust means an investment company which (A) is organized under a trust indenture, contract of custodianship or agency, or similar instrument, (B) does not have a board of directors, and (C) issues only redeemable securities, each of which represents an undivided interest in a unit of specified securities; but does not include a voting trust.

A separate account funding a variable life insurance policy most commonly is registered as a unit investment trust under the Investment Company Act. Separate accounts registered as unit investment trusts are divided into sub-accounts, each of which invests in a different open-end management investment company, or mutual fund, which the variable life release calls a Portfolio Company. Both separate account unit investment trusts and the Portfolio Companies in which they invest are registered as investment companies under the Investment Company Act, and their securities are registered under the Securities Act. Investors in variable life insurance policies receive the prospectuses for both the separate account unit investment trust and the Portfolio Companies.

The variable life release adopts a new registration form, Form N-6, for insurance company separate accounts that are registered as unit investment trusts and that offer variable life insurance policies. The form is to be used by these separate accounts to register under the Investment Company Act of 1940 and to offer their securities under the Securities Act of 1933.

The variable annuity release adopts amendments to the registration form for insurance company separate accounts that are registered as unit investment trusts and that offer variable annuity contracts. Form N-4 is the registration form used by insurance company separate accounts organized as unit investment trusts that offer variable annuity contracts to register under the Investment Company Act and to register their securities under the Securities Act.

The variable annuity release describes sub-accounts and the funds behind them in a footnote. Variable annuity separate accounts registered as unit investment trusts are divided into sub-accounts, each of which invests in a different Portfolio Company. A Portfolio Company may be a registered investment company, or a series of a registered investment company, in the case of a series company. Each contractowner selects the sub-accounts, and thus the Portfolio Companies, in which his or her account value is invested.

Sections 26(f) and 27(i) of the Investment Company Act

Section 2(a)(7) of the Investment Company Act provides that Commission means the Securities and Exchange Commission. Section 26 of the Investment Company Act is titled Unit investment trusts. Section 26(f) is titled Exemption, and its paragraph (1), titled In general, provides that subsection (a) does not apply to any registered separate account funding variable insurance contracts, or to the sponsoring insurance company and principal underwriter of such account.

Section 26(f)(2), titled Limitation on sales, provides that it shall be unlawful for any registered separate account funding variable insurance contracts, or for the sponsoring insurance company of such account, to sell any such contract unless the conditions in subparagraphs (A) and (B) are met. Under subparagraph (A), the contract may not be sold unless the fees and charges deducted under the contract, in the aggregate, are reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company, and, beginning on the earlier of August 1, 1997, or the earliest effective date of any registration statement or amendment thereto for such contract following October 11, 1996, the insurance company so represents in the registration statement for the contract.

Under subparagraph (B), the contract may not be sold unless the insurance company meets three requirements. Under clause (i), the insurance company complies with all other applicable provisions of the section, as if it were a trustee or custodian of the registered separate account. Under clause (ii), the insurance company files with the insurance regulatory authority of the State which is the domiciliary State of the insurance company, an annual statement of its financial condition, which most recent statement indicates that the insurance company has a combined capital and surplus, if a stock company, or an unassigned surplus, if a mutual company, of not less than one million dollars, or such other amount as the Commission may from time to time prescribe by rule, as necessary or appropriate in the public interest or for the protection of investors. Under clause (iii), the insurance company, together with its registered separate accounts, is supervised and examined periodically by the insurance authority of such State.

Section 26(f)(3), titled Fees and charges, provides that, for purposes of paragraph (2), the fees and charges deducted under the contract shall include all fees and charges imposed for any purpose and in any manner. Section 26(f)(4), titled Regulatory authority, provides that the Commission may issue such rules and regulations to carry out paragraph (2)(A) as it determines are necessary or appropriate in the public interest or for the protection of investors.

Section 27 of the Investment Company Act is titled Periodic payment plans. Section 27(i) is titled Applicability to registered separate account funding variable insurance contracts. Paragraph (1) provides that the section does not apply to any registered separate account funding variable insurance contracts, or to the sponsoring insurance company and principal underwriter of such account, except as provided in paragraph (2). Paragraph (2) provides that it shall be unlawful for any registered separate account funding variable insurance contracts, or for the sponsoring insurance company of such account, to sell any such contract unless such contract is a redeemable security, and the insurance company complies with Section 26(f) and any rules or regulations issued by the Commission under Section 26(f).

FINRA Rule 2320 and Separate Accounts

Rule 2320(a), titled Application, provides that the rule shall apply exclusively, and in lieu of Rule 2341, to the activities of members in connection with variable contracts, to the extent such activities are subject to regulation under the federal securities laws.

Rule 2320(b)(3)(E) provides that offeror shall mean an insurance company, a separate account of an insurance company, an investment company that funds a separate account, any adviser to a separate account of an insurance company or an investment company that funds a separate account, a fund administrator, an underwriter and any affiliated person, as defined in Section 2(a)(3) of the Investment Company Act, of such entities.

Rule 2320(c), titled Receipt of Payment, provides that no member shall participate in the offering or in the sale of a variable contract on any basis other than at a value to be determined following receipt of payment therefor in accordance with the provisions of the contract, and, if applicable, the prospectus, the Investment Company Act and applicable rules thereunder. It also provides that payments need not be considered as received until the contract application has been accepted by the insurance company, except that by mutual agreement it may be considered to have been received for the risk of the purchaser when actually received.

Rule 2320(d), titled Transmittal, provides that every member who receives applications and/or purchase payments for variable contracts shall transmit promptly to the issuer all such applications and at least that portion of the purchase payment required to be credited to the contract.

Rule 2320(e), titled Selling Agreements, provides that no member who is a principal underwriter as defined in the Investment Company Act may sell variable contracts through another broker-dealer unless the broker-dealer is a member and there is a sales agreement in effect between the parties. It also provides that the sales agreement must provide that the sales commission be returned to the issuing insurance company if the variable contract is tendered for redemption within seven business days after acceptance of the contract application.

Rule 2320(f), titled Redemption, provides that no member shall participate in the offering or in the sale of a variable contract unless the insurance company, upon receipt of a request in proper form for partial or total redemption in accordance with the provisions of the contract, undertakes to make prompt payment of the amounts requested and payable under the contract in accordance with the terms thereof, and, if applicable, the prospectus, the Investment Company Act and applicable rules thereunder.

Rule 2320(g), titled Member Compensation, applies in connection with the sale and distribution of variable contracts. Under paragraph (g)(4), no member or person associated with a member shall directly or indirectly accept or make payments or offers of payments of any non-cash compensation, except as the paragraph provides.

The content outline for the Securities Industry Essentials examination lists variable contracts/annuities and unit investment trusts (UITs) under Topic 2.1.4, Packaged Products, in Section 2, Understanding Products and Their Risks. It also lists FINRA Rule 2320(g)(4), titled Non-cash Compensation, in the FINRA rules list for Section 4, Overview of the Regulatory Framework. Candidates should check the current outline before the examination.

Common Misunderstandings

The corrections below come from Section 2(a)(37), Section 26(f) and Section 27(i) of the Investment Company Act, the variable life release, the variable annuity release, FINRA Rule 2320 and the FINRA annuities page.

Premium payments under every life insurance policy go to the insurer's general account. Under a traditional life insurance policy, premium payments are allocated to an insurer's general account, while premium payments under a variable life policy are invested in an insurance company separate account.

A separate account and a sub-account are the same thing. Separate accounts registered as unit investment trusts are divided into sub-accounts, each of which invests in a different Portfolio Company.

The money a contract owner puts into a variable annuity is invested in the insurer's general account. Under a variable annuity contract, purchase payments are invested in an insurer's separate account created under state law and legally segregated from the assets of the insurer's general account.

The income, gains and losses of a separate account are the income, gains and losses of the insurance company. Section 2(a)(37) provides that income, gains and losses, whether or not realized, from assets allocated to the account are credited to or charged against the account without regard to other income, gains, or losses of the insurance company.

A separate account is registered only under the Securities Act. Both separate account unit investment trusts and the Portfolio Companies in which they invest are registered as investment companies under the Investment Company Act, and their securities are registered under the Securities Act.

A separate account that funds variable insurance contracts may sell them at any level of fees. Section 26(f)(2)(A) makes it unlawful to sell any such contract unless the fees and charges deducted under the contract, in the aggregate, are reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company.

A variable contract may be sold without a redemption feature. Section 27(i)(2) makes it unlawful to sell any such contract unless it is a redeemable security, and Rule 2320(f) provides that no member shall participate in the offering or in the sale of a variable contract unless the insurance company undertakes to make prompt payment of the amounts requested and payable under the contract upon receipt of a request in proper form for partial or total redemption.

A separate account is a type of account kept only for variable annuities. Rule 2320(b)(2) defines variable contracts as contracts providing for benefits or values which may vary according to the investment experience of any separate or segregated account or accounts maintained by an insurance company, and the variable life release describes separate accounts funding variable life insurance policies.

Key Points

Section 2(a)(37) of the Investment Company Act defines a separate account as an account established and maintained by an insurance company pursuant to the laws of any State or territory of the United States, or of Canada or any province thereof, with income, gains and losses credited to or charged against the account without regard to other income, gains, or losses of the insurance company.

A separate account funding a variable life insurance policy most commonly is registered as a unit investment trust under the Investment Company Act.

Separate accounts registered as unit investment trusts are divided into sub-accounts, each of which invests in a different Portfolio Company.

Under a variable annuity contract, purchase payments are invested in an insurer's separate account created under state law and legally segregated from the assets of the insurer's general account.

Section 26(f)(2)(A) makes the sale of a variable insurance contract by a registered separate account or its sponsoring insurance company unlawful unless the fees and charges deducted under the contract, in the aggregate, are reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company.

Section 27(i)(2) makes it unlawful to sell such a contract unless it is a redeemable security and the insurance company complies with Section 26(f).

Rule 2320(b)(2) defines variable contracts by reference to the investment experience of any separate or segregated account or accounts maintained by an insurance company.