Re-Examining Insurance Companies Annual Disclosure Obligations to - - PDF document

* Mark B. Koogler is a partner with Porter Wright Morris & Arthur LLP. He is head of the firm’s Insurance and Financial Services Practice. His legal practice focuses on insurance transactional and regulatory matters, financial services organizations, and mergers and acquisitions. ** Shawn G. Lisle is an associate with Porter Wright Morris & Arthur LLP. He focuses his practice on employee benefits and ERISA matters.

Re-Examining Insurance Companies’ Annual Disclosure Obligations to Employee Benefit Plans

Mark B. Koogler* Shawn G. Lisle** An Overview Through recent initiatives, the insurance industry and regulators are demanding that insurers and brokers provide greater disclosure of commissions and similar fees. Changes in the securities industry and retirement plan marketplace, designed to assure greater transparency in the fees borne by participants in employee benefit plans subject to the Employee Retirement Income Security Act of 1974 as amended (ERISA), may also impact these disclosure obligations. Recently, the Department of Labor (DOL) provided new guidance about an insurer’s obligations to report commissions and fees paid to persons in connection with ERISA plans. Accordingly, now is the time for all insurers issuing products and services to ERISA plans to review their disclosure obligations to plan administrators and, if necessary, modify disclosure practices to comply with applicable law. Plan administrators should likewise pay careful attention to the growing trends of transparency and the recent DOL guidance. They should make certain they are receiving accurate and timely information from insurers in order to prepare the Annual Return/Report of Employee Benefit Plan (Form 5500 series) and in fulfilling their fiduciary duties to ensure that the fees being charged are reasonable in light of the services provided. Insurers and similar organizations are generally required by ERISA and DOL regulations to provide plan administrators with the information necessary to complete annual Form 5500 filings, including insurance information required to be reported on Schedule A thereto. Such information must be provided by an insurer within 120 days after the end of the plan year. As part of the information required to be reported on Schedule A, plan administrators must identify all persons who received commissions or fees from an insurer in connection with services rendered to the plan or its participants, the amount of such compensation, and the purpose of such fees. The DOL construes the meanings of commissions and fees broadly, as is evidenced in Advisory Opinion 2005-02A, which was issued on February 24, 2005. The recent Advisory Opinion reiterates prior DOL guidance that all commissions and fees, directly or indirectly attributable to a contract or policy between a plan and an insurance company or similar organization must be reported on Schedule A. The new guidance makes it clear that the instructions for Schedule A should not be interpreted as limiting an insurer’s reporting of commissions and fees to only sales commissions paid on contracts or policies issued to ERISA plans. Instead, the Advisory Opinion unequivocally explains that commissions and fees paid to brokers or agents, must be reported if they are in any way based on the value of a contract or policy issued to an ERISA plan. Accordingly, persistency and profitability bonuses must be reported. Likewise, finder’s fees and

2 similar payments made by third parties to brokers, agents, and others must be disclosed if the insurer reimburses the third party separately or as a part of the overall fees paid to the third party. Fees and commissions classified as “profit-sharing” payments, delayed compensation, or reimbursements for various marketing and other expenses must also be disclosed. The DOL guidance provides that the disclosure obligations apply even if payments are made from a separate bonus fund and not the insurance company’s general assets. Nonmonetary compensation, such as prizes, trips, gifts, awards, memberships, vehicle leases, stock awards, and

• ther benefits, must also be disclosed if any part of it is based on a policy or contract placed with

ERISA plans. Advisory Opinion 2005-02A also describes how insurers should allocate fees and commissions among ERISA and non-ERISA plans. Based on the new DOL guidance, we believe that bonuses in the nature of commissions paid to brokers, agents, third-party administrators (TPAs), and registered investment advisors (RIAs) generally will have to be disclosed by insurers and reported by plan administrators on Schedule

• A. Similar disclosure and reporting obligations also seem applicable to commissions and

administrative expenses paid out of asset fees charged under an insurance product, as well as to payments made by insurers to TPAs as reimbursements for plan administration and similar services. As previously noted, insurers should be providing such disclosures to plan administrators within 120 days after the end of the plan year. However, we believe it would be prudent for plan administrators, in connection with fulfilling their ERISA fiduciary duties and annual reporting

• bligations, to request commission and fee information from the insurers that provide products

and services to their ERISA plans. In this regard, plan administrators should ask appropriate questions, as necessary, to ensure that they have complete and accurate information about fees and commissions paid by insurers during the plan year. If an insurer refuses to provide the information requested, plan administrators are instructed by DOL to note the refusal directly on Schedule A. Revenue sharing arrangements have been a customary and long-standing practice in the insurance and securities worlds, particularly among annuity providers and mutual funds. However, such arrangements are often not disclosed to plan sponsors. Given the current regulatory and legal climate of moving towards greater transparency in insurance product pricing, insurers may want to consider the benefits of voluntarily disclosing to plan administrators the sources and amounts of payments received pursuant to revenue sharing arrangements with mutual funds offered under variable annuity contracts sold to ERISA plans. Several insurance industry leaders have reportedly already begun to fully disclose revenue sharing arrangements to their clients. Insurers should also monitor judicial and regulatory interpretations of state unfair trade practice statutes to assure that their current disclosure practices concerning compensation arrangements under their insurance products comply with applicable state law.

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An Analysis of Insurers’ Disclosure Obligations with Respect to Employee Benefit Plans

Insurance companies that provide products or services to employee benefit plans governed by ERISA have certain legal obligations to disclose to plan administrators information needed to prepare the Annual Return/Report of Employee Benefit Plan (Form 5500 series). In this regard, an insurer is required to disclose fees and commissions it paid to brokers, agents, and others in connection with products and services provided to ERISA plans. Such information is, in turn, reported by plan administrators on Schedule A to Form 5500. Insurance companies’ disclosure

• bligations were recently clarified and reinforced by newly issued DOL Advisory Opinion 2005-

05A, which is discussed below. In addition, as a regulated entity, an insurer has certain legal

• bligations to assure that the offering of its insurance product to employee benefit plans complies

with state insurance laws’ requirements with respect to unfair trade practices. Persons who offer their products within an annuity contract, such as mutual funds; those who sell the annuity contracts or other insurance products; or those who administer plans that offer such annuity contracts or insurance products have their own disclosure or reporting obligations. Some disclosure obligations have recently received increased scrutiny by state insurance regulators and law enforcement agencies. The trend appears to be advancing toward more expansive disclosure. The failure to comply with reporting and disclosure obligations may create potential liability and compliance issues for both insurers and plan administrators. Thus, it is appropriate for all insurers offering insurance products to employee benefit plans to evaluate their current practices regarding disclosure of their compensation practices and to decide if modifications, whether legally required, evolving, or voluntary, are appropriate. Plan sponsors whose plans use insurance products or services should also ascertain that they are receiving complete and accurate information from insurers about such compensation arrangements. Such information is crucial for purposes of preparing complete and accurate annual returns/reports for a plan and for purposes of evaluating the true extent and reasonableness of plan expenses. Annuity Contract Fees and Payments Annuity contracts generally have several tiers of fees built into their pricing. The fees generally consist of: (i) an asset fee, which is designed to reimburse the insurer for commissions paid to retail brokers/agents and may, in some cases, pay TPA expenses incurred in providing administrative services to plans; (ii) an investment management fee, designed to reimburse the insurer for the expenses associated with its accounting and recordkeeping services provided to the mutual funds offered under its annuity contract; and (iii) the mutual funds’ fees applicable with respect to a particular fund’s subaccount offered under a variable annuity contract. Generally, the insurer may also pay commissions and other fees to various persons engaged in the marketing or sale of the annuity contract or to persons providing administrative or investment advisory services to plans that offer the annuity contract.

4 Asset Fee Many annuity contracts charge an asset fee in an amount equal to a percentage of a participant’s account value on each monthly anniversary. In many cases, the insurer sends product detail reports to the plan administrator, sponsor, or third-party administrator, which identifies the commissions-paid portion of the asset fee. Plan administrators typically use such information to prepare Schedule A to the Form 5500, which reports, among other things, commissions and fees paid to persons providing products and services to the plan. In cases where the insurer serves as the TPA, the insurer may prepare the Form 5500 filing and include the commissions-paid portion

• f the asset fee on Schedule A.

Investment Management Fee Variable annuity contracts usually charge an investment management fee, which is determined by a calculation applicable to each of the separate accounts offered under a variable annuity

• contract. The investment management fee is usually disclosed in the annuity contract, so the plan

sponsor is given notice of the fee and how it is calculated. The investment management fee also affects the unitized value of a participant’s account, so it is generally set forth in the participant’s account statement. Revenue Sharing Arrangement Many insurers that offer variable annuity contracts have revenue sharing arrangements with each

• f the mutual funds offered through the subaccounts of the variable annuity. Such arrangements

typically provide that each mutual fund pays to the insurer a portion of its 12b-1 fees and subtransfer agent fees. These fees are paid to insurers in exchange for the distribution and administrative efficiencies offered by the insurer’s bundling of those mutual funds under the variable annuity contracts. As a result, some of the insurer’s administrative and recordkeeping costs incurred in bundling the mutual funds under the variable annuity contract are offset. Historically, the revenue sharing arrangements between insurers and each mutual fund offered as a subaccount of its variable annuity contract have not been widely disclosed or otherwise reported to plan sponsors or participants. Commissions and Other Fee Payments to Third Parties Insurers pay sales commissions to retail brokers/agents for selling their insurance product. At its discretion, an insurer may also pay brokers/agents annual bonuses in addition to sales commissions based on the volume of business written or retained. Generally, the asset fee set forth in the insurance product is a reserve from which such sales commissions are paid. Some insurers disclose these sales commissions to plan administrators as the commissions-paid portion

• f the asset fee under the insurance product. Plan administrators, in turn, report the commissions
• n Part I of Schedule A. It is not clear if there is an industry-wide practice concerning the

disclosure and reporting of supplemental bonus payments made to brokers/agents.

5 Insurers may, in some cases, also help to offset a plan’s administrative expenses where TPAs administer plans in which the insurer’s products are offered. In such cases, insurers may pay a portion of the asset fees to TPAs. The asset fee set forth in the insurance product may serve as a reserve from which such payments are made. In addition, some TPAs may enter into bonus agreements under which the insurer pays an annual bonus, calculated on a sliding scale and based on numerous criteria, such as assets under management, retention of assets, and new business under management. It is our understanding that many insurers have not historically disclosed such payments to plan administrators or sponsors. Consequently, plan administrators were not likely to know of such administrative reimbursement fees and bonuses, which, in turn, resulted in them not being reported on Schedule A. Insurers also sometimes make bonus payments to RIAs who advise plan sponsors about the merits of a particular insurance product. If the insurance product, such as a variable annuity contract, is ultimately offered under a plan, a bonus payment may be made by the insurer to the RIA, which is designed to offset the expense charged by the RIA to the plan sponsor. It is believed that a number of insurers have not historically disclosed to plan sponsors or administrators such bonus payments. As a result, such payments are not typically captured by plan administrators for Schedule A reporting purposes. Applicable Reporting and Disclosure Requirements Insurers are subject to various disclosure requirements concerning compensation payments related to the marketing and sale of their insurance products to employee benefit plans. Some of the ERISA disclosure requirements relating to insurers are fairly straightforward, such as reporting sales commissions, and have historically been followed by insurers. An insurer’s

• bligations to report other types of commissions and fees for ERISA purposes have, until

recently, been less clear and subject to interpretation and industry practice. As discussed below, a recent DOL Advisory Opinion has provided additional clarification to insurers about their disclosure requirements to plan administrators regarding commissions and fees paid. Non- ERISA disclosure obligations for brokers and insurers are also quickly moving toward statutory, regulatory, or judicial disclosure requirements, especially in cases of contingent commissions paid by insurers to brokers, as discussed below. ERISA Disclosure Obligations for Insurers and Form 5500 Reporting Requirements Section 103(a)(2)(A) of ERISA and the corresponding DOL regulations describe, in general terms, insurance companies’ obligations to report to plan administrators certain information needed to comply with ERISA’s annual reporting and return requirements for ERISA-governed plans. This obligation extends to the disclosure of commissions and fees paid by insurers in connection with the sale of products or services to ERISA plans. Until recently, the

• nly official interpretative guidance to insurers about the scope of their disclosure obligations

was a little-known 1986 DOL Advisory Opinion (Advisory Opinion 86-17A) (April 28, 1986). Advisory Opinion 86-17A described, in general terms, the reporting obligations of insurers with respect to ERISA plans; however, it appears that some insurers were unaware of these

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• bligations, interpreted the requirements differently than the DOL, or otherwise failed to follow

them. Section 103(a)(2) of ERISA requires an insurance carrier, which provides some or all of the benefits under a plan or holds assets of a plan in a separate account, to transmit and certify information, within 120 days after the end of the plan year, as needed by a plan administrator in

• rder to file its Form 5500 annual report. DOL Regulation §2520.103-5 requires each insurer to

provide a listing of all transactions of the separate account and, upon the request of the plan administrator, to provide such information contained in the insurer’s ordinary business records, which is needed by the plan administrator to comply with its annual reporting obligations. Section 103(c) of ERISA provides that except in the case of a person whose compensation is minimal and who performs solely ministerial duties, the plan sponsor’s annual report is required to include the name of each person (including any broker or insurance carrier who rendered services to the plan or its participants), the amount of such compensation, the nature of his services to the plan or its participants, his relationship to the employer of the employees covered by the plan, and any other office, position, or employment he holds with any party in interest. Section 103(e) of ERISA requires the annual report to include a statement from the insurance company covering the plan year enumerating the names and addresses of the brokers, agents, or

• ther persons to whom commissions or fees were paid, the amount paid to each, and for what

purpose. Schedule A Instructions Schedule A to Form 5500 and the Instructions describe the information plan administrators are required to report. Plan administrators must list under Element 2 of Schedule A all commissions and fees paid regardless of the identity of the recipient. Element 2(b) requires the reporting of all sales commissions paid to agents, brokers, and other persons; however, override commissions, salaries, bonuses, etc., paid to a general agent or manager for managing an agency or for performing other administrative functions are not required to be reported. Fees that represent payments by insurance carriers to agents, brokers and other persons for items

• ther than commissions (e.g., service fees, consulting fees, and finder’s fees) must be reported

under Element 2(c). The Instructions provide that fees not in the nature of commissions paid by insurance carriers to persons other than agents and brokers should be reported under this

• element. The Instructions further remind readers that for purposes of Elements 2(b) and 2(c),

commissions and fees include amounts paid by an insurance company on the basis of the aggregate value (e.g., policy amounts, premiums) of contracts or policies (or classes thereof) placed or retained. The amount (or pro rata share of the total) of such commissions or fees attributable to the contract or policy with or retained by the plan must be reported in Element 2(b) or 2(c), as appropriate.

7 With respect to the identity of the person to whom such commissions or fees are paid, the Instructions list specific categories, in addition to a general “other” category, which include but are not limited to the following: insurance agent or broker, agent or broker other than insurance, TPA, or investment manager/adviser. DOL Advisory Opinion 2005-02A On February 24, 2005, DOL issued Advisory Opinion 2005-02A (Advisory Opinion) in connection with a request from Fortis Benefits Insurance Company (Fortis) regarding the annual reporting requirements applicable to ERISA plans and insurance companies. In connection with its submission, according to the DOL, Fortis alleged “that some in the insurance industry have developed a pattern and practice of underreporting commission and fee payments to brokers and agents based on incorrect interpretations of the Schedule A, the Schedule A Instructions, and Advisory Opinion 86-17A.” In issuing the Advisory Opinion, the DOL stated that it was “providing the following guidance in an effort to clearly explain the Department’s view regarding the current Schedule A reporting requirements.” The guidance provided by the Advisory Opinion corrects the misperceptions of many insurers as to the extent and scope of their disclosure requirements to plan administrators. Although some insurers may view this guidance as contrary to the standards generally viewed as applicable to insurers or as a material change in practice, each insurer, as well as each plan administrator, needs to understand the impact of the Advisory Opinion and take immediate steps to assure compliance. The Advisory Opinion states that: For each contract for which a Schedule A must be filed, sections 103(a)(2), 103(c), and 103(e)(2) of ERISA and the Department’s regulations thus impose a legal duty on insurance companies and other organizations that provide benefits under an ERISA plan, or hold plan assets in a separate account, to furnish the plan administrator with accurate information about commissions and fees paid to brokers, agents, and other persons needed by the plan administrator to complete the Schedule A. Further, section 501 of ERISA makes it a criminal violation for any person to willfully violate any provision of Part 1 of Subtitle B of Title 1, including section 103(a)(2), or any Department regulation issued under such provision. The DOL guidance goes on to state that commissions and fees required to be disclosed by insurers include all commissions and fees directly or indirectly attributable to a contract or policy between a plan and the insurer. This includes those commissions and fees payable to a person where the eligibility for the payment or the amount of payment is based on the value of the contracts or policies placed with the ERISA plan. More than just sales commissions are required to be reported. Other forms of compensation paid by insurers must also be disclosed, which include but are not limited to the following:

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• nonmonetary compensation (prizes, trips, gifts, memberships, vehicle leases, stock

awards, etc.);

• fees and commissions paid from a separate bonus fund and not directly from an

insurer’s general assets;

• fees and commissions classified as profit-sharing, delayed compensation, or

reimbursements for marketing or other expenses; and

• finder’s fees and similar payments made by third parties to brokers, agents, and others

in connection with an insurance policy or contract, where the insurer reimburses the third party for such payments either separately or as part of the total fees paid by the insurer to the third party. According to the Advisory Opinion, “insurers must provide plan administrators with a proportionate allocation of commissions and fees attributable to each contract for which a Schedule A must be filed.” To meet this obligation, an insurer may use any reasonable method of allocating commissions and fees to an ERISA plan as long as such allocation does not attribute a disproportionate share of the commissions and fees to non-ERISA plans to avoid reporting. Concerns with Current Reporting on Schedule A It appears that in the past some insurers may not have followed the ERISA disclosure obligations in the manner recently interpreted by DOL. However, the Advisory Opinion provides specific guidance about what is now required of insurers in terms of required disclosures, and should be instructional as insurers evaluate their disclosure practices. We describe below what we generally believe would be the disclosure requirements for certain types of fees and bonus arrangements based on our interpretation of the Advisory Opinion; however, unique facts or circumstances could change these general observations and conclusions, so insurers should consult their individual counsel to determine what disclosures they may be required to make to plan administrators. Disclosure of Commissions Paid From Asset Fees Charged to Plans Based on the Instructions and the Advisory Opinion, it seems clear that the commissions paid from asset fees, which reflect sales commissions paid to a retail broker/agent for a particular plan, must be disclosed to plan administrators and reported on Schedule A. It would also appear that fees paid by insurance companies to agents, brokers and other persons (including TPAs) for items other than commissions (e.g., service fees, consulting fees and finder’s fees) should likewise be disclosed. Disclosure of TPA Reimbursements for Plan Administration Services The Advisory Opinion and the Instructions require that plan administrators report on Schedule A all fees paid by insurance companies to third parties. The Advisory Opinion lists examples of certain types of fees that should be disclosed by insurers (e.g., service fees, consulting fees, and finder’s fees), but those examples are by no means meant to be an exhaustive list. Insurers are

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• bligated to disclose to plan sponsors any commissions and fees where such payments are

directly or indirectly attributable to a contract or policy between a plan and the insurer, according to the Advisory Opinion. This standard is broad enough, we believe, to encompass many types of payments made by insurers to third parties, including cases in which payments for plan administration services are paid from an asset fee that is charged to plans under an insurance

• contract. This would extend to reimbursements paid to TPAs and others for plan administration

services and the like. Accordingly, insurers should disclose the existence and amounts of these types of payments to plan administrators at least annually. Although this will likely be a change and contrary to current industry practices (at least to the date of the Advisory Opinion), we believe the clarity provided by the Advisory Opinion has changed this practice for everyone. Disclosure of Broker/Agent Bonuses The Advisory Opinion and Instructions require that payments in the nature of commissions paid by insurance companies to agents, brokers, and “other persons” be disclosed by insurers and reported by plan administrators on Schedule A. Bonus payments to brokers/agents that are based

• n the volume of business written or retained appear to fall within the ambit of disclosure

contemplated by the Advisory Opinion, since such bonuses are generally based on the value of contracts or policies placed with ERISA plans. We understand that historically some insurers may not have disclosed bonus payments made to brokers/agents that are in addition to traditional sales commissions. Insurers that have not been disclosing bonus payments should consider modifying their disclosure practices. Disclosure of TPA Bonuses As explained above, payments in the nature of commissions by insurance companies to agents, brokers, and “other persons” are required to be reported by plan administrators. TPAs are considered “other persons” for purposes of Form 5500 disclosure rules. We believe that bonus payments made to TPAs, where the payments are based on criteria such as assets under management, retention of assets, new business under management, or similar value-based metrics, would be treated by the DOL similar to bonus payments made to brokers/agents. Payments such as these appear to fall squarely within the broad disclosure requirements conveyed in the Advisory Opinion. Accordingly, the conservative approach would be for insurers to disclose any TPA bonus payments and bonus sharing arrangements. Plan administrators should, in turn, report such information on Schedule A. Disclosure of RIA Bonus Payments RIAs are identified in the Instructions as a type of organization for which payments by insurers in the nature of commissions and fees need to be reported on Schedule A. Based on the same reasoning explained above in the discussion of bonus payments to brokers, agents, and TPAs, we believe that bonus payments made by insurers to RIAs would likely be construed under the DOL guidance as commissions paid to “other persons.” Accordingly, we believe it would be prudent for insurers to disclose to plan administrators any bonus payments made to RIAs.

10 Disclosures for the 2004 Plan Year With respect to calendar year plans, insurers still have a limited window of opportunity this year to disclose to plan administrators the full extent of fees and commissions that were paid in 2004 to brokers, agents, and others. The deadline set forth in ERISA by which insurers are required to transmit and certify to plan administrators the information regarding such information is 120 days after the end of the plan year. This means that for calendar year plans, an insurer must provide 2004 plan year information no later than April 20, 2005. Revenue Sharing Arrangements ERISA-Related Disclosure Obligations Revenue sharing, particularly among annuity providers and mutual funds is, of course, a customary and long-standing practice in the insurance and securities worlds. There is nothing illegal about revenue sharing; it is simply one of many ways by which administrative and distribution efficiencies are allocated and reimbursed. Further, to our knowledge there has been no official word from DOL about whether an insurer has any disclosure requirements concerning its revenue sharing arrangements. Such arrangements appear to be outside the scope of DOL’s recent interpretation of commissions and fees that must be disclosed; however, such issues are fluid and it would not be surprising if subsequent guidance is ultimately issued to formally answer the question. Revenue sharing arguably impacts the true price of retirement plans in that the expenses generally incurred in distributing mutual funds’ shares are incurred by an insurer. The payment to an insurer represents a reimbursement of expenses not otherwise reflected in the pricing of the insurance product. It is therefore arguable that plan administrators are not being fully informed

• f the true costs incurred when an insurance product is purchased.

Regardless of whether there is a legal obligation for an insurer to disclose the amount of revenue it receives from participating mutual funds, there are pragmatic reasons for doing so. An insurer’s employee benefit plan clients may find it hard to understand the true administrative and service costs of their retirement plans without such information. Many commentators have recently suggested that vendors help plan fiduciaries meet their ERISA obligations by providing a clear understanding of the expense realities of their plans. These commentators believe that undisclosed financial arrangements may be material to retirement benefits over the long term and should be considered by plan fiduciaries when acting in the exclusive interests of plan participants and beneficiaries. Several industry leaders have reportedly already begun to fully disclose revenue sharing arrangements to their clients. Insurers should consider fully and voluntarily disclosing to plan fiduciaries the sources and amounts of the payments received from revenue sharing arrangements. Such disclosures will help plan administrators meet their

• bligations under ERISA, and will help demonstrate the insurer’s good faith disclosure efforts.

State insurance departments and state law enforcement agencies also appear to be moving toward an atmosphere of greater transparency in pricing as well. Accordingly, full and voluntary

11 disclosure of revenue sharing arrangements should help to minimize allegations about an insurer’s conflict of interest in offering certain mutual funds under its annuity contracts. The failure to fully disclose the existence and impact of revenue sharing arrangements to plan fiduciaries could lead to arguments that insurers are being influenced to offer mutual funds as sub-accounts due to reimbursements by mutual fund companies, despite the fact that other mutual funds may be better suited for plans and their participants. If aware of a revenue sharing arrangement, a plan administrator should inquire about the details and determine if its impact on pricing is appropriate. Disclosure of this arrangement seems to be an easy answer that will solve a potential problem. In addition, by disclosing these arrangements, an insurer will join other industry leaders who have already begun disclosing revenue sharing arrangements to their clients. Insurance Code Disclosure Requirements Applicable or Relevant to Insurers People of State of California v. Universal Life Resources, et al. Generally, insurance laws require insurers not to make or omit to make statements that would be misleading to potential policyholders. The insurance laws do not normally distinguish between life/annuity carriers and personal lines/commercial carriers for this purpose. The pricing of a product, as well as the payment of commissions with respect thereto, historically have not been construed to fall under these requirements. However, as detailed below, recent litigation in California calls the interpretation of these laws into question. An insurer should monitor the evolution of this novel application of a state unfair trade practice statute to assure itself that it does not run afoul of state regulation by the manner in which it discloses certain payments under its insurance product. On November 17, 2004, the California Department of Insurance filed a suit alleging that insurance broker Universal Life Resources and insurers MetLife, Inc., Cigna Corporation, Prudential Financial, Inc., and UnumProvident Corporation violated the state’s unfair trade practices act by concealing hundreds of millions of dollars in undisclosed or inadequately disclosed fees, commissions, and other compensation in connection with employee benefit plans. The California Insurance Commissioner alleged that the insurer defendants had a duty under the California Insurance Code to disclose all material facts to policyholders relating to their insurance policies, including compensation paid to brokers, but failed to do so. These insurer defendants paid brokers, in addition to standard commissions, other compensation generally known as “broker bonus plans” in return for placing a certain amount of business with the insurer. This compensation was based on such factors as (i) total volume of insurance placed with the insurer, (ii) renewal of that insurance (i.e., persistency), and (iii) its profitability. However, according to the complaint, such other compensation arrangements were not disclosed

• r were inadequately disclosed to the insurers’ clients. In addition, the insurer defendants failed

to disclose that other additional fees paid by their clients were recouped by the insurer defendants by building those costs into the products’ premiums. According to the California

12 Insurance Department, these undisclosed or inadequately disclosed compensation arrangements

• perated as kickbacks to the brokers for placing insurance with the insurer defendants and that

California policyholders were not made aware of their existence, operation, or effect on their insurance contracts. The California Insurance Department alleged that the failure of the insurer defendants to communicate, in good faith, the material facts surrounding compensation paid to the brokers; the impact on the premium rates charged to insureds; the pricing of the insurance policies; their steering of clients to purchase their insurance products; and the terms, benefits, or advantages of their insurance policies violated Section 332 of the California Insurance Code. That section, entitled “Required Disclosures,” provides: Each party to a contract of insurance shall communicate to the other, in good faith, all facts within his knowledge which are or which he believes to be material to the contract and as to which he makes no warranty, and which the other has not the means to ascertain. In addition, the California Insurance Department alleged that the acts of the insurer defendants violated Section 790.03(b) of the state’s unfair trade practice statute, which defines the following as an unfair trade practice: Making or disseminating or causing to be made or disseminated before the public in this state, in any newspaper or other publication, or any advertising device, or by public outcry or proclamation, or in any other manner or means whatsoever, any statement containing any assertion, representation, or statement with respect to the business of insurance or with respect to any person in the conduct of his or her insurance business, which is untrue, deceptive or misleading, and which is known, or which by the exercise of reasonable care should be known, to be untrue, deceptive, or misleading. Further, the California Insurance Department alleged that the conduct of the insurer defendants violated Section 790.03(c) of the California Insurance Code, which defines an unfair method of competition and unfair and deceptive act or practice in the business of insurance as: Entering into any agreement to commit, or by any concerted action committing, any act of boycott, coercion or intimidation resulting in or tending to result in unreasonable restraint of, or monopoly in, the business of insurance. The broker defendants have entered into a settlement agreement by which they are enjoined from engaging in these acts. The insurer defendants continue to fight the allegations against them. We are not aware of any other judicial or regulatory interpretation of a state unfair trade practice statute that would currently require an insurer to disclose the various compensation payments under its insurance product. Revenue sharing arrangements, payments of TPA reimbursement

13 fees from asset fees, and bonus payments from an insurer to brokers/agents or TPAs, however, all may be affected by the claims made in the California litigation. As discussed above, these types of payments may not have historically been disclosed by insurers, but arguably could affect the pricing of an insurance product. Such payments could also be construed as incentives to steer customers towards insurance products that offer revenue sharing arrangements. The allegations made by the California Insurance Department against the insurer defendants are based on state law and, therefore, fall outside the ERISA reporting obligations applicable to insurers’ arrangements with plan sponsors. It is interesting to note, however, that the California complaint alleged that the failure to adequately disclose these other compensation arrangements evidenced failure on the part of the insurers to disclose non-sales commission compensation to plan fiduciaries for purposes of annual reporting on Schedule A to Form 5500. As of this date, to

• ur knowledge, no other court or regulator, including the DOL, has publicly commented on the

California litigation with respect to this claim. However, Section 790.03(b) of the California Insurance Code is substantially similar to the unfair trade practice statutes of other states and, therefore, this litigation could be viewed as a step in the evolutionary trend of a more expansive application of such statutes. Custom and tradition in the insurance industry would suggest that such an application would be a leap, but the California litigation is now a precedent for just such a leap. Such a change in interpretation would cause the industry to evaluate the well-established practices of offering inducements to independent insurance agents and brokers to write business with an insurer. However, as a result of the New York Attorney General complaint and recent $850 million settlement with Marsh & McLennan, the investigations of brokerage compensation practices by

• ver 20 state insurance departments and the recent adoption of an amendment to the Producer

Licensing Model Act by the National Association of Insurance Commissioners, the environment in this regard with respect to retail brokers has significantly changed in the past six months. On March 4, 2005, the New York Attorney General, as well as the Attorneys General of Connecticut and Illinois announced the settlement of anticompetitive practices of Aon Corporation in connection with contingent commission practices. Aon has reportedly agreed to provide $190 million in restitution. On January 20, 2005, the Massachusetts Secretary of State subpoenaed Morgan Stanley as part

• f an investigation as to the adequacy of disclosures by brokers of payments received from

insurers in the sale of variable annuities. As with the complaint against Marsh and the California litigation, it appears investigators are trying to determine whether contingent commissions or

• ther undisclosed compensation arrangements to brokers in the variable annuity marketplace

caused those brokers to steer business that may not have been in the best interest of their clients. On March 3, 2005, The Principal Financial Group also reportedly received a subpoena from the New York Attorney General seeking information on compensation arrangements associated with the sale of retirement products. Further details of the scope of the subpoena are, at this time, believed to be nonpublic.

14 The above events should not necessarily be viewed as precedents for disclosing compensation payments to third parties in order to comply with state insurance laws. We do, however, recommend that insurers carefully monitor the developing litigation in this area and other trends in regulatory investigations. When appropriate, insurers should re-examine their disclosure practices to minimize the risk of similar legal and regulatory actions against them. Insurers should also take steps to comply with the recent guidance in the Advisory Opinion, which requires the disclosure of many types of commissions, bonuses, and fee payments that occur in connection with the offering of insurance products to ERISA plans.

Disclaimer: This newsletter is intended to provide general information for clients or interested individuals and should not be relied upon as legal advice. Please consult your attorney for specific advice regarding your particular situation. If you do not have an attorney, you may contact Mr. Koogler at mkoogler@porterwright.com or (614) 227-2133 or Mr. Lisle at slisle@porterwright.com or (614) 227-2162.

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