Although insurance advisors may have a more difficult time selling segregated funds as regulators move to harmonize the disclosure regime of seg funds with that of mutual funds, investors will benefit from the shift toward greater transparency.
In December, the Canadian Council of Insurance Regulators (CCIR) published a position paper highlighting the regulators’ new expectations surrounding seg fund-related disclosure and sales practices. The regulatory body’s paper calls for several changes, including new annual disclosure requirements related to seg fund costs and performance, a standard of care for insurance advisors equivalent to the one facing mutual fund advisors, and requiring advisors to follow needs-based sales practices for seg funds.
The proposed framework stems from stakeholder feedback received following a May 2016 CCIR paper that outlined gaps between the regulatory requirements facing mutual funds and those facing seg funds.
“Seg funds have been a laggard in transparency and compliance,” says Chris Ambridge, president of Transcend Private Client Corp., a subsidiary of portfolio management firm Provisus Wealth Management Ltd. (Both firms are based in Toronto.)
The move toward greater transparency is “a good initiative and an improvement over what currently exists,” says Harold Geller, associate with MBC Law Professional Corp. in Ottawa. “Compliance in seg funds is largely non-existent.”
“The insurance industry is in full agreement with greater disclosure if it permits consumers to make informed decisions,” says Lyne Duhaime, president of the Quebec chapter of the Canadian Life and Health Insurance Association Inc.
Mutual funds and seg funds are similar in their investment objectives. But seg funds are sold as insurance contracts and include: a minimum guarantee, usually 75%-100% of invested capital at maturity of the contract, which is at least 10 years from the date of purchase; a guaranteed death benefit that’s not subject to probate; and creditor protection in cases such as bankruptcy and lawsuits.
However, these additional benefits come at a cost. Seg funds’ management expense ratios (MERs) typically are 50 to 150 basis points higher than those of an equivalent mutual fund, according to the CCIR report.
Ambridge contends that the additional benefits of seg funds “are illusionary and, to a large degree, more of a marketing gimmick.” He says the guarantees are not needed in a vast majority of cases because a decline in the value of the underlying investments over a 10-year period is rare.
However, says Raymond Yates, senior partner and financial advisor with Save Right Financial Inc., a managing general agency in Brampton, Ont.: “Most investors see the guarantees and added cost of seg funds as an investment in peace of mind.”
Despite seg funds’ similarities to mutual funds, the former are held to a lower standard of disclosure, the CCIR paper notes. That’s because of the second phase of the client relationship model (CRM2) – a comprehensive set of disclosure rules for compensation and investment returns that applies to mutual funds, but not to seg funds.
The CCIR’s paper recognizes that the differences between mutual funds and seg funds and their distribution models means CRM2 disclosure can’t be applied across the board to seg funds.
The CCIR’s paper recommends that seg funds must provide full cost disclosure annually, including: a breakdown in dollar amounts of the MER to state management fees; distribution costs, such as trailing, front-end and deferred commissions; administrative expenses; and insurance costs. The proposed changes also include requiring an explanation of the costs. These proposed disclosures are more onerous than those required for mutual funds, which are required to disclose distribution costs only.
The CCIR’s paper also recommends that seg funds provide investors annually with a personal total rate of return, net of charges, using a money-weighted method for periods of one year, three years, five years, 10 years and since contract inception.
As well, the paper recommends that seg funds provide seg fund investors with comprehensive details of their insurance contract, including guaranteed redemption amounts at different phases of the contract, any bonuses added to the protected value of the account and information on automatic resets of guarantees.
In addition to product-specific information, the CCIR paper states that the value of sales incentives, such as travel and accommodation paid for intermediaries to attend conferences, must be disclosed to clients.
The CCIR’s paper reiterates that insurers are legally responsible for oversight of their intermediaries, and that those intermediaries must follow needs-based sales practices. The latter process must be documented and copies of the needs analysis and product recommendation documentation must be provided to investors.
The CCIR’s paper states that although anecdotal statements indicate that regulatory arbitrage is taking place in the mutual fund and seg fund industries, no supporting evidence has been found. The paper notes that in order to protect consumers, the CCIR will seek “to proactively amend standards, where appropriate, to ensure that intermediaries have little incentive to prioritize their interests over those of their clients.”
The CCIR’s position paper also recommends that the standard of care for dealing in seg funds should be equivalent to that for mutual funds. Accordingly, the paper urges provincial insurance regulators to consider harmonization with the securities industry of “know your product” and due-diligence requirements for intermediaries.
Regarding the “know your client” (KYC) document required for mutual fund representatives, the CCIR paper concludes that a similar questionnaire is not necessary for insurance intermediaries because the principles of KYC are embodied in the needs-based sales practices required for seg funds.
Although greater disclosure might be good for investors, it will create new challenges for advisors, Yates says: “[This] definitely will have an impact on the sales process, especially if you have to justify your compensation. [It] would not be more difficult, but [would be] more onerous to explain the value you bring to the table.”