RCA - December 1998 - Internal Rates of Return in Variable Life Hypothetical Illustrations

Under certain conditions, NASD Regulation is permitting wider use of internal rates of return (IRR) by member firms in hypothetical illustrations used with prospectuses on behalf of variable life insurance policies. NASD Regulation recognizes that IRR can help investors to understand how policy costs affect cash value and death benefit for different time periods. Effective immediately, member firms may include IRR in variable life insurance policy hypothetical illustrations directed to retail customers as well as sophisticated investors. Since 1990, NASD Regulation had limited the use of IRR to hypothetical illustrations of split dollar plans that were directed to sophisticated investors. NASD Regulation based this restriction on an advisory position taken by the Variable Contracts Committee, a former standing committee of the NASD Board of Governors. Upon further review of the manner in which IRR is presented in variable life prospectuses, and the potential benefit to investors from this information, NASD Regulation has determined to permit wider use of this information in supplemental sales material. In developing this position the staff has consulted with the Variable Insurance Products Committee, the NASD Regulation standing committee that now serves in this area.

Hypothetical Illustrations

NASD Conduct Rule 2210(d)(1) generally requires that all member communications with the public provide a sound basis for evaluating the facts regarding a particular security and that they include material qualifications necessary to ensure that the communications are fair, balanced, and not misleading. The Rule also prohibits the use of exaggerated, unwarranted, or misleading statements or claims. IM-2210-2, entitled, "Communications with the Public About Variable Life Insurance and Variable Annuities" sets forth specific guidance for how hypothetical illustrations may be used in members' communications with the public (the Variable Product Guidelines).

The Variable Product Guidelines permit member firms to use hypothetical illustrations that demonstrate the operation of a given variable life insurance policy. Using assumed rates of return, the illustrations show how the performance of the variable investment accounts that underlie the policy could affect its cash value and death benefit over time. Members may use assumed rates of return of up to 12% provided that a 0% illustration is also included. Illustrations must depict the effect of the maximum (guaranteed) mortality and expense risk charges. The presentation also must explain prominently that the illustration is hypothetical, that it is intended to show how the performance of the underlying investment accounts could affect policy cash value and death benefit, and that it may not be used to project or predict investment results.

IRR Disclosures

Under the new policy, member firms may incorporate IRR in the form of additional columns in standard hypothetical illustrations used with variable life insurance policy prospectuses. Because the selective use of IRR for a single time period may mislead customers to believe that the figure is indicative of the future performance of the variable life insurance policy, the illustrations must depict IRR for each time period included. In addition, the illustrations must include IRR columns for both the cash value and death benefit to provide the customer with a complete picture of the relationship of costs to policy values over time. Finally, because the concept of IRR may not be familiar to all investors, illustrations featuring IRR must include a clear explanation of what the measure reflects.

Member firms are reminded that the format of hypothetical illustrations for variable life policies registered under the Investment Company Act of 1940 must be filed with the Advertising/ Investment Companies Regulation Department within 10 days of first use as required by NASD Conduct Rule 2210(c)(1). Revision of a previously reviewed illustration to include IRR would constitute a material change to that illustration and would require its resubmission.

Questions regarding the use of IRR may be directed to the Advertising/Investment Companies Regulation Department at (202) 728-8330.