B-Ds reluctant to OK exchanges into LTC

Financial advisers had hoped to begin this year with new momentum — the ability to swap clients out of existing annuities or insurance in exchange for long-term-care coverage — but broker-dealers have hit the brakes, citing problems with large amounts of paperwork to process the business, among other troubles.

A provision of the Pension Protection Act of 2006 went into effect Jan. 1, permitting a tax-free exchange from an annuity or life insurance policy into a qualified LTC insurance policy. These transactions are commonly known as Section 1035 exchanges under the Internal Revenue Code.

But nearly three months after the provision kicked in, broker-dealers and advisers are still largely waiting on the sidelines. Firms said that performing the product swaps is a paper-laden process, and it raises questions of suitability and supervision among broker-dealers that scrutinize advisers’ fixed-insurance business.

“The concept sounded good on the surface, and we had this flurry of activity as we tried to develop our strategy,” said Merry Mosbacher, a principal in the insurance marketing unit at Edward D. Jones & Co. LP. “But when we started looking at the opportunity, it didn’t seem very practical.”

The heart of the problem lies with the use of 1035 exchanges to fund LTC insurance. Currently, there aren’t any stand-alone LTC products that can be paid with a single premium, so a full exchange in one transaction isn’t possible.

As a result, swaps out of an annuity have to be performed in increments through a partial 1035 exchange in order to pay annual LTC premiums.

From the point of view of the broker-dealer, the exchange is considered an insurance replacement, and to meet state insurance regulatory requirements, it requires additional disclosure paperwork by the adviser performing the transaction.

How closely the broker-dealer supervises the transaction can vary, as firms are technically not required to examine the sales and exchange of fixed-insurance products. Variable products fall under broker-dealers’ purview, so firms are responsible for overseeing a transaction in which a variable annuity is liquidated in exchange for a fixed product.

Because of the variation in supervision, many firms aren’t sure how to oversee a case in which a fixed annuity or insurance policy is incrementally transferred into a long-term-care policy. Product suitability tends to be based on the initial contract purchase — in this case, the old annuity — but not the annual replacement to cover recurring premiums.

As a result, firms have questions as to whether they have to perform a suitability check and supervise each partial exchange into the long-term-care product. That’s a labor-intensive process, firm executives said.

“When you pay the recurring premium from another policy, it is deemed a replacement by state insurance regulations, and triggers a requirement for disclosure and supervision,” Ms. Mosbacher said. “But you don’t have a system to trigger the supervision; the adviser would have to know to send in the replacement documents.”

Long-term-care insurers, including The Prudential Insurance Company of America, have also sent letters to advisers and distributors warning that there are possible adverse tax implications for the client behind the partial 1035 exchange at the carrier level, too.

Carriers need to manage the exchange properly so that the insurer who issues the original contract is directly paying the company issuing the new long-term-care product. Failure to perform the partial 1035 exchange the right way could make the payment appear to be a taxable distribution from the annuity.

The American Council of Life Insurers and the Internal Revenue Service have been in talks on how to contend with the difficulties involved in the tax treatment of partial 1035 exchanges but haven’t come to a firm conclusion yet.

One possible way to knock out some of the hindrances would be to offer a single-premium annuity with a long-term-care rider. Insurers with such hybrid products include Genworth Financial Inc., OneAmerica Financial Partners Inc. and Mutual of Omaha Insurance Co.

“We have been getting full 1035 exchanges into our product from people who have accumulated some amount of money in an annuity,” said Bruce Moon, vice president of The State Life Insurance Co., the subsidiary of OneAmerica that provides the hybrid annuity. The firm sells through a mixture of banks, independent agents and some broker-dealers.

Broker-dealers are intrigued by the hybrid annuity but continue to worry about an additional level of supervision for transfers into the product, as well as the cost and labor of expanding LTC licensing to registered representatives who might want to participate.

“Coming up with another layer of supervision would be time-consuming: If you liquidate one account to buy a second, then the ends have to justify the means, and that’s the element to look at,” said Bonnie Gee, first vice president and variable annuity manager at Cadaret Grant & Co. Inc. “Going from a fixed annuity to a hybrid fixed annuity with long-term-care insurance, you wouldn’t know who’d supervise it if the producer didn’t have a securities license.” But she added that there would “definitely” be an advanced layer of supervision of the hybrid product if her firm were to work with them.

Further, the hybrid products would have to be integrated into broker-dealers’ annuity platforms.

LICENSING IS A HURDLE

Additionally, licensing reps to sell long-term-care coverage is a second hurdle, as states have different requirements, and some call for extensive continuing-education courses, Ms. Gee added.

Advisers aren’t hearing any guidance from their broker-dealer firms on the matter of the 1035 exchanges and the hybrids, but they remain interested in the concept as their firms figure out how to proceed.

“It’s an excellent idea, and I haven’t heard anything, because the annuities are so new that nobody’s pushing them yet,” said Robert Straka, president of GrandView Financial Group LLC, an affiliate of Multi-Financial Securities Corp. He would not disclose the firm’s assets under management. “But there’s going to be gobs of paperwork if you want to change out of an old annuity.”

E-mail Darla Mercado at [email protected].