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VAs Under Pressure Over Market Timing


Brace yourselves. Recent problems in the mutual fund industry with market timing arbitrageurs could spill over into the variable annuity industry.

Stephen Cutler, director of the Securities and Exchange Commission enforcement division, has said the SEC is looking at variable annuities as part of its investigation. And sources told sister publication Annuity Market News that 80 investment and insurance companies are under scrutiny.

Earlier in the year, New York Attorney General Eliot Spitzer subpoenaed a dozen variable annuity issuers. The subpoenas asked for the names of all sales reps in New York, as well as product prospectuses and information on customer complaints.

A number of insurance companies declined comment or did not return phone calls. Others said they are reviewing their policies and procedures.

Putnam Investments, Boston, one of the nation's oldest mutual fund companies, already has been charged with securities fraud in the market timing scandal (see related story, page 1). The SEC and Massachusetts securities regulators have charged that Putnam failed to adequately prevent two fund managers and others from participating in illicit short-term trading.

Hartford Life issues the Putnam Hartford Capital Manager variable annuity. Christina Divigard, a spokeswoman for Hartford, of Simsbury, Conn., said her company is taking a close look at the situation and that Hartford discourages market timing in all its variable annuities and has procedures in place to prevent it.

"We are in close contact with Putnam and are reviewing the situation," she said. When asked if Hartford is the subject of any regulatory investigations or legal actions, she responded, "We are reviewing policies and procedures ourselves."

Michael Arcaro, a spokesman for Prudential Financial, New York, could not comment on market timing issues involving the company's variable annuities.

However, Prudential issued a press release in September confirming that it had "received additional formal requests for information from regulators, including the Securities and Exchange Commission, the NASD and the State of New York Attorney General's Office. These requests were "in connection with issues related to the purchase and sale of mutual fund shares." The release stated that "Prudential is cooperating fully with all such inquires and is conducting its own internal investigation."

No System Foolproof

Over the years, variable annuities have instituted a number of measures to discourage market timing. They typically monitor trades and limit the number of times funds can be switched. But no system is foolproof.

The issue is whether variable annuity issuers could be subject to class action lawsuits or actions by state and federal regulators because of market -timing arbitraging activities in their mutual fund sub-accounts.

If the state of Massachusetts and the SEC are successful in prosecuting Putnam Investments, experts say you could see legal actions taken against insurance companies. "There are a roster of funds that have been affected, and insurance producers are not immune to class-action lawsuits or actions by state securities regulators and the SEC," said Joan Boros, a partner with the Washington law firm of Jordan Burt Boros.

Boros, is advising her insurance clients to review their market-timing prevention procedures. Variable annuity issuers that offer international mutual funds that do not do fair-value pricing are asking for trouble, Boros said. The funds are susceptible to market timers. As a result, they could attract the attention of the regulators.

She is advising her clients to make sure that their proprietary and non-proprietary international funds in their products' sub-accounts use fair-value pricing.

Market timing arbitrageurs take advantage of time zone differences in foreign stock prices to make profitable mutual fund trades. Fair-value pricing models capture information that arises between the closing of foreign and United States markets to adjust a fund's net asset value. This reduces the potential for short-term gains by market timers.

For example, research by Ananth Madhaven, managing director at Barclays Global Investors, San Francisco, found that by using a stock-specific regression model, fair-value pricing can reduce market-timing arbitrageurs' profits by 92% in mutual funds.

Who Knew?

Unfortunately, no one seems to know which funds use fair-value pricing. Spokespersons for Morningstar, Chicago, and Lipper, New York, said they do not have an official list. They have not conducted any research comparing the performance of fair-value-priced funds versus non-fair-value-priced funds. But they agree that most of the major fund groups use fair-value pricing.

"We don't have a list, and we have not compared the performance of funds that do and do not fair value price," said Morningstar Analyst Greg Wolper. "A list would be difficult to come by. Those that are doing it use different methods. And it is hard to tell how often they are doing it."

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