What comprises due diligence? This depends on whom you ask. The sales manager probably has quite a different concept of due diligence than the general counsel or the chief compliance officer. And the regulators' and litigators' viewpoints are even more diverse. This article will be confined to conducting product due diligence on variable annuities (VAs), as well as some related matters. But keep in mind that assembling all the due diligence materials and creating matrices is worthless unless they are dynamically integrated with the institution's sales practices.

Product Category Selection

The 'business side' of the house, the sales and marketing management teams, usually determine the nature and scope of what the broker-dealer sells. They use market surveys and historical customer demand, as well as literature from product manufacturers and registered representatives, and financial press articles and broadcasts to determine what customers want and are buying from other broker-dealers. Bank broker-dealers are generally more conservative than the independents, and for the most part, their product lines are narrower and generally focus on third-party packaged products, such as mutual funds and annuities. Once the business side determines a product category will be offered to its customers, the qualitative process begins.

Due Diligence Defined

The bank broker-dealer Compliance Department is generally charged with the responsibility for collecting VA information, establishing criteria for screening, maintaining current and comparative information on all products on the approved list, and delivering verbal and written reports that can be relied upon by the sales and marketing teams.

It is necessary to both define and document "due diligence" so that the compliance department understands the goals to be achieved: to ensure that no harm is done to the broker-dealer's customers, to itself, or to the parent institution. The broker-dealer must be able to demonstrate that it made ordinary, prudent, and reasonable efforts to avoid harm to its stakeholders.

In the moments prior to consummating a VA, no 'harm' is done; but afterward, the future is uncertain. The customer enters into the transaction with certain understandings and expectations that may or may not be realized. No compliance or sales department can accurately predict market behavior or the economic environment, but they must take all reasonable and prudent steps to investigate, with documentation, the VA products they offer. And all of this must be accomplished before tangential sales practices are considered.

The investigation must also be timely and uniform, and result in useable, comparative information that is applied to both the carrier and the product selection. Due diligence research is generally conducted on information in the public domain; investigating non-public sources is generally not necessary. Unlike research departments that deal in stocks and bonds, few bank broker-dealers have the credentials or resources to develop due diligence information from the ground up.

Organizing the Task

The typical due diligence structure comprises a Product Review Committee chaired by the chief compliance officer. The Product Review Committee generally includes sales, marketing, legal, operations, and IT (information technology) personnel, so that all perspectives are included in the process. This committee will not only review new products, but also will conduct the annual review of existing products and have continuous oversight of product changes between annual reviews. Many bank programs often limit the introduction of new carriers to an annual window; this enables the committee to compare each product to all other products in a uniform time frame.

Creating the Information Grid

How do we establish the initial due diligence process or review an existing process? A good idea is to look at what most other bank broker-dealers are doing—and who knows that better than the VA carriers? A call to their compliance department with a request for their due diligence package will save you a lot of time hunting for resources. Explain that you are creating a VA Request for Information (RFI) for product due diligence. Can they offer a few examples of what they consider to be some of the best and most complete requests they have answered? Carriers are generally very cooperative with this approach. When you have gathered several of these reports from nationally recognized carriers, the elements for your spreadsheet will be in hand.

The Almighty Spreadsheet

The basic information for the spreadsheet grid will include carrier name, address, and contact phone numbers. It is also important to maintain information on products that are considered but not approved so that so that the integrity of the due diligence process can be demonstrated. Spreadsheet information will include, but is not limited to:

• Credit worthiness of the carrier.
• Solvency of the carrier expressed as ratings from Standard & Poor's, Moody's, and A.M. Best.
• A 1-10 rating code can be used to indicate the reputation of the carrier.
• A check-off system can be used to indicate the receipt of all sales materials related to the product being considered, such as forms, regulatory reports, news articles, performance reports, analysts' research reports, and input from managers and brokers.

The grid should also verify the receipt of similar information for each of the investment options and each of the component sub-accounts. And this is just the beginning.

Filling in the Blanks

Gathering due diligence information is usually done by sending RFIs to prospective carriers as well as approved VA product providers. Many of the larger carriers have special teams whose sole purpose is to respond to RFIs. Good RFIs assist the carriers with organizing the information that will be provided, and this in turn helps the Product Review Committee in uniformly melding the information with the comparative grid used for decision making and the approval process.

All of the information must be retained in the compliance department files for reference and to support any challenge that might arise regarding the integrity of the due diligence process. Most of the information has a short shelf life, so the Product Review Committee must explicitly require VA carriers to update their materials with the latest revisions. In the event of arbitration or litigation, these documents will serve as important evidence that due care has been taken to protect all stakeholders before and after the sale. The more complex the product, the more complex will be the due diligence process—and the more extensive the documentation.

Establishing Screens and Thresholds

It is unlikely that a bank will determine it is in the best interests of the program or its customers to sell every product that meets the minimum standards. Few institutions have the time or money to evaluate VAs that do not make it through the initial screening process. Keep records of those products that meet the standards but are not selected (and the reasoning). This will enable the Product Review Committee to demonstrate that is selective.

Threshold minimums will be determined for credit agency ratings, carrier size, reputation, state approvals, and so forth. This screen will eliminate many carriers and allow the committee to focus on qualified products. Once these broad, general criteria are satisfied, any future exceptions should be avoided. Exceptions to these basic standards should be very rare, and require unanimous endorsement and thorough documentation.

Support Systems and Resources

Support system and resource consideration is critical, because the process has become at least as important as the product. Good product is not hard to find; just open the door! But not so with good systems. Good systems enable the bank broker-dealer to minimize their involvement in processing and servicing the business after the sale, and are critical to profitability and customer satisfaction. The agent is the key player in the customer relationship, but he/she is also key to productivity. If the agent's time is absorbed in non-productive work, even for the finest VA product, the program will not meet the contribution goals established by the bank.

Many carriers have proprietary online ordering and tracking systems. For a bank that sells numerous different VA products from several carriers, this can be a problem. This is where the IT person on your committee can weed out those systems that do not easily integrate into your bank's systems. Often, a bank lags in efficiency because of systems that require additional personnel that are not cost-justified by volume and/or profitability.

Among the critical variables is the ability of the carrier to provide instant, online order-status reporting. Phone calls that get into the 'return call cycle' are a waste of time for all stakeholders; they must be documented and re-documented. If the carrier cannot provide information in the bank's approved format, product approval is likely a waste of time and effort.

An excellent tracking and reporting system will also enable the carrier to pay the bank broker-dealer in a timely manner without additional reconciliation. Some carriers pay twice monthly because they have systems in place to support the sales process. Some technology providers have streamlined 1035 Exchange reporting to the extent that commission adjustments are no longer necessary in the following commission cycle. If the Product Review Committee can screen for these systems and reporting capabilities, it can make a substantial difference in profitability.

Field wholesale support is primarily the concern of the sales manager, but it is worth considering at the Product Review Committee level. If your bank has a large branch network that requires significant sales/product training, approving a product that does not have 'visible means of support' would not be in the broker-dealer's best interest.

In the end, the screen for systems and support resources will support the statement: "This carrier has demonstrated its ability and willingness to meet the standards, and deliver the product we have reviewed."

Basic Feature Screens

Marketing materials are a good guide to the universe of available features, and the list is a long one. Many carriers have more than 50 features and options, but it is the bank broker-dealer's responsibility to determine which features will be offered to their customers and to provide the framework for controlling the sale of those options that don't offer sufficient benefits—that is, weed out the 'overly complicated product.'

Examining the Features and Options

The VA spreadsheet matrix described will be as complex as the VA product, itself. It will illustrate the investment and annuitization options, and all guarantee options. During the accumulation period, the customer will be looking for growth and tax shelter; during the withdrawal phase, the customer will want withdrawal provisions and guarantees of account value, income, and death benefits.

The Product Review Committee, in coordination with sales, must determine which guarantees, options and riders will be offered for approved VAs. Not all VAs will offer all of the available riders in the VA marketplace. New riders introduced after a VA is approved must be reviewed by the committee. Riders pose a special due diligence challenge for the committee, because similarly named riders might have fees that are calculated differently from product-to-product. Each carrier's riders' fees, calculation methods, and timing of charges must be determined for comparative purposes.

Once developed, the spreadsheet should be reviewed quarterly to ensure that it is up to date with current markets and offerings. Carriers on the review list must agree to notify the bank of any changes in ratings or finances, as well as news releases or regulatory issues that relate to the product. Files on each carrier and each product reviewed must be maintained, and these files must be updated as information becomes available.

Keep in mind that standard-setting is a dynamic, iterative process. When examining materials supplied by a vendor, the Product Review Committee might discover that the VA carrier has only 3 sub-account categories, while another product carrier has 10. A standard must be created (and documented). For example: "A variable annuity approved for sale by XYZ must have sub-accounts that include, but are not limited to, equity growth, equity income, short-term fixed income, long-term fixed income, and money market accounts, one of which must be a government fund." The standards can complex or simple—whatever is determined to be in the best interests of the stakeholders.

The Product Review Committee must determine the level of due diligence that will be completed directly by the team and what contribution the VA provider will make. The team should question the VA carrier on the level of due diligence performed during its sub-accounts selection process. If the committee determines the level of due diligence performed by the VA carrier meets its standards, copies of the carrier's due diligence reports should be obtained and maintained in the bank broker-dealer's compliance files.

Performance Representations

When it comes to mutual fund sub-accounts, the complexity of VA due diligence is further complicated by the performance representations. The mutual funds used in VA sub-accounts are not the same as those publicly offered by mutual fund companies in their standalone funds. Therefore, the performance must be properly represented and reflect the funds in the sub-accounts being considered. The Product Review Committee must determine its 'level of comfort.' What will they require from the VA carrier regarding the performance representation of the sub-accounts? This 'level of comfort' must be documented as standard.

For example, the standard for the actual performance of the growth equity component might read: "The growth equity sub-account of any approved VA must be in the top four deciles of its peer group, as reported by Morningstar for each of the five years prior to review and approval." Standard too tough? Then create one that fits your institution. The spreadsheet grid must illustrate the performance and decile ranking of each component. If the committee team is depending on the VA carrier to supply the actual performance records of each sub-account, the carrier should also provide signed affirmation attesting to the necessary representations and warranties, and that the performance numbers are deemed accurate.

Benefits and Guarantees

We are witnessing a continuing shift from annuitization options to guarantees. Customers' life expectancies are increasing, and so is their need for continued income. Many complain that they do not understand the complex income options. A guarantee that ensures income at a certain level is distinctly different than one that increases income commensurate with the rate of inflation. Do the VA carrier's marketing materials clearly distinguish these concepts and explain them in plain English? The compliance officer should be alert to and certain that the sub-account options are correctly elected, based on the client's interview and the suitability determination. For example, if a customer indicates a need for inflation-adjusted income, but elects a long-term fixed income option, this question might be posed: Would their objective be better met by an equity fund invested in dividend-paying stocks that will likely increase in payouts over time?

Fees and Charges

All VAs offer a death benefit which is paid from the mortality and expense charges. When comparing the variable annuity death benefits, the committee must determine if the product offers a traditional death benefit, a compounded death benefit reset, a ratcheted death benefit reset, or a highest anniversary value reset (the most popular). Do the resets apply until the client reaches a specific age? What are the terms and conditions that govern the benefit? Making these comparisons takes a lot of time and research... and documentation.

The guaranteed living benefits must be examined in the same detail. Nearly all VAs now offer a guaranteed minimum account value (GMAV), guaranteed minimum income benefit (GMIB), and a guaranteed minimum income payment (GMIP). The Product Review Committee will need to consider all of these guarantees' features and the formulas for payments to the annuitant. Large carriers 'manufacture' the hedges that back the guarantees; other carriers purchase coverage for the guarantees from third parties. It is necessary to understand and evaluate the strength of these guarantees, depending upon their construction. It is possible that a VA with guarantees that are dependent upon outside vendors could be restrictive in their offerings if the vendor elects not to sell the coverage to the carrier, leaving the bank's sales force without a product to offer its customers.

Guarantees mean complexity and costs, and there is no easy way to protect the bank or its broker-dealer, other than through product due diligence, and ongoing supervision of sales and marketing. It is interesting that broker-dealer customers report they are increasingly "comfortable" with their financial futures. But is their increasing comfort level derived from the purchase of VA product guarantees? Would a 10-percent market correction change this? These factors will be better understood over the next decade as the retirement boom becomes a reality. Meanwhile, a bank's best protection is to make certain that its product selection due diligence process and its compliance program are as solid as its sales and marketing programs.

Marketing Support

Make sure the Product Review Committee understands the marketing plan of the VA carrier, and how the carrier interfaces with the bank's agents and customers. The carrier must agree to the bank's marketing restrictions and standards. It is not unusual that a VA wholesaler is aware of a new rider option before the bank's compliance department has been informed. Carriers must agree that no new product features or benefits will be discussed with the bank's agents until they have been approved by the compliance officer.

Some institutions permit a wholesaler to accompany an agent on a sales call in which the wholesaler actually makes the presentation. It is essential that, if your institution permits this activity, the presenter must be made fully aware of all suitability criteria that are specific to that client. And, you must determine if your privacy policies permit sharing that information with a third party. In general, having wholesalers make client presentations is a slippery slope.

Many banks have wholesalers speak at sales meetings. Frequently, they use presentations that have been prepared by the carrier's distributor. Banks should obtain a written statement from the carrier that any and all materials or presentations will have prior written approval from the carrier's compliance department, and that they will meet all regulatory requirements. This information can be represented on the due diligence spreadsheets for quick, at-a-glance reference.

Follow-up

The compliance department should initiate contact with each approved carrier at least twice annually to verify the due diligence information on both the VA product and the carrier. If possible, this should be documented with appropriate notations in the carrier's file, including the time and date of contact. It is strongly recommended that the chief compliance officer visit the carrier's headquarters to verify the carrier's representations.

Again, this is an iterative, dynamic process that, when complete, will provide the Product Review Committee with an enormous amount of comparative information. This information will be used to document the due diligence process, to frame the basis for written product standards, and to create the sales guidelines that are required for any product (but which are specific to variable annuities). This process will never be complete; from it emerges the approved variable annuity list.

Contracts

The Product Review Committee should also be involved in finalizing the product/carrier contracts. All approved VA carrier contracts must be carefully negotiated to include the requirement that carriers immediately notify the bank broker-dealer compliance department of any of the following:

• Any changes in ratings,
• Methods used in calculating any element of the VA,
• The addition/deletion of any mutual fund sub-account option and the reasons for change,
• Regulatory action that is adverse to the carrier,
• The addition/deletion of any rider,
• The filing of any regulatory notice,
• Any change of personnel support to the bank broker-dealer account, and
• The approval for distribution of any sales/marketing materials (paper or electronic).

Preferred Vendors

Most bank programs have a preferred vendor/product list, and the due diligence committee is responsible for ensuring that all of the carriers and products on the list meet the highest standards established by the Product Review Committee. If a carrier paid the bank program a fee to be included on its preferred product/vendor list, this will only subject the carrier to higher scrutiny. If a bank program is challenged regarding the products and/or carriers on the preferred list, the burden of defense will be greatly relieved if it can be demonstrated that the challenged product meets or exceeds other products reviewed by the committee.

Sales Guidelines

Regardless of the extent and detail of the VA due diligence process, it is not a VA sales guideline. It is not a suitability guideline. And it is not a 'sales to seniors' guideline. It is some of each of these—all woven into a complete compliance-sales fabric.

Risk Management

Regulators require banks to name a chief risk officer whose responsibility is to understand and manage the holistic risk exposure of the bank, and its various subsidiaries and affiliates. The chief risk officer needs to understand the risks attributable to products being offered to bank customers and its affiliates. A sound, well-developed, and documented due diligence process, properly executed and maintained, is very valuable protection for the customer, the broker-dealer, and the bank. While resource-intensive, it will serve the institution well in the event of compliance challenge from any quarter.

Communicate

It is highly recommended that the bank conduct an annual meeting for all VA providers and, for that matter, all product providers. The chief compliance officer and general counsel should make a presentation regarding product standards, sales, and marketing compliance standards, as well as expectations and requirements. This should be an open forum for questions and answers, and all providers should hear the same information at the same time. The bank should require that carriers' compliance officers attend so that the meeting is not just another element of a sales meeting. These meetings establish a working relationship that is very difficult to do on a one-by-one basis. They reinforce the understanding that all carriers are playing by the same rules.

In Summary

So where does this all end? It doesn't! Product due diligence and broader compliance routines are expensive, resource intensive, and time consuming, and it is unlikely this will get better. The Baby Boomers are moving through the demographic snake in huge numbers, and in addition to age, they share another characteristic: They have generally failed to save enough to maintain their life style in retirement, and they are increasingly looking for the guarantees that VAs offer. When the market goes up, everyone is happy; and when the market goes down, customers look for someone to blame. Make sure the 'blame game' is not forfeited by having an inadequate product due diligence process... and documentation to support it!

Richard D. Starr is BISA Director of Government Affairs, and is Chairman of BISA's Legislative, Regulatory & Compliance Committee. He is a regular contributor to Bank Insurance & Securities Marketing magazine, as well as President of Financial Institutions Group, Inc., a full-service financial services consulting firm focusing on bank broker-dealers and insurance agencies. He can be contacted at rstarr@bisanet.org.