Chicago Legal Battle Exposes Annuity Market Timing

December 12, 2003 (PLANSPONSOR.com) - The annuity business has apparently been hit with the same type of improper marketing timing that has kept the fund industry locked in scandal in recent months.

A Chicago lawsuit alleges that an investment company was able to market time an insurer’s funds and earn an explosive 45% return in less than 18 months, according to a Reuters report. Insurance companies fear if improper trading were found to be systematic, it would slam an industry that is keen to keep its reputation pristine. Though stopping market timing is difficult, abuse of the industry is rare, experts say.

While market timing isn’t illegal, the practice has been at the center of probes by New York Attorney General Eliot Spitzer and other state and federal securities regulators. But companies discourage it, especially on a large scale, as it reduces the earnings of other investors.

The insurance industry has been on edge ever since regulators in late October began asking about the firewalls it has against improper trading in variable annuities — retirement accounts made up of stock and bond funds. Though insurance industry experts charge speculation about abusive trade in annuities has been spread by mutual fund companies under investigation, a lawsuit by a Chicago area investment company provides details about at least one instance of market timing in variable annuities.

Lawsuit Background

In October 2000, Emerald Investments LP of Northbrook, Illinois, sued Equitable Life Assurance Society of the United States, a unit of Axa Financial Inc., alleging that the insurer broke contracts it said allowed Emerald to frequently trade in three accounts it had opened in the second quarter of 1999. Axa, a division of France’s AXA, countersued for fraud, and said Emerald violated its policies against market timing.

Neither party will talk publicly about the case being heard in the US District Court for the Northern District of Illinois. Also, parts of the case are sealed, making it hard to determine certain events.

For example, it is unclear how a company could take out a variable annuity or why it would do so, considering the higher fees and penalties for withdrawing funds than a normal mutual fund. A withdrawal from an annuity after a short-term investment is subject to a capital gains tax at the ordinary rate, a 10% early withdrawal penalty like a 401(k) retirement plan and a surrender fee, which can be 7% in the first year.

Emerald, which claims Axa knew it intended to frequently trade the sub-accounts, or mutual funds, in its annuity contracts, is suing for damages, loss of profits and the return of a $2.16 million surrender fee.

Whatever costs Emerald may have incurred, it posted a tidy return. Its initial investment of $36 million taken out in April and May of 1999 grew to $52.2 million by October 16, 2000, according to the Reuters report.

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