When the variable annuity first came on the horizon, security dealers were often confused by this particular feature. They were accustomed to think in terms of property law. A share of stock represents ownership in a portion of a business. By analogy, security dealers thought of variable annuities as a device for distributing shares of stock. Viewed in this way the security dealers were greatly mystified by the sudden "disappearance of shares" at the death of an annuitant. By thinking of a life annuity as a chose in action this confusion can be avoided.

1. Annuities Certain

The hallmark of the life annuity is that the duration of the periodic payment of a sum of money is determined by the life span of the annuitant. Annuities certain, on the other hand, usually take one of two forms. The annuity payments may be made for a specified period, for example, the commitment might be to make 120 equal monthly payments. Or the commitment might be to pay $100 a month as long as the funds last. Life insurance companies customarily assume a certain rate of interest on the funds during the payment period.

Mutual funds frequently arrange for the distribution of mutual-fund shares as an annuity certain. Most mutual funds will permit a liquidation of a constant number of shares each year or each quarter. For example, if there are 10,000 shares the investor might arrange to liquidate 1,000 shares each year for 10 years. Or if the investor preferred, he might arrange to liquidate sufficient shares to provide him with $1,000 each quarter year as long as the proceeds last. If the liquidation is spread over a reasonably long time and prices of shares remained relatively stable, the first of these methods would result in a progressive and substantial reduction of the annuity return over time. Since mutual funds regularly pay out the income on the funds each year, they will be paying out income on a constantly dwindling number of shares. This effect has been largely overlooked in recent years because the steadily increasing market has increased the value of the shares to be liquidated. Where the shares are liquidated to provide a constant dollar income, the principle of "dollar cost averaging" is applied in reverse with the result that more shares will be sold at low prices than high prices.

Some years ago there was great interest in an investment known as the face-amount certificate.1 Face-amount certificate companies often sold an investment contract providing for installment payments to the

41 The Investment Company Act of 1940 contains specific provisions for the regulation of face-amount certificate companies. 54 Stat. 829, 15 U.S.C. § 80a-28 (1958).

company for a certain period. At the end of this period the investor was entitled to a lump sum exceeding the sum of his investments. The exact amount was usually calculated by assuming a certain interest rate on the funds, and the investor was frequently given the option to receive annuity payments for a specified period in lieu of a lump sum. The sum of the installments would exceed the amount he could get as a lump sum in advance.

43

Statutes authorizing life insurance companies to grant, purchase and dispose of "annuities" usually do not distinguish between life annuities and annuities certain.42 At one time it was customary for life insurance companies to sell annuities certain in which there was no life contingency. These contracts were often attractive to purchasers during the first thirty years of this century. During the period 1920 to 1930, the average net yield of life insurance companies exceeded five percent per annum. As this net yield began to decline after 1930, the issuance of annuitycertain contracts by life insurance companies fell into disuse. This interest rate declined steadily after 1930 to a low of 2.88% in 1947.** Since then it has been gradually climbing. The life insurance company net average yield for 1959 was 3.95%. If this yield continues to increase, life insurance companies may again be interested in selling annuities certain as separate contracts.

Most life insurance policies today contain settlement options providing for the distribution of the proceeds to beneficiaries. Usually one of these options is the payment of the proceeds as an annuity certain.

Presumably the authority for the use of annuities certain by a life insurance company stems from the broad definition of the word annuity to include both life annuities and annuities certain. In the state of New York the sale of annuities certain and the use of annuities certain in settlement options became established under a law authorizing life insurance companies to grant, purchase and dispose of annuities.46 The New York insurance law was amended, however, limiting the right of a domestic life insurance company to engage in the annuities business to life annuities. The present New York insurance law indicates the scope of insurance business thus:

42 E.g., Cal. Ins. Code § 100; Conn. Gen. Stat. § 38-154 (1958); Ind. Ann. Stat. § 393501 (Supp. 1959); Minn. Ann. Stat. § 60.29 (Supp. 1959).

43 1959 Fact Book at 59.

44 Ibid.

45 This figure was supplied to the author by the Institute of Life Insurance which body authors the Life Insurance Fact Book.

46 N.Y. Ins. Law 1909, ch. 33, § 70.

1. "Life insurance". . . . The business of life insurance shall be deemed to include . . . optional modes of settlement of proceeds.

2. "Annuities," meaning all agreements to make periodical payments where the making or continuance of all or of some of a series of such payments, or the amount of any such payment, is dependent upon the continuance of human life, except payments made under the authority of paragraph one.47

An interesting question could arise in New York as to whether the settlement of the proceeds of a deferred-annuity contract written by a domestic life insurance company in the state of New York as an annuity certain is authorized. Is the reference to optional modes of settlement of proceeds in section 46(1) limited to that section? In fact, domestic life insurance companies in New York are today issuing deferred-annuity contracts providing for annuities certain in accordance with the custom prevailing when the New York insurance law was amended. In short, we can look to custom and practice rather than to the statutory language. This is but another instance of the need for examining customs and tradition in the regulation of annuities. It also shows that definitions are not a satisfactory guide in and of themselves to determine whether. a particular situation should be classified as an annuity.

2. Conventional Fixed-Dollar Annuities

A conventional fixed-dollar annuity as written by a life insurance company is a contract. The annuitant owns a chose in action. There is a debtor-creditor relationship, not a trust relationship.48 The annuity is "charged on the person of the grantor," viz., the insurance company. There is no lien on specific assets. In determining what rate shall be charged for the benefit promised, the insurance company takes three factors into consideration: interest, mortality and expenses. The actuaries first determine a net premium rate based on assumptions as to mortality and investment yield. A "loading" is then added to the net premium rate to cover the guarantee as to expenses and to provide funds to meet contingencies, since the three assumptions may not always work out as planned. In one sense each of these three elements is guaranteed, although the guarantee or indemnity agreement is expressed with regard to the total. In its simplest form the company guarantees a fixed number

47 N.Y. Ins. Law § 46.

48 Hughes v. Sun Life Assur. Co. of Canada, 159 F.2d 110 (7th Cir. 1946); 1 Appleman, Insurance Law and Practice § 81 (Supp. 1960).

of dollars each month to the annuitant for life in exchange for a specified amount of premium.

We may think of this type of annuity as being fully funded since great care is taken to see that at all times the "reserves" are adequate to meet the liabilities of the company toward its annuitants.

There is a common misconception that life insurance companies use "life expectancies" to value their annuity reserves. This is not strictly true and much confusion will result from failure to grasp clearly the mode of valuation. The company does use a mortality table to determine how much it must have on hand to pay its annuitants a certain amount each year for their remaining lifetimes. These calculations are based on, and vary in accordance with, the precise age and sex of the annuitants. This computation is based upon two assumptions: (1) the rate at which people die at each age; and (2) the rate of return that will be earned on the assets held to support these liabilities. The actuary distills these assumptions down to a present value factor, sometimes called the present value of a life annuity of one per year. This method of valuing annuities is not confined to life insurance companies; it is generally considered the most accurate way of valuing all types of life annuities.

The status of the reserve fund of a life insurance company has seldom been analyzed by the courts. As mentioned above the reserve is a liability," but it is both a reserve and a liability. It sometimes appears to be a trust fund, but is not. In a legal sense an annuity contract creates a debtor-creditor relationship. In an accounting sense the reserve is a liability. The life insurance company will be considered to be insolvent if its assets do not exceed its liabilities including its reserves, and it is not enough that current assets are equal to current liabilities. Annuity contracts may last for many years-for the remainder of the annuitant's lifetime. Thus, there is a public interest in making sure that funds will be available to meet liabilities at remote periods in the future. To accomplish this end, elaborate provisions have been included in insurance laws to make certain that the "reserves" will be adequate.0 This has become known as the legal-reserve system for life insurance companies. This arrangement can hardly be said to impress the assets of the company with a trust relationship since none of the underlying assets are segregated-there is no trust-the assets belong to the com49 Maclean, Life Insurance 114 n.1 (8th ed. 1957).

50 The Illinois Insurance Code of 1937 presents a representative example of such provisions. Ill. Ann. Stat. ch. 73, §§ 879-80 (Supp. 1959), 885-87, 889, 890 (Supp. 1959), 891.

pany, not to the policyholders. But the company must tread a carefully prescribed legal path in order to keep its franchise. The system, being unorthodox, seems confusing to many accountants for two reasons. (1) The principal liabilities—the reserves-are not on the books of account of the company; they are calculated by an actuarial department and are checked out accurately only once a year. (2) The companies use a process called "fund accounting" which bears some slight resemblance to trust accounting, but is not the same. Fund accounting merely involves adopting the fiction that a certain account has a separate status for a certain purpose with no segregation of funds in fact. For example, let us assume that a particular company had certain policies in which a three-percent interest assumption was made and other policies in which a four-percent interest assumption was made. If the company earned precisely four-percent net interest on all its funds it might credit some excess interest earned on the fund supporting the first group of policies but not on the fund supporting the second group. A failure to distinguish between fund accounts and segregated accounts has sometimes led to the failure to recognize that the status of an annuitant is that of a creditor of a life insurance company, rather than a beneficiary of a trust. Even in Roman days there were problems of valuing annuities in an estate. In the Lex Falcidia compiled about 40 B.C., the heirs of an estate were entitled to receive at least one-fourth of the inheritance. As the will was sometimes made when the testator was in much better financial straits than at the time of his death (a situation which often exists today), it became necessary to reduce proportionately the value of the legacies. When the testator had provided for a life annuity to be payable to one or more legatees, questions arose as to how the annuity should be valued. The Romans were skilled in finance and in mathematics, and thus understood that an annuity would be valued differently depending upon the age and sex of the annuitant. They, therefore, understood that a proper mathematical basis was necessary to capitalize the annuities at a certain value. In Kopf's discussion of early annuities, the author sets forth the table of Ulpian, attributed to the Prefect Ulpianus (225 A.D.), and states that diligent inquiry has been made to establish whether the values shown are those of the "expectation of life" or "the value for an annuity of one per year." This dispute has never been settled. It is interesting to note, however, that if this table represents a valuation of annuities by using the value of an annuity of one per year, it follows

51 Kopf, The Early History of the Annuity, XIII Proceedings of the Casualty Actuarial Soc'y 225, 231-33 (1927).