The Investment Company Institute sent a comment letter entitled, "Re: Money Market Fund Reform – Diversification under Section 817(h)," to the Internal Revenue Service last week on how Variable Annuity, or Variable Insurance MMFs may run afoul of IRS diversification rules if they convert to Government money market funds. We learned of the news from mutual fund publication ignites, which covered the letter yesterday in its story, "ICI to IRS: Loosen Up on VA Money Market Regs." Over the past few months, we have heard from 7 VA MMFs with about $6 billion that they plan to convert from Prime to Government due to pending reforms. (For other recent insurance-related News, see Wednesday's, "MetLife Stable Value Study Says Time to Reconsider Money Markets.")

The 8-page ICI letter, addressed to Helen Hubbard, Associate Chief Counsel (Financial Institutions and Products) at the Internal Revenue Service, says, "The Investment Company Institute appreciates the opportunity to have spoken with you and your colleagues on November 5, 2015, regarding the effect of the recently adopted money market fund rules on variable annuity and life insurance products (collectively, "variable insurance products"). As we discussed in our meeting, money market funds that serve as investment vehicles underlying variable insurance products are concerned that the evolving market for U.S. government securities, in light of the new money market fund rules promulgated by the Securities and Exchange Commission ("SEC"), will make it increasingly difficult or impossible for the insurance company segregated asset accounts investing in those funds to satisfy the diversification requirements under section 817(h). As you know, the consequences of failing section 817(h) can be quite dire for the contract holders, insurance companies, and the underlying funds."

Author Karen Lau Gibian, ICI Associate General Counsel, Tax Law, continues, "Given the changing money market fund industry and the expected increased demand for government securities, we ask the Internal Revenue Service ("IRS") to provide a safe harbor under section 817(h) for segregated asset accounts that qualify as, or invest in, "government money market funds," as defined under Rule 2a-7 under the '40 Act. As explained in greater detail below, pursuant to this safe harbor, the IRS would view a segregated asset account investing in a '40 Act-registered fund as adequately diversified under section 817(h)(1) if, among other things: (1) the fund intends to qualify as a government money market fund under SEC Rule 2a-7; (2) the fund manager is authorized to invest in any and all money market fund-eligible government securities, as defined in section 2(a)(16) of the '40 Act; and (3) the fund manager uses its sole discretion to determine in which government securities it will invest."

The letter continues, "Money market funds are a typical investment option in variable insurance products and play a unique role in the functioning and operation of those products. In particular, in addition to serving as a stable very low risk option to which contract owners can allocate a portion of their contract value, they are utilized to process transactions and act as a temporary holding or "parking" place within variable insurance products."

ICI's letter explains, "It is imperative that variable insurance products be able to continue offering as an investment option stable NAV money market funds with no fees or gates.... The only way to continue doing so will be to offer government money market funds, under the recently adopted SEC rules. Given the anticipated increased demand for U.S. government securities, however, it likely will become increasingly difficult or impossible for variable insurance products that seek to qualify as government money market funds to obtain the variety of government securities necessary to satisfy any of the existing diversification tests under section 817(h) and Treas. Reg. S1. 817-5(b). This will have significant impact on the ability of firms to continue to offer these products. It also is likely to have a greater impact on smaller funds than large funds, creating inequities in the industry."

Further, they write, "We thus ask the IRS to issue guidance that would allow variable insurance products to continue to include government money market funds as underlying investment options. Specifically, we urge the IRS to issue a revenue procedure indicating that it will treat a segregated asset account as adequately diversified for purposes of section 817(h).... This revenue procedure would apply only to those variable insurance product funds that are intended to qualify as government money market funds under the SEC rules and would not alter the diversification test under Treas. Reg. S1.817-5(b) for other types of funds."

The ignites story explains, "The Investment Company Institute wants the IRS to provide relief for variable annuity products, loosening restrictions related to diversification requirements for government money market funds included within their investment menus. The concern hinges on requirements that government funds offered through VAs include holdings from at least five issuers in according to certain proportions and the impact on the availability of such products in the face of sweeping industry reform. The ICI notes that there are only five major issuers of government securities in which money funds invest: Treasurys, Federal Home Loan Bank, Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac); and the Federal Farm Credit Bank System (Farmer Mac)."

It adds, "In response, many providers have converted or announced plans to convert prime retail and prime institutional funds, which will be subject to fees and gates, to government products. Crane Data projects that at least $257 billion will move from prime to government money market funds by October 2016." It quotes Joan Ohlbaum Swirsky, counsel at Stradley Ronon, "I understand the hardship.... `Likely, there will be an increased demand for government securities and that might make it difficult for funds to satisfy the test."

As mentioned previously, our running tally of funds planning to convert to Government include 7 Variable Annuity MMFs with about $6 billion in assets. These include: Fidelity VIP MMF, Goldman Sachs VIT MMF, Invesco VI MMF, Dreyfus Variable Investment MMP, Deutsche MM VIP, Nationwide VIT, and Oppenheimer MM VA. To date, we have not heard from VA MMFs from Vanguard, Sunamerica, Transamerica or others, but we'll continue watching filings and announcements.

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