Proposed Tax Reform Act Targets Hedge Fund Reinsurance Strategies

Institutional Investor's Alpha
By Perry Lerner

Several high profile hedge funds have recently raised significant amounts of capital for offshore reinsurance companies, which invest in or along-side their principal investment strategies. Investing in a reinsurance affiliate of a hedge fund is an attractive proposition for both the fund and its investors. For the fund managers, the capital is permanent and thus not subject to redemption. As an offshore company earnings on its reserves are exempt from current U.S. Taxation.

Investing in a reinsurance affiliate of a hedge fund is an attractive proposition for both the fund and its investors. For the fund managers, the capital is permanent and thus not subject to redemption. As an offshore company earnings on its reserves are exempt from current U.S. taxation, as long as the company is not conducting business in the U.S. In lieu of redemptions, investors seeking liquidity may sell their shares in the market. Moreover, if investors have held their shares for 12 months, their gains on selling their reinsurer shares are long-term capital gains, taxed at more favorable rates than the underlying hedge fund’s earnings, which often consist of short-term gains. As long as the exposure to reinsurance risk is kept under control—often through a variety of third party risk reducing arrangements—the investor has all the economic benefits of investing in the hedge fund, with favorable tax treatment and fewer administrative burdens. As a result, many hedge fund-sponsored reinsurance vehicles trade at a premium to book value.

This happy state of affairs may come to an end, however.  A little-noticed provision of the Tax Reform Act of 2014 proposed by House Ways and Means Committee Chairman Dave Camp (R-MI) strikes at the heart of this strategy. For now, capital exposed to a fund’s reinsurance business is limited to the amount needed for the offshore company to be classified as an insurance company under local insurance law. As a result of operating as an insurance company, the hedge fund reinsurer is excluded from taxation that would normally apply to an offshore investment vehicle under the Passive Foreign Investment Company (PFIC) rules.  Current law does not provide any minimum level of insurance premium income to qualify for this exemption.  Accordingly, only a minimal amount of the company’s income need be from reinsurance activities and the preponderance of the income can be from its hedge fund investments.                                                       

Representative Camp’s proposal would require that 50 percent of the reinsurer’s gross receipts consist of insurance premiums to avoid being treated as a PFIC.   This is a departure from the current PFIC test, which is based solely on a carrier’s reasonable reserves.  As a result, a reinsurer’s investment income would be limited and its earnings capped. Should a reinsurer not satisfy the proposed new standard and therefore receive PFIC treatment, it would result in the current inclusion of income, conversion of long-term gain to ordinary income, and, in some cases, an additional charge when tax is deferred. The proposal, if enacted, would significantly decrease the benefits of the reinsurance model among fund managers.

We think the tax proposal targets the reinsurance strategy and will attract continued attention from tax reformers and regulators as the legislative process evolves in Washington, D.C. Hedge fund managers and investors should take note of the ongoing legislative debate and prepare accordingly.

 At a minimum, the existing reinsurance vehicles should determine the feasibility of increasing their premium income.  The issue, of course, is whether this can be done without increasing the risk of loss in the fund’s insurance operations.   Investors seeking returns from insurance company investments can easily invest in traditional insurance companies.  As for those thinking of this strategy, the time and expense of creating and operating a reinsurance vehicle is not inconsiderable and may cause many to pause until there is greater clarity on the potential tax risks. Hedge fund managers considering the reinsurance strategy should look at the potential benefits of creating an Insurance Dedicated Fund (IDF) for the benefit of their investors. An IDF offers many of the benefits of reinsurance affiliates without the insurance or tax risks. An IDF is a fund, often a hedge fund clone, that is only available to life insurance or annuity investors.

For investors reluctant to take the risk of insurance company operations, individuals or institutions can simply purchase a private placement life insurance policy or annuity, which invests in an IDF invested in a strategy similar to the sponsor’s hedge fund. In the case of life insurance, there is no current income taxation and all gains are exempt from income tax on the death of an insured.  Where an investment is held in an annuity, tax is deferred until the time of withdrawal. Every withdrawal is treated as a partial recovery of the investment in the insurance contract so the rate of tax is always reduced until the entire investment has been withdrawn. This more than compensates for the loss of capital gains treatment.                                                                    

An increasing number of funds are creating IDFs either instead of, or as a complement to, the creation of a reinsurance company. First, the experience of most of the entities with IDFs is that withdrawals are less frequent than customary hedge fund redemptions. Second, the costs of creating and operating an IDF are considerably lower than operating a reinsurance company. Third, managers of an IDF can concentrate on what they know best- generating alpha and positive returns while avoiding the risks entering a business that is far less familiar. Moreover, none of the recent tax reform proposals affect the taxation of life insurance and annuity products.                                                                   

 Perry Lerner is chairman and CEO of Crown Global Insurance LLC, which partners with clients to enhance alternative investments.