After months of back and forth between Senator Ron Wyden (D-Ore.) and John Koskinen, the Commissioner of the IRS, regarding hedge fund reinsurance, the Commissioner has vowed to produce further IRS guidance. On February 3, 2015, the Commissioner told Senator Wyden that he would produce guidance within 90 days. Over the past several months Wyden has berated the IRS for allowing hedge fund managers to take advantage of a tax “loophole” by organizing offshore reinsurance companies which then funnel money into the manager’s fund (For a general discussion on hedge fund reinsurance, read my previous article by clicking here.)
Personally, I was amazed to see that the Commissioner of the IRS had agreed to commit scarce departmental resources to issue further guidance on a tiny, remote corner of the reinsurance industry at the behest of Senator Ron Wyden. Who knew that a single Senator could basically badger and guilt the Treasury Department into issuing guidance? Perhaps Senator Wyden can make some more prominent sections of the Code his next cause and get taxpayers some badly needed and long overdue guidance. It’s not clear why Senator Wyden finds hedge fund managed reinsurance so offensive, but Treasury and the IRS should be left alone to determine where guidance is needed and the priority each project deserves.
Hedge fund reinsurance is, in most instances, just like any other reinsurance company except that it chooses to have its reserves managed by a single hedge fund manager. The concept is that traditional reinsurance, and insurance for that matter, historically has sought to create value only on the liability side of the balance sheet. They typically make or lose money by writing insurance or not writing insurance versus certain risks. In instances where an insurer does decide to write insurance (i.e., instances where it thinks it can make a profit), the premiums received are generally invested in fixed income securities with relatively low risk and maturities chosen to best match the anticipated liabilities.
The idea behind hedge fund reinsurance is that value can be created on both sides of the balance sheet. Using the typical reinsurance model on the liability side but utilizing the hedge fund model on the asset side. Not only does this dual sided methodology enhance asset yields, it also permits the reinsurer to be smarter and more selective on the liability side, thereby increasing liability side profits as well. Having a profitable asset side of the balance sheet permits an insurer to not write insurance when the risk/reward profile is less than optimal. Traditional insurers and reinsurers, profiting only from the liability side of the balance sheet, do not typically have this luxury. If they are not writing insurance and collecting premium on a monthly basis, their profits become stagnant.
Of course, not writing insurance in a buyer’s market flies directly in the face of Senator Wyden’s belief of what a “real” insurance company is. The Senator seems to believe that a low ratio of insurance liabilities to total assets proves that an insurance company is really just a tax “loophole.” In fact, allowing an insurance company’s insurance liabilities to fall in times of bad risk/reward profiles is simply good business. However, the Senator has keyed in on a determining factor. The ratio of insurance liabilities to total assets does, at specific points in time, differentiate a traditional liability side only reinsurance company from a modern reinsurance firm with advanced asset managers (i.e., a hedge fund managed reinsurance company). As stated above, the traditional reinsurance company can rarely afford to stop writing new insurance so their ratio of insurance liabilities to assets is fairly stable. But this is not always the best business case for the company.
In Notice 2003-34, 2003-1 C.B. 990, the IRS analyzed the very issue that Senator Wyden has recently latched onto. In that Notice, the IRS came to the conclusion that as long as the insurance company wrote real insurance or reinsurance to third parties and took on real insurance risk, it would be permitted to avail itself of the exemption from PFIC treatment for a company predominantly engaged in the active conduct of an insurance business. The IRS correctly recognized that there are methods to severely limit the economic risks under insurance contracts and that such a ruse should not be afforded the tax qualification as real insurance. However, making the determination between real insurance and limited risk contracts is a delicate, fact specific analysis. Thus, distinguishing between a real reinsurance company and an investment company seeking to avoid U.S. tax is also a fact-specific analysis. After all, every insurance company is, in essence, an investment company that also writes insurance in varying degrees. Simply looking at a company’s insurance liability to total asset ratio at a particular moment in time is not logical, let alone accurate. For example, traditional reinsurers that specialize in catastrophe risk can have relatively low insurance writing activity for substantial periods of time.
So, how might the Commissioner fulfill his promise to Senator Wyden and produce effective guidance that properly distinguishes a real reinsurance company from a hedge fund? If one wanted to simply ban the practice of U.S. fund managers setting up offshore reinsurance companies the proposal could focus on reinsurance companies that have more than 90% of their assets managed by a single external manager. That would effectively differentiate the traditional reinsurers from the modern hedge fund sponsored vehicles. However, what if the reinsurer writes a significant amount of reinsurance coverage but nonetheless has its entire asset base managed by a single external manger? Should that company not be afforded the insurance exception from PFIC status? The rule would need to identify companies with a combination of a single external manger and a low insurance risk to asset ratio. However, as stated above, a momentary low risk to asset ratio is not necessarily indicative of tax avoidance. Thus, any such insurance risk to asset ratio should be measured over a meaningful period, say 36 months. In short, the IRS reached the right conclusion in its 2003 Notice. A hedge fund managed reinsurance company can qualify as a real reinsurance company under the correct set of facts. Furthermore, there is no hard and fast rule that can correctly differentiate between a real reinsurance company and an investment company that occasionally writes insurance.
Treasury and the IRS should police this area of the law and should be vigilant in rooting out bad actors, but Senator Wyden’s talents are probably best devoted elsewhere. The resources of the IRS should not be at the disposal of a single Senator regardless of what the issue is. It was simply bad form for the Commissioner to bow to the whims of Senator Wyden, in this case. There are myriad areas of the tax world begging for IRS and Treasury attention that are much more deserving than hedge fund advised reinsurance.
For more information on hedge fund advised reinsurance or any other asset management tax issues, please contact your normal WithumSmith+Brown partner.