Bloomberg has reported that once again the U.S. Treasury department is actively considering targeting the hedge fund backed reinsurance sector, as it seeks to close what it considers a “tax loophole”.
Bloomberg News reported yesterday that it has ‘obtained’ a letter dated August 9th in which the Treasury told Senate Finance Committee Chairman Ron Wyden of its concern about hedge fund managers establishing reinsurers in low-tax domiciles to route investment capital through to reduce their tax burden.
This has long been a threat to the hedge fund backed reinsurer business model, which continues to be considered as a tax dodge by many in authority. The Treasury, it is said, is weighing legislative and administrative responses.
Bloomberg’s article goes on to explain that the Internal Revenue Service had promised a crackdown in 2003 and the Treasury is concerned that so far nothing has been done and that hedge fund reinsurers continue to be set up.
Bloomberg explains that investors in hedge funds would typically have to pay the normal income tax rate on their earnings, but that by investing in an offshore reinsurers owned by the fund they can pay a lower, long-term capital gains tax rate on sale of the investment.
The hedge fund reinsurer strategy sees a hedge fund manager set up a reinsurer, typically with third-party investors also backing the reinsurer. The reinsurer underwrites business and the premium income is invested in a separate account of the hedge fund itself, so providing a more active or aggressive investment strategy that a traditional reinsurers. At the same time the business underwritten is often lower volatility, mid to long tail, which provides more certainty and duration in the investment timeline for the manager.
Some of the newer hedge fund or asset manager backed reinsurers have actually been set up by reinsurance business people in partnership with a high performing asset manager in order to attempt to outperform the market. That is the same strategy, just the set up is different. The motivation of leveraging premiums within a hedge fund style investment strategy to boost returns is the same.
In fact, often the hedge fund backed reinsurer does not actually invest in the hedge fund, rather it has a private mandate or account which is invested by the hedge fund manager, so investors are accessing a different, albeit similar strategy. It’s also worth noting that the hedge fund itself does not typically invest in the reinsurer, sometimes the manager does though.
So, the concern seems to be that investors are simply using these vehicles to access the hedge fund but to pay less tax than they would if they invested in the U.S. However, the returns investors get from an investment in a hedge fund reinsurer are a combination of the return derived from underwriting, plus investment return of the premium float, minus losses, expenses, operational costs, cost of sales etc, the same as a traditional reinsurers return to investors. That is the same combination of factors that an investor in an offshore non-hedge fund backed reinsurer benefits from.
The difference is the targeted higher investment return happens to come from a hedge fund manager, rather than from the reinsurer investing its own assets more conservatively. However, with insurers and reinsurers currently looking to adjust investment strategies, to compensate for lower underwriting returns, many more will be investing more actively in future.
The key concern is about hedge fund reinsurers which hold a lot of investor and often manger capital, but that do not actually underwrite very much reinsurance business at all. Bloomberg mentions Paulson’s PACRe and Steve Cohen’s SAC Re, which were singled out for having a very low ratio of insurance liabilities to assets.
That shows that not much underwriting was happening at the time, however both were still starting up in 2012 when they were singled out. It would be interesting to see what the ratios were today, with PACRe operated under the Validus group and SAC Re now morphed into Hamilton Re under the watch of Brian Duperreault.
In fact, the hedge fund reinsurers we cover all seem to be doing increasing amounts of underwriting, as they grow and prove the business model to their investors. So the Treasury really needs to find a way to measure whether this is simply a new reinsurance business model that happens to involve major hedge fund managers, or whether they have good reason for their concerns.
Of course the problem with any tax loophole is that someone will find a way to take advantage of them. Look at huge multi-national corporations such as Google, Starbucks, Apple, oil majors etc and you will find they almost all use offshore domiciles, such as Bermuda, Cayman, Dublin and British Virgin Islands, to route finances through in order to reduce tax liabilities.
Perhaps the Treasury, if it really wants to shut tax loopholes and increase its revenues, should look to the wider issue of corporations avoiding paying their dues locally, rather than focusing on a business model which is actually a reinsurance play with a high performing asset management strategy.
By all means, if evidence that specific hedge fund reinsurers have been established simply as tax avoidance conduits can be proven, then those companies should be legislated against or perhaps even stopped from doing that business. However if the Treasury is wrongly targeting a whole segment of the reinsurance market simply because of the involvement of high profile hedge funds, then perhaps it should look to close the loopholes that other industries are already known and proven to take advantage of.
Note: At Artemis we can have no idea of the motivations of an investor in a hedge fund reinsurer regarding their tax arrangements. All we can comment on is the business model, which appears a viable alternative to the traditional reinsurance strategy at this time.
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