IRS to issue regulations on hedge fund reinsurance strategy

The U.S. Internal Revenue Service will aim to release regulations related to the hedge fund reinsurance strategy within 90 days, after its commissioner was quizzed on the lack of movement on an issue that has been raised repeatedly in Senate.

Internal Revenue Service Commissioner John Koskinen told members of the Senate Finance Committee on yesterday that his agency would seek to draw up legislative guidance in order to address the perceived issue. The aim is to stop what some see as a way for hedge funds to avoid tax on income by using offshore reinsurance operations and for their investors to avoid U.S. tax laws too.

At the Senate Finance Committee hearing yesterday, which was ostensibly supposed to address IRS funding, Koskinen was pressed to present a timeline for issuing guidance regarding the hedge fund reinsurance strategy.

Once again it was Senate Finance Committee Chairman Ron Wyden who raised the issue, asking Koskinen to provide the timeline. Wyden said that he believes that some hedge funds “masquerade” as reinsurers, establishing operations in domiciles where tax laws are more favourable.

The hedge fund backed reinsurer business model has for a long time been considered as a potential route to avoid tax by some in authority in the U.S. They see the ability of a hedge fund manager to accumulate assets to invest offshore, while undertaking minimal underwriting, as a way to obtain long-term capital without the end-investors paying U.S. taxes on it or the hedge fund being taxed being taxed as highly.

The accusation has in the past been primarily leveled at hedge fund reinsurers that do not deploy all of their capital in underwriting, suggesting that more is invested in the hedge fund investment strategies than is actually used for reinsurance business. The U.S. Senators have sought guidance from the Treasury and now the IRS as they seek to close any loopholes that they perceive as existing.

The strategy typically sees a hedge fund manager setting up a reinsurer, with third-party investors also backing the vehicle. 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 reinsurer would follow. 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. This is how the strategy generates float, or longer-term capital to put to work.

This is a legitimate strategy employed by many insurers and reinsurers though and is becoming increasingly prevalent now that many reinsurance firms are moving into longer-tailed lines of business, or seeking to add some additional performance via a higher risk investment strategy.

The Senators concerns revolve around the ability of end investors to avoid tax and of the hedge fund managers to pay less tax, due to deferment and then only being required to pay capital gains.

However, as we’ve written before, the profits investors get from investing in a hedge fund reinsurer are a combination of the return derived from underwriting, plus the investment return contribution of the premium float, minus losses, expenses, operational costs, cost of sales etc. That is the same combination of factors that an investor in an offshore non-hedge fund backed reinsurer benefits from.

However, Wyden sees a “decade worth of foot-dragging” on this issue, as it had originally been raised to the IRS and Treasury in 2003. Wyden said that every time he raises it the issue is passed around between the Treasury and the IRS and he wants to see it resolved.

Koskinen said “We have already prepared guidance and are working with Treasury to put it into final form,” so this guidance or regulation is definitely coming. Koskinen said they are committed to doing so and will do their best to make their guidance on hedge fund reinsurers public in 90 days.

Koskinen said that the IRS has also worked with and met with insurance associations as there are legitimate reinsurance companies that have large reserves to invest, due to their claims being episodic. So the IRS needs to produce rules that target the perceived tax issue directly, so as to avoid affecting other legitimate reinsurance firm strategies.

This continues to appear a way to specifically target hedge funds, perhaps instead of addressing wider issues of taxation and under-payment. If the U.S. truly wants to stamp out the ability of investors to avoid paying U.S. taxes, it perhaps first needs to address the issue of mega-corporations that shift money around the world to reduce taxation.

Not a week passes without a press article regarding a large multinational company that doesn’t pay its full taxes in one country or another. This issue requires an international solution rather than seeking to target the handful of hedge fund backed reinsurers.

The interesting thing about this issue is that there are in fact only a handful of reinsurance firms that are backed by hedge funds, including Third Point Re (backed by Dan Loeb’s Third Point LLC), PaCRe (backed by John Paulson’s Paulson & Co) and Greenlight Capital (backed by David Einhorn’s Greenlight).

Others that could be considered might include Watford Re, the hybrid reinsurer partnership set up by Arch and Highbridge Principal Strategies, LLC, a subsidiary of J.P. Morgan Asset Management. Or perhaps even Hamilton Re, as its assets are managed by Two Sigma, which could be considered a hedge fund. Or what about some of the significantly smaller asset manager owned reinsurance firms?

In fact, we’d struggle to count ten in total even including the very small start-ups, which is hardly a prevalent strategy in the reinsurance market. Even in the currently challenged environment which does encourage partnering with asset managers as a way to enhance the returns on the premium investments, the strategy is not being adopted widely at all quickly.

It will be interesting to see how exactly the IRS and U.S. Treasury elect to address this perceived issue. It’s not going to be a simple task to satisfy everyone and how this is implemented is going to be key to its actual success, without hindering the activities of legitimate reinsurance firms.

Once again we have to stress that at Artemis we can have no idea of the motivations of an investor in a hedge fund reinsurer, or the hedge fund manager, regarding their tax arrangements. All we can comment on is the business model, of more aggressive investment of premium float from mid to long-tailed risks to improve overall returns, which continues to be a viable alternative to the traditional reinsurance strategy at this time.

You can view the exchange in the U.S. Senate yesterday in this YouTube video below.