PFIC rules could affect catastrophe bonds, sidecars, ILS funds & cells

by Artemis on May 26, 2015

In current form, the U.S. Treasury Internal Revenue Service’s proposed rules for Passive Foreign Investment Companies (PFICs) could impact a number of alternative risk, reinsurance and ILS structures and activities.

The IRS released the proposed rules as an attempt to clamp down on a perceived tax loophole, which certain politicians believe is benefiting hedge fund backed reinsurance companies and their investors.

These legislators have claimed that some hedge fund managers are using reinsurance and offshore vehicles to help them avoid paying tax on income that would normally be taxable domestically.

PFIC looks specifically at how active an insurance or reinsurance company is, testing it for passive income and active conduct. However, the proposed PFIC rules are now so broad that they risk encompassing a raft of reinsurance company and ILS business strategies.

In current form the regulations may negatively impact the ability of such vehicles as catastrophe bond issuers, collateralized reinsurance sidecars, ILS fund structures and also protected cell companies (PCC’s) to carry on as they operate today.

The proposed PFIC regulations are raising concern across the reinsurance and ILS sector due to the lack of explanation about how they would test for “active conduct”.

In their current form the regulations appear to require reinsurance or insurance-linked securities (ILS) vehicles to have their own employees and officers providing substantial of the services required to operate the business.

Of course when you look at the ILS space and its use of reinsurance vehicles that effectively act as mechanisms to transact, transform or pass-through insurance and reinsurance risks, often without any real employees at all, it’s clear that the proposed regulations could be an issue.

Laura Barzilai, the co-leader of law firm Sidley Austin LLP’s tax practice, spoke with Artemis to highlight what it would mean for the ILS market if the PFIC regulations went ahead unchanged.

“The recent issuance of the proposed PFIC regulations is a significant event for non-U.S. reinsurance companies and it has particular ramifications for the alternative risk transfer space.

“If the regulations were finalized as proposed, every cat bond issuer or side car would be a PFIC, as would many reinsurance companies owned or accessed by ILS funds, because of the lack of employees,” Barzilai explained.

Catastrophe bonds are special purpose reinsurance vehicles which effectively have no active employees. Typically transacting a single reinsurance contract to effect the risk transfer and transformation, from insurance, to reinsurance, to securitised notes, the vehicle acts as a tool rather than an active insurance business.

Under the proposed PFIC regulations, where insurance businesses would need to have employees, officers and directors actively engaged in operating the business, a cat bond issuer could be designated as a Passive Foreign Investment Company (PFIC).

Similarly a reinsurance sidecar vehicle is largely a passive company, that holds risk in order to segregate it and enable third-party investors to fund it. The underwriting is often undertaken by a parent company, the claims and other functions also provided by the parent or outsourced. So again, designation as a PFIC could occur under the proposed rules for many of the current collateralized reinsurance sidecars.

ILS fund manager business structures often feature reinsurance vehicles used to transact and transform collateralized reinsurance. These vehicles typically have little to no employees, as the staff of an ILS manager are typically employed by the investment manager company.

Again, that could mean that ILS fund manager-owned reinsurance vehicles would be designated as PFIC’s, under an unchanged version of the proposed rules.

Barzilai explained further; “In determining whether a company is engaged in the ‘active conduct’ of an insurance business, the proposed regulations do not take into account activities performed by employees of ‘related’ entities. The proposed regulations don’t define what it means to be ‘related.’

“Many companies use some form of shared services arrangement, so it seems likely that after comments are absorbed, the final regulations may count the activities of employees that work for ‘related’ companies, perhaps defining ‘related’ as ‘commonly owned.’ This change, however, wouldn’t help an ILS fund sponsor, because the fund sponsor probably wouldn’t be treated as “related” to the reinsurance company.”

So in their current form the proposed PFIC regulations could have wide-reaching ramifications for the ILS sector. Unchanged the regulations could see many ILS structures designated as PFIC, which could be detrimental to the ILS market and ILS manager businesses, depending on how investors and counterparties viewed the designation.

The PFIC regulations could also affect the use of segregated or protected cell companies by ILS players, a commonly used vehicle or structure for transacting collateralized reinsurance, or for enabling investors to access the returns of reinsurance portfolios and contracts on a segregate, bankruptcy remote basis.

Tracy Williams, co-head of the insurance tax practice at Sidley Austin LLP, commented; “The alternative risk transfer market accesses segregated accounts for a variety of purposes. A different set of proposed regulations would treat each segregated account as a separate corporation.

“Because there are no employees at the segregated cell level, the combined effect of the two sets of proposed regulations could be that no segregated cell (regardless of how many reinsurance contracts are written on its behalf) can avoid PFIC status.”

So again, this comes down to the view that under the proposed regulations reinsurance companies need to have dedicated full-time staff, at least performing a substantial proportion of operations, in order to avoid being designated as a PFIC.

It’s hoped that there will be a sufficient response to the IRS’ request for comments on the proposed PFIC regulations in order to avoid any impact to the ILS space. Market participants should make their concerns known and explain why the structures used in ILS are operated as they are.

The proposed regulations perhaps seem to have been rushed out, without the full potential impacts on the reinsurance market having been thought through. Hence the consultation period and the importance of having your say, if you have any concerns, about how these rules might be finalised.

It’s likely that, even in their unchanged form, the ILS market would be able to find ways to navigate these rules, adjusting their structures with the help of legal experts. However that would make life more difficult, expensive and force unnecessary change on ILS managers and third-party reinsurance capital structures, even though they are not the target of the PFIC rules.

Also read:

U.S. IRS proposes hedge fund reinsurer tax regs, requests comments.

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