ABIR responds to proposed IRS hedge fund reinsurer tax rules (PFIC)

by Artemis on July 27, 2015

The Association of Bermuda Insurers and Reinsurers (ABIR) has submitted comments in response to the U.S. Treasury Internal Revenue Service’s proposed rules targeting the perceived tax issue associated with hedge fund reinsurance strategies.

The proposed rules, originally published by the IRS in April, ultimately seeks to address “passive income” issues in offshore reinsurance vehicles operated by onshore hedge fund managers.

The IRS and other U.S. politicians say that hedge fund managers are actively avoiding taxation through this ‘loophole’, which the proposed rules would seek to close.

However, the PFIC rules in their proposed form could impact the operations of many legitimate reinsurance and insurance businesses, including those affiliated with hedge fund managers, and could also impact the insurance-linked securities (ILS) and catastrophe bond business.

Hence the ABIR has provided a thoughtful response, including five suggestions for changes to the rules, which it believes would help to establish regulation that makes it harder to establish insurance or reinsurance businesses for the purpose of deferring or reducing tax, but avoids negatively impacting legitimate re/insurers and related ILS strategies.

In current form, the IRS’ proposed regulations would “result in current US taxation of income for a wide range of genuine foreign insurance and reinsurance companies,” explains ABIR President and Executive Director Bradley Kading in the response letter.

The ABIR, the letter says, believes that at the heart of the issue is the question whether an insurance or reinsurance entity is actively underwriting and holding insurance risk. Regardless of the business model chosen, the primary purpose of a re/insurer is to assume risks from customers.

The “promise to pay” future losses is what distinguishes insurance and reinsurance from other businesses and is made possible by the capital of the companies, therefore the ABIR believes that the proposed regulations should focus on objective ways to measure assumed insurance risk.

The five recommendations cover many of the key points raised that affect the ILS, catastrophe bond, collateralized reinsurance and related business models, while still maintaining a way to test whether a re/insurer is active or purely an investment driven vehicle.

Firstly, the ABIR recommends removing the piece from the active conduct provision where it restricts “recognition of affiliated, shared or contracted employees.”

This “active conduct” piece of the proposed PFIC rules is so broad that it risks encompassing a raft of reinsurance company and ILS business strategies, including catastrophe bond issuers, sidecars, protected cell companies (PCC’s) and other vehicles.

In 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.

The “broad requirement for employing underwriting, investment and administrative staff within the legal entity is not consistent with how insurance business is generally conducted today,” the ABIR’s letter explains.

It would impact many legitimate insurance and reinsurance business models, the ABIR notes, and also take the U.S.’s regulations out of step with other regions such as the EU, making it impossible for foreign re/insurers to comply with both the U.S. and the EU at once.

As a result, the ABIR recommends; “The provisions in the active conduct definition restricting recognition of affiliated, shared or contracted employees should be removed from the proposed regulation.”

The second issue the ABIR raises and makes an alternate recommendation for, is the issue of outsourcing investment operations.

“The analysis of an active insurance business should not dictate where or what form the investment advice takes for an insurance company as long as it is clear that the responsibility for investment outcomes rests with those responsible for overseeing the contracted services,” the letter states.

Insurers and reinsurers around the world have been outsourcing some of their investment activities for years and the requirement that investment is provided within the legal insurance entity would be restrictive and a step backwards.

It’s also important to note that in the low yield investment world insurers and reinsurers are looking for better returns for their asset portfolios, which is driving many to investigate alternative investments. These strategies will largely result in some further investment outsourcing.

The ABIR recommends; “The restrictions on outsourcing investment management should be removed from the proposed regulation. If they were applied to US insurers they would disqualify large numbers of companies as active insurers.”

Next, the ABIR asks that the IRS’ rules take into account the fact that insurers and reinsurers are subject to a variety of requirements in order to be licensed and registered in a specific domicile, and that this should be considered part of a test that they are indeed active.

For example, under Bermuda law an insurance or reinsurance company has to meet certain characteristics to even be registered or licensed as such.

The ABIR recommends; “The proposed regulation should recognize licensing and regulation as an insurer in a domiciliary jurisdiction as being an integral part of a test for an active insurer.”

The next recommendation looks at how to establish a ‘bright line’ test for a reserve to assets ratio. Here the ABIR goes to some length to explain that any test needs to be guidance, followed up by further investigation to truly establish whether a company is flouting the rule to be an investment vehicle.

The percentage of reserves to assets differs for many reasons, from stage of a company’s life, to business model, risks underwritten, regulatory environment and oversight, strategy and more. Therefore any test needs to be at a reasonable level, below the averages seen widely across the international insurance and reinsurance market.

The ABIR explains the importance of a bright-line test; “If such a test could be accurately constructed it would remove long standing uncertainty with regard to application of PFIC rules and it would allow Treasury to accomplish its objective of challenging companies that are attempting to “defer and reduce the tax that otherwise would be due with respect to investment income.””

The ABIR recommends a “bright line safe harbor test of a 15% reserve to assets ratio” is created. As well as the test, the ABIR recommends that it is important to offer “a facts and circumstances test which would allow some insurers that are disqualified under the bright line test to be qualified after documenting their insurance industry risk bearing activities.”

That would ensure that legitimate companies are not caught out by the bright-line test, such as start-ups or companies with specific scenarios that may require lower ratios to be operated for periods of time.

“ABIR determined 15% (reserves equal to or exceeding 15% of assets) as the appropriate ratio for the bright line based on an analysis of publicly available data for US and Bermuda insurers and modeling of reserves-to-assets,” it goes on to explain.

The ABIR analysed 40 Bermuda insurance and reinsurance firms using that 15% bright-line and found that 4 would have failed based on data at the end of 2014, with 2 of these being companies “sometimes identified in the press as potential foreign investment companies.”

By failing they would then need to prove via other measures that they qualify for the exception, the facts and circumstances test.

ABIR says that 15% seems about right for a bright-line test, as ; “A leading US personal lines insurer had a ratio of 17.3% in 2014, and a leading commercial lines carrier had a ratio of 18%. A large US insurer, part of a diversified holding company group, had a ratio of 18.5%. And the country’s oldest insurer— established by Benjamin Franklin in 1725— had a ratio of 14.6%.”

The ABIR recommends; “The proposed regulation should be amended to include a bright line safe harbor test of a 15% reserves to assets ratio.”

The final recommendations is concerned with a facts and circumstances test, which the ABIR believes should include an analysis of the insurer or reinsurers insured exposures.

“An analysis of insured exposures should be an essential element of such a test. To afford a fair review in a timely fashion, we recommend this facts and circumstances test be promulgated under a rebuttable presumption combined with a deeming provision,” the ABIR explains.

The ABIR’s letter notes that for property catastrophe reinsurance firms the light hurricane years have enabled them to run down much of their prior year reserves, while also building assets due to lower loss levels.

As a result these property catastrophe reinsurers, that are “obviously in the reinsurance business and have reinsured substantial risk during this light hurricane experience period” could fail a bright-line reserves to assets test.

“Since Treasury has indicated they do not intend to penalize insurers taking on substantial risk, a facts and circumstances test would need to be timely and workable to exempt these insurers,” the ABIR writes.

Continuing; “We believe that it is necessary to also have a forward-looking test that takes into account that an insurance company must also hold capital to meet its “obligations” under contracts to pay claims on losses that have not yet occurred. This is particularly important for specific types of insurance companies, such as start-up companies, property catastrophe insurance companies and other specialty companies that form a large proportion of the insurance companies domiciled in Bermuda.”

The ABIR polled some of its membership to report probable maximum losses for a 250 year and a 100 year U.S. hurricane and U.S. earthquake event, finding for the 16 reporting entities:

  • For a 1/100 year net US earthquake event, insurers risk losing 8% of their capital due to a single loss event;
  • For the 1/250 year net US earthquake event, insurers risk losing 13% of their capital due to a single event;
  • For a 1/100 year net US hurricane event, insurers risk losing 17% of their capital due to a single event;
  • For a 1/250 year net US hurricane event, insurers risk losing 23% of their capital due to a single event.

The ABIR concludes; “Based on the confidential survey of ABIR members, we believe it will be beneficial for the IRS to review insured exposure data as one of the key elements in a facts and circumstances test. Review of such data helps solve some of the problems created by an exclusive reliance on a bright line backwards looking reserve to assets test.”

The ABIR recommends; “A measure of insured exposures is a way to understand insured risk held by the legal entity and assess the adequacy of capital to support that risk. Both aggregated insured limits and PML measures are common ways to measure and weigh the impact of insured exposures held by a legal entity and are appropriate elements of any facts and circumstances review.

“The proposed regulation should include a facts and circumstances test to allow a review of insurers which do not qualify under the bright line test. To afford a fair review in a timely fashion, we recommend this facts and circumstances test be promulgated under a rebuttal presumption approach with a deeming provision. Insurers would make documentation available that would define their status as an active insurer. In the course of an audit, US taxpaying shareholders could make the material available to the IRS. Unless informed by the IRS within 90 days that the taxpayer submission is insufficient to establish that the insurer is actively engaged in the business of taking on insurance risk, the taxpayer can operate as it does currently without the insurer being identified as a PFIC. If the IRS determines that more information is needed then it informs the taxpayer that additional information must be provided and reviewed by the IRS so that within the preceding 90 days the IRS can reach an affirmative decision after a review of the additional facts and circumstances.”

The ABIR believes that if the Treasury were to adopt these recommendations it could establish a fair active insurer PFIC test which would provide legitimate insurers and reinsurers a way to remove uncertainty about their tax status.

At the same time the Treasury would be able to identify those re/insurers which it could test for classification as an investment vehicle. The ABIR also notes that its recommendations would be reasonable to administer in a timely fashion.

The recommendations would enable a bright-line test to test for active insurers, allowing those to be removed from scrutiny, provide a facts and circumstances test to enable those failing a bright-line test to be further scrutinised and immediately allow the Treasury to identify any re/insurers that should be categorised as PFIC.

The ABIR recommends a three-year transition rule to allow existing companies to document activities to their shareholders, in order to comply with new regulations. The ABIR requests a public hearing on the proposed rule making in order to ensure concerns are heard and fully explained.

The letter from the ABIR addresses the concerns that the insurance and reinsurance industry have with these rules, by proposing that companies should have a chance to undergo a facts and circumstances test which would allow them to demonstrate that they are taking on risks and not purely an investment vehicle.

That goes a long way to solving the core issues, while the removal of items about active conduct resolve the issues related to ILS and catastrophe bond vehicles being classified as PFIC.

You can read the full document from the ABIR here.

Other comment letters have been submitted to the IRS regarding this proposed rule making, however they seem to predominantly focus on hedge fund managers and simply call for any tax loophole to be closed, without offering any way to address the concerns that the proposed rules are too broad and all-encompassing.

The ABIR offers a way for the Treasury and IRS to get what they want, while also protecting legitimate insurance and reinsurance businesses and making sure that individual company circumstances and strategies are considered, which is vital should any rule be enforced.

The 90 day deadline for comments officially expired last Thursday, so it will now be in the IRS’ hands to consider all the comments it has received before coming forwards with any further recommendations or bringing a rule into law.

Also read:

No rating impact from offshore reinsurance tax changes: A.M. Best.

Hedge fund reinsurance tax legislation introduced by Wyden.

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

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

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