Legislation has been introduced by Oregon Senator Ron Wyden stipulating rules under which a hedge fund or hybrid investment / underwriting reinsurance firm would have to ensure a certain percentage of its assets were allocated to underwriting at all times.
Wyden, a member of the Senate Finance Committee, has been seeking to close what he deems a loophole that could allow hedge fund managers to avoid paying as much tax on their assets, by utilising offshore reinsurance structures.
It’s a discussion that has been ongoing for a number of years, with Wyden pushing for tighter controls on the way reinsurance firms linked with hedge funds go about their business.
With this bill that he’s introduced, Wyden hopes to provide a “bright-line test” to evaluate which insurers or reinsurers are enabling asset owners to engage in this perceived hedge fund reinsurer tax loophole.
Clearly, since this issue first came to light as long ago as 2012, the hedge fund or investment-oriented reinsurance strategy has evolved considerably, with many different degrees of underwriting or investment focus proposed by a number of recent high-profile start-ups.
Specifically, Wyden seems to be aiming to target well-known, large hedge fund managers who started reinsurance companies in the last five years or so.
The concern about rules of such nature is that a bright-line test, which provides a strict guideline on how much of a reinsurers assets should be actively engaged in insurance or reinsurance business at any time, could risk hurting legitimate business strategies.
This all comes back to the topic of active conduct and the PFIC, or Passive Foreign Investment Company, rules that we wrote about recently here.
Wyden’s bill, named ‘The Offshore Reinsurance Tax Fairness Act’, focuses specifically on active conduct from the point of view of the proportion of assets which are allocated to underwriting, or to investment activities, in reinsurance firms.
It proposes that an insurance or reinsurance company’s liabilities must be greater than 25% of its assets. If the figure is less than 25% but above 10% then the proposed bill says that the company could still be engaged in insurance or reinsurance, depending on facts and circumstance.
If the figure is less than 10% then the company would not be considered an insurer or reinsurer and would not be eligible for PFIC exemption and therefore would be subject to the current levels of taxation, the bill explains.
Wyden believes that those falling below 10% would be company’s that are not legitimately engaged in insurance or reinsurance business, which his bill overview says would “target most of the hedge fund reinsurance companies that are taking advantage of the current law loophole, making them ineligible for the PFIC exception and stopping this abuse.”
A problem here is that some of the investment-oriented reinsurers that have been established in recent years target a slow build up, converting assets into liabilities carefully, to ensure duration is right and that liabilities match asset return ambitions. This can mean a company could fall below 25% easily in its first year or two of existence, as underwriting traction builds.
Another problem is that recent business strategy evolution sees re/insurers launching which actively seek to ride the market cycle by allocating more capital to underwriting, when the market is conducive, but pulling back and putting more assets into the investment side, when the underwriting conditions are not so attractive. Richard Brindle’s Fidelis is an example of a high-profile, rated company launching with exactly this strategy.
So perhaps the loophole that the Senator perceives is not as clear-cut and a bright-line test could risk challenging some of the interesting business models to come to market in recent months?
The nuances of new hybrid underwriting and investment reinsurance strategies makes such a bright-line test particularly challenging to implement without hurting legitimate business models. Company’s will likely launch which have no hedge fund backing, but which use hedge fund’s for their investment purposes, again perhaps Fidelis is an example here.
Putting in place legislation that hurts or makes it impossible to execute a legitimate new business model, or perhaps makes it impossible to execute as effectively, seems rash. Perhaps any legislation needs to consider the evolution of the insurance and reinsurance market and how the business is changing?
‘The Offshore Reinsurance Tax Fairness Act’ would make abusing the taxation status of offshore reinsurance harder, that is undeniable, but whether it truly meets the Senator’s goals without harming future legitimate business models is perhaps questionable.
The bill does not go into the other PFIC issue of outsourced employees, another part of the active conduct issue that we wrote about in our previous article and that could have wider ramifications for insurance-linked securities (ILS) business. Wyden’s bill instead solely focuses on the percentage of liabilities to assets factor.
Wyden explained; “We need a fair tax code that doesn’t allow for winners and losers. For over ten years now this loophole has allowed some hedge fund investors to avoid paying hundreds of millions of tax dollars. It’s time we shut it down for good.”
The overview of Wyden’s bill is found below and the proposed legislative changes can be found here (in PDF format).
The Offshore Reinsurance Tax Fairness Act
Offshore businesses that reinsure risks and that invest in U.S. hedge funds create the potential for tax avoidance of hundreds of millions of dollars. In these arrangements, a hedge fund or hedge fund investors make a capital investment in an offshore reinsurance company. The offshore reinsurance company then reinvests that capital (as well as premiums it receives) in the hedge fund. The owners of the reinsurer take the position that they are not taxed on corporate earnings until either those earnings are distributed, or the investors sell the corporation’s stock at a gain reflecting those earnings.
The passive foreign investment company (“PFIC”) rules of U.S. tax law are designed to prevent U.S. taxpayers from delaying U.S. tax on investment income by holding investments through offshore corporations. The PFIC rules provide an exception for income derived from the active conduct of an insurance business. The exception applies to income derived from the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business and which would be subject to tax under Subchapter L if it were a domestic corporation.
Current law does not prescribe how much insurance or reinsurance business the company must do to be considered predominantly engaged in an insurance business. Senate Finance Democratic staff investigative efforts show that some companies that are not legitimate insurance companies are taking advantage of this favorable tax treatment.
The Offshore Reinsurance Tax Fairness Act would provide a bright-line test for determining whether a company is truly an insurance company for purposes of the exception to the PFIC rules.
Under the new rule, to be considered an insurance company, the company’s insurance liabilities must exceed 25% of its assets. If the company fails to qualify because it has 25% or less (but not less than 10%) in insurance liability assets, the company may still be predominantly engaged in the insurance business based on facts and circumstances. A company with less than 10% of insurance liability assets will not be considered an insurance company and, therefore, would be ineligible for the PFIC exception and subject to current taxation.
Legitimate insurance companies will be able to meet the 25% test. Those that do not meet the test and are truly involved in the insurance business will be eligible for the PFIC exception based on a facts and circumstances determination. We believe the rule disqualifying companies with less than 10% of insurance liability assets should target most of the hedge fund reinsurance companies that are taking advantage of the current law loophole, making them ineligible for the PFIC exception and stopping this abuse.