The two highest profile hedge fund reinsurance firms, operated by leading investment managers Daniel Loeb and David Einhorn, have both highlighted the risks and uncertainty that potential changes to U.S. taxation rules pose to their businesses.
For Third Point Re, backed by hedge fund manager Daniel Loeb and his Third Point LLC firm, and Greenlight Re, backed by hedge fund manager David Einhorn’s Greenlight Capital, Inc., the uncertainty created by proposed taxation rules designed to prevent reinsurers being used as a mechanism for U.S. investors to avoid taxation.
There are two proposals that Loeb and Einhorn’s reinsurance firms fear, the IRS’ proposed legislation for Passive Foreign Investment Companies (PFICs), as well as a senate proposal 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.
Both sets of rules specifically target offshore re/insurers, intending to define which are actively engaged in insurance or reinsurance and whether any re/insurers are operating as a sophisticated way to shift investment capital offshore to avoid U.S. taxation.
Both Loeb and Einhorn’s reinsurance firms are considered to be targets of the proposed rules, with the two hedge fund managers among the most high-profile in that space. Both of the reinsurers outlined their clear concerns about whether the rules would allow them a fair chance at operating their investment oriented strategies in their 10K filings with the SEC this week.
Third Point Re said that the rules are not well-defined as to what constitutes an active insurance or reinsurance business, versus a passive investment company.
“There is very little authority as to what constitutes the active conduct of an insurance business for purposes of the PFIC rules,” the reinsurer explained in its 10K, adding that “At this time it is unclear whether final regulations will include a specific methodology and how any such methodology would apply to us.”
Third Point Re said that it believes itself to actively conduct insurance and reinsurance business involving “sufficient transfer of risk”, and that its financial reserves are consistent with industry standards and are not held “in excess of the reasonable needs of our insurance business”
“However, we cannot assure you the IRS will agree with our position and will not successfully assert that we do not qualify for the insurance exception,” Third Point Re continued.
Similarly, on the Wyden proposal and certain other senate tax reform proposals, Loeb’s reinsurance firm said; “If any such legislation were enacted in its current form, no assurance can be given that we would be able to operate in a manner to satisfy these requirements in any given year.”
Meanwhile David Einhorn’s Greenlight Re said that; “We believe that each of Greenlight Capital Re and Greenlight Re was a PFIC in 2006, 2005 and 2004. We do not believe, although we cannot assure you, that none of Greenlight Capital Re, Greenlight Re or GRIL has been a PFIC from 2007 onwards. We cannot provide assurance that none of Greenlight Capital Re, Greenlight Re or GRIL will be a PFIC in any future taxable year.”
Right now Greenlight Re believes that it would not be deemed a PFIC, however, like Third Point Re, it cannot be sure and cannot guarantee that it won’t qualify as one in the future.
“We believe that we are currently operating and intend to continue operating our business with financial reserves at a level that should not cause us to be deemed PFICs, although we cannot assure you the IRS will not successfully challenge this conclusion,” Greenlight Re’s 10K explains.
Additionally, Greenlight Re highlights that the definition of risk transfer within an insurance contract is subjective; “Whether our insurance contracts possess adequate risk transfer for purposes of determining whether income under our contracts is insurance income, and whether we are predominantly engaged in an insurance business, are subjective in nature and there is very little authority on these issues. We cannot assure you that the IRS will not successfully challenge our interpretation of the scope of the active insurance company exception and our qualification for the exception.”
On both the PFIC rules and Wyden’s proposal Greenlight Re, like Third Point Re, remains unclear as to how it will affect its ability to conduct reinsurance business going forwards.
“We are monitoring developments with respect to both the IRS proposed regulations and the Wyden bill. At this time, we cannot predict whether or what, if any, regulations will be adopted or legislation will be enacted,” the reinsurer said.
The uncertainty faced by these reinsurance firms will not help, as they struggle to recover from recent financial market volatility that hit their investment returns hard in 2015. By spelling out the risks in their 10K’s they are at least preparing shareholders for the potential that rules come into force that push them to adjust their strategies in order to continue operating effectively.
Whether the rules, if enacted, would affect other reinsurance firms and vehicles with total return or investment oriented strategies remains to be seen. Companies such as Fidelis and Hamilton both operate investment oriented strategies, with Fidelis explicitly stating that it would hold more capital for investment when underwriting conditions were not as attractive.
The ability to flex allocation of capital to the underwriting or investment site depending on market conditions makes a lot of sense, but could see re/insurers falling foul of any rules regarding how active they are as insurers.
Therefore it is vital that any rules are properly thought through and do not hinder genuine insurance and reinsurance businesses from following their strategy. Strategies are changing as the reinsurance market increasingly focuses on efficiency and perhaps in some cases regulators are lagging behind in their understanding of the state of the market.