New PFIC regs released, relevant to ILS & hedge fund reinsurance strategies

The U.S. Internal Revenue Service and Department of the Treasury has published a new set of proposed regulations relating to passive foreign investment companies (PFICs), which are relevant to many in insurance and reinsurance, but have particular relevance to certain ILS and hedge fund reinsurer strategies it seems.

The updates to the proposed regulation of passive foreign investment companies (PFICs), which were published this week, have been made to replace the proposed rules published in April 2015.

In particular, law firm Sidley explained that they are updated to reflect the changes to the PFIC regime made by the 2017 Tax Cuts and Jobs Act, while also reflecting certain “look-through” rules contained in the Internal Revenue Code and feature new rules relating to the determination of the “active conduct” test.

Sidley noted that the updates are relevant to insurance-linked securities (ILS) strategies, while they also look highly relevant to hedge fund backed reinsurance or total-return strategies as well.

Sidley highlights some of the main features of the new rules of relevance to the insurance and reinsurance sector.

In particular the first two seem particularly of relevance:

Proposed standards for determining whether a foreign insurance company is a “qualifying insurance corporation” (QIC), including whether it:
– is “predominantly engaged in the insurance business,”
– has “applicable insurance liabilities” that exceed 25% of its total assets; or
– failed to satisfy the 25% test “solely due to runoff-related or rating-related circumstances.”

This proposed standard could have ramifications for some of the hedge fund reinsurance strategies, if they do not have enough underwriting business of substance to pass the “applicable insurance liabilities” test.

A proposed standard for determining whether a QIC is engaged in the “active conduct” of an insurance business, including a proposal that would deny the insurance exception to companies that pay significant fees to outside service providers for underwriting and asset management.

The above standard could have ramifications for certain ILS strategies, where third-party fees are paid for underwriting services. This could affect reinsurer owned third-party capital vehicles, which pay fee income back to the parent for underwriting services rendered. It could also have ramifications for the way ILS funds have their underwriting vehicles, such as collateralized reinsurers, or even rated vehicles, set up.

While other rules of relevance to insurance and reinsurance are:

Provisions coordinating and clarifying the application of the look-through rules that apply to 25% owned corporations and the special look-through rules for 25%-owned domestic corporations.

Guidance regarding the elimination of certain intercompany assets and income (e.g., stock of subsidiary, intercompany debt) in determining the percentage of passive income and assets.

Guidance regarding the treatment of the income and assets of direct and indirect domestic insurance subsidiaries in determining the income and assets of a tested foreign corporation.

That last piece, on income and assets, could also have ramifications for ILS vehicles, particularly related to the income distributions provided to investors or to funds, however greater clarity and legal guidance is needed, which will be forthcoming over the next few weeks we’d imagine.

Sidley and other law firms are expected to provide further guidance in the weeks to come, as the reinsurance and ILS sector digests these updates to the proposed PFIC regulations.