U.S. Treasury Moves on Reinsurance Loophole

Apr 24 2015 | 5:11pm ET

The U.S. Treasury Department has released proposed rules aimed at limiting theability of hedge funds to delay or lower their taxes by funneling investments through offshore reinsurance companies.

The draft IRS regulations, which will not take effect until after a public comment period and any subsequent revisions, are aimed at a so-called loophole in the U.S. tax code that allows hedge funds and their partners to defer and/or pay lower tax rates on income generated from investments held within reinsurance subsidiaries domiciled in low-tax jurisdictions.  

Generally speaking, the tax code does not allow hedge funds (or anyone else) to defer or lower taxes through the use of offshore vehicles. However, the rules appear to offer an exception when dealing with reinsurance subsidiaries. 

Because of this exception, a large number of hedge funds have established reinsurance operations in places like Bermuda and the Cayman Islands. Dan Loeb’s Third Point, David Einhorn’s Greenlight, and John Paulson’s Paulson & Co. are just a few of the hedge funds that have formed such subsidiaries. Others include AQR, SAC, Cerberus and Citadel.

In addition to favorable tax treatment of investment gains, these companies also provide a steady source of capital to the hedge fund sponsoring them. In a typical structure, the reinsurers assume long-tail risks from primary insurance companies in return for insurance premiums, the float from which is then invested with the hedge fund.

Regulators and certain members of Congress, including former Senate Finance Committee chairman Ron Wyden (D-Oregon), have long expressed concern that such subsidiaries are primarily in the business of aiding their hedge fund sponsors, and not the business of reinsurance.

For instance, John Paulson’s Bermuda-based reinsurer Pacre Ltd. has no employees, writes less insurance coverage than the industry average, and promptly invested the $450 million of seed capital it received from Paulson executives right back into Paulson & Co. funds. 

Under pressure from Congress, the IRS promised a crackdown on abusive reinsurance structures in 2003. However, making the distinction between a reinsurance company focused on actually underwriting insurance risk as opposed to one facilitating tax efficiency for its parent can be very tricky.

The result has been little enforcement and continued proliferation of offshore reinsurance firms tied to hedge funds. 

The draft IRS rules, however, do not invoke the agency’s ability to immediately stop activity that it views as abusive or designed solely for the purpose of avoiding tax. The concern is that overly broad rules will end up including legitimate reinsurance providers, a key element of the global insurance industry. 

In fact, the proposal specifically asks for help in how to best structure the methodology to use in measuring which portion of a resinsurer’s assets are being held to meet potential obligations under insurance contracts, and which are an capital investment or tax efficiency channel.

As with other tax structures, the IRS’ litmus test will be two-fold: are the assets in question being held in reserve for use in legitimate reinsurance operations (i.e. at risk), and was the structure in which they sits created primarily to avoid or delay taxes?

The day the draft rules were released, Senator Wyden called the move "an important first step" in closing what he has termed a "glaring tax loophole" that has been a problem for over ten years.

Release of the draft rules start a 90-day comment period, after which revisions to the rules will be considered. The rules are then subject to further change, and potentially subject to a subsequent 90-day comment period. In any event, final regulations are unlikely to be issued before the fourth quarter of the year. 

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