Hedge Funds: Still Usable With Private Placement Variable Life

The use of private placement variable life insurance products with high net-worth individuals has been of increasing interest to insurers, producers, estate planning lawyers and financial planners.

Private placement VL products enable policy owners to obtain greater investment flexibility than is often possible with traditional retail products. Perhaps no underlying investment for these products has been more popular than hedge fund investments.

Although a relatively new type of investment entity, hedge funds have had phenomenal success over the past few years and are very popular with sophisticated investors–the same people who also have the need for large amounts of life insurance. Still, the private placement VL industry has, in recent times, experienced considerable confusion over the propriety of using hedge funds to underlie private placement VL products.

The Internal Revenue Service has recently made available a Private Letter Ruling (PLR 200244001, dated May 2, 2002) that seeks to clarify one of the more prevalent causes of this confusion.

Everyone in the variable insurance product business knows that variable insurance products that use mutual funds as the underlying investments are required to use funds that cannot be purchased other than in a variable insurance product. This requirement, known as the “public availability” doctrine, was part of the September 1981 issuance of Rev. Rul 81-225.

The policy consideration that gives rise to this requirement is that the IRS does not want a taxpayer to be able to obtain the tax-deferral inherent in insurance products with investments that are otherwise available to the general public outside of the variable insurance product.

In 1984, Congress made major modifications to the tax laws affecting life insurers and life insurance products. Variable annuities and variable life insurance were greatly affected by these modifications. When the Treasury Regulations implementing these changes in the law were issued regarding investments underlying VAs and VLs, there appeared to be a loophole with respect to use of publicly available hedge funds that were organized as “non-registered” partnerships. (See Treasury Regulations 1.817-5(g)(f)(2)(ii))

Virtually all hedge funds are organized as non-registered partnerships. Therefore, if the Treasury Regulations meant what they appeared to say, then publicly available hedge funds could be used as the investments underlying variable insurance products.

Most mutual fund management companies have established one or more “clone” mutual funds that are exclusively dedicated to use with variable insurance products. Hedge fund operators have been reluctant to set up insurance dedicated hedge funds in the same way, however.

Therefore, insurers that wanted to use hedge funds to underlie their private placement VL products found it easier to rely on the apparent loophole in the Treasury Regulations. They did this by purchasing the hedge funds operators regular publicly available hedge funds rather than create entirely new insurance dedicated entities.

When the acceptance of hedge funds with variable insurance products began to take off, many observers were concerned about the apparent difference in treatment between mutual funds and hedge funds when used with variable products. Although the Treasury Regulations seemed to create a clear exemption from the public availability rules for partnerships, few observers could see the reasons for such a difference in treatment.

In informal discussions with the IRS, some counsels for insurers concluded that the apparent exemption in the Treasury Regulations for publicly available hedge fund partnerships was an aberration and that it would be dangerous to rely on it. The recent PLR proved that such concern was warranted.

Some recent articles in the financial press have seemed to conclude that the PLR stands for the proposition that no hedge funds can be used with variable insurance products.

A careful reading of the PLR should lead to a different conclusion, however. Bottom line, the PLR merely holds non-registered partnerships and mutual funds to the same standard–i.e. that only insurance dedicated investment entities can be used to underlie variable insurance products.

This conclusion should not have really surprised anyone. The tax policy considerations are identical with both forms of investment. It may be that there was too much reliance on purely legal analysis without considering the tax policy considerations.

In fact, the entire investment structure imposed on variable insurance products for over a quarter of a century through a stream of Revenue Rulings and finishing with the enactment of 817 of the Internal Revenue Code have been iterations of tax policy with little legal reasoning or precedent.

The IRS does not want taxpayers to be able to choose tax-deferral on investment income merely through the use of an insurance product without something more to differentiate the insurance product from a pure investment. This something more is the creation of a special, dedicated investment entity that is legally different from those available to the general public outside the insurance product, even if the investment objectives, policies and procedures are identical.

Thus, to paraphrase Mark Twain, the “rumors of the death of hedge funds with variable insurance products is premature.”

The recent PLR merely requires that there be a level playing field among all investment entities underlying the variable products. Hence, hedge funds will continue to be used with cutting-edge private placement VL products; they merely will be different hedge funds from those available to the general public outside of insurance products.

Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are principals in the Westport, Conn., and Ft. Lauderdale, Fla., law firm of Blazzard, Grodd & Hasenauer, P.C. E-mail at Norse.Blazzard@BGHPC.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, December 16, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.