Hedge Funds: Still Usable With Private Placement Variable Life

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.