Considerations When Using Hedge Funds In Variable Products

By Gregory T. Pusch

Several large U.S. insurance carriers now offer policyholders the opportunity to purchase variable insurance products employing hedge funds as the underlying investment vehicle.

Wrapping a variable annuity or variable life insurance policy around a hedge fund creates an attractive product, especially given the current popularity of hedge funds. The result is a hybrid allowing gains on hedge fund investments to be tax deferred, often while also allowing a policyholder to borrow against the cash value of the policy and to make tax-free exchanges and transfers within the policy.

These products are sold to high net worth (or more often “super high net worth”) individuals, usually in an estate planning context. They also are sold as funding vehicles for deferred benefit plans for executives or donors, such as supplemental executive retirement plans (SERPS), bank-owned life insurance (BOLI) and corporate-owned life insurance (COLI).

Typically the policyholder receives institutional pricing at the insurance contract level, including very low sales loads or commissions (if any), and low annual fees, such as mortality and expenses (M&E) asset-based fees and cost of insurance (COI) charges. In many instances the overall pricing may be individually negotiated with the policyholder.

In one sense the legal structure is relatively straightforward–a VA or VL insurance policy that is funded through a separate account or subaccount of the insurance carrier. This is the same basic structure used for retail products employing registered investment companies (mutual funds) as the underlying investment vehicles.

However, detailed requirements under the Internal Revenue Code with respect to investor (policyholder) control, the treatment of loans against the policy as distributions, and diversification of the hedge fund investments must be satisfied when structuring and administering these policies.

In particular, while there is some debate among tax practitioners about the merits of a recent IRS private letter ruling on the subject, it seems clear, at least for now, that a hedge fund used in a variable insurance product may not be sold to other types of investors.

Consequently, a manager of an existing hedge fund wishing to participate in these products likely will need to form a “clone” fund to be used only for this purpose. In addition to incremental increased legal and other costs of creating a clone fund, the hedge fund manager also will need to consider disclosure and other issues relating to the use of the managers existing performance record in selling the product.

On the other hand, using a clone fund was probably already a better practice in any event, particularly for a Securities & Exchange Commission regulated investment advisor and is a relatively small burden if significant assets are involved.

The underlying hedge funds used most often are fund-of-funds, or hedge funds that invest in other hedge funds. Assuming the IRS requirements for looking through the first layer of funds are met, this helps to easily achieve the requisite diversification for the policy to receive tax-deferred treatment. Additionally, use of a fund-of-funds may provide investment diversification among different management styles while avoiding the complications of dealing directly with multiple hedge fund managers.

In any event, the contract between the hedge fund manager and the insurance carrier, whether structured as some sort of participation agreement or otherwise, should be carefully considered, especially with respect to indemnification and other provisions relating to compliance by the hedge fund manager with any applicable investment guidelines, valuation procedures or other restrictions.

Unlike mutual funds used in variable insurance products, currently there are no specific disclosure requirements applicable to hedge funds that are exempt from registration under the Investment Company Act of 1940. Likewise, many hedge fund managers are themselves exempt from registration and ongoing regulation by the SEC under the Investment Advisers Act of 1940 (although they remain subject to the anti-fraud provisions of the Act).

However, because the premise inherent in a variable insurance product is that the investment risk is shifted to the policyholder, such products are securities for purposes of the federal securities laws. Therefore, the anti-fraud provisions of Rule 10b-5 under the Securities Exchange Act of 1934 still apply, for example, as do the anti-fraud provisions of state securities laws.

Similarly, because (unlike a mutual fund-based policy), these products are privately placed and are not registered under the Securities Act of 1933 (the “Securities Act”), all of the usual requirements for a valid private placement apply. This typically means that the safe harbor provisions of Regulation D under the Securities Act must be met.

Insurance carriers therefore need to be particularly careful in their diligence efforts regarding prospective hedge fund managers for variable insurance products. Thoughtful consideration also should be given to the amount and quality of disclosure about the underlying hedge funds and managers that will be provided to policyholders.

Furthermore, while these types of policyholders often are sophisticated, or at least very wealthy, proper manner of offering and suitability controls are nevertheless important to avoid potential securities laws problems.

The attraction of these products for an insurance carrier is clear: These types of polices are likely to be written only for substantial amounts where even institutional asset-based pricing can be significant, or in connection with a relationship with an important client.

However, there are risks over and above those of a more traditional mutual fund-based variable product that must be well managed. This is particularly the case given the explosive growth, and therefore wide range in quality, of hedge fund managers in the last few years and the increasing SEC scrutiny of the hedge fund industry.

Attorney Gregory T. Pusch is an Associate in the Insurance and Reinsurance Practice Group of Edwards & Angell, LLP, a national law firm focusing on financial services, private equity and technology. He may be reached at: gpusch@ealaw.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, May 26, 2003. Copyright 2003 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.