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.