The past 10 years have seen a huge growth in hedge funds–both domestically and internationally. These funds have enjoyed some of the best (and, in some cases, the worst) investment performance in the securities business.

Once, it was easy to define a hedge fund as an entity, not registered as an investment company under federal securities laws, which used specially designed hedging techniques or leverage to avoid the volatility of the more traditional securities market.

Now, a hedge fund is more properly defined as an unregistered investment company catering to investors with sufficient sophistication to enable the fund to avoid the necessity of becoming an entity registered with the Securities and Exchange Commission.

By their very nature, hedge funds tend to be tax inefficient for Americans. The funds generally develop short-term capital gains from their investment operations, so the bulk of their yield is usually taxable at ordinary income tax rates. This has spurred considerable interest in developing variable insurance products with hedge funds as the underlying investment.

There have been numerous variable products–primarily variable universal life policies–that have hedge funds as the underlying investments. However, the vast majority of these have been available only to sophisticated investors who qualify to purchase “private placement” investments.

Meanwhile, most retail variable annuity and variable life products registered with the SEC have been unable to adapt hedge funds for use as underlying investments. This is because the technical requirements imposed under federal securities laws on registered variable insurance products make it difficult to use hedge funds as the underlying investments in the same manner as variable products traditionally use mutual funds.

The Investment Company Act of 1940, for example, requires daily valuation, forward pricing and immediacy of redemption–all elements that are inconsistent with the basic nature of most hedge funds. Moreover, most hedge fund operators tend to lack the discipline in their administrative and valuation procedures required for registered variable insurance products.

In short, in the world of registered products, time frames are absolute and discipline is a must.

Even for “private placement” variable insurance, using hedge funds as the underlying investments is not an easy matter due to other regulatory issues.

The hedge funds that have been used with variable products generally have been of the “funds of funds” type. These funds of funds permit the investment manager to allocate investments among a number of publicly available hedge funds in much the same manner as listed securities are purchased on the open market. State insurance laws require that reasonable time frames be met for valuation to enable payment of surrenders, loans and death claims.

In addition, tax laws applicable to hedge funds used with variable insurance products have been confused. The Treasury Regulations [in 1.817-5(f)(2)(ii)] seemed to permit the use of hedge funds that were organized as unregistered partnerships to be used with variable insurance products, even though not dedicated exclusively for use with such products.

As a result, considerable sentiment developed in the industry for the proposition that, even though “publicly available” mutual funds (i.e., funds that were not dedicated exclusively to use with variable insurance products) could not be used with variable products, publicly available hedge funds were acceptable.

Last year, the Internal Revenue Service clarified this issue with the promulgation of a Private Letter Ruling (PLR 200244002, dated May 2, 2002). This determined that use of “publicly available” hedge funds would violate the IRS policy against variable insurance products where the policyowner had too much control over investments. The IRS has now formalized this position with Revenue Ruling 2003-92, issued on July 23, 2003.

There has been some concern that Revenue Ruling 2003-92 somehow expanded the limitations imposed by the earlier PLR. Part of this concern derives from the caption that was used in the release issued by the Treasury Department announcing the Ruling (and also announcing the issuance of Revenue Ruling 2003-91 regarding investment choices permitted under variable annuities). This caption stated: “Treasury works to Stem the Inappropriate use of Life Insurance and Annuity Contracts.”

In fact, the Rulings contained nothing really new. They were merely the formalizing of the Treasury Departments policies that have been in effect for nearly a quarter of a century. Revenue Ruling 2003-92 now puts the industry on formal notice that non-insurance dedicated hedge funds cannot be used as the investments underlying variable insurance products.

The prior PLR was not, by its terms and by practice of the IRS, precedent for any of the propositions described therein. Revenue Ruling 2003-92 is precedent; those who do not comply do so at their peril.

On July 29, 2003, as this was being written, the Treasury Department issued proposed Regulations (Reg-163974-02) that would further impact the use of hedge funds with variable insurance products. If adopted, these will repeal Treasury Regulations 1-817-5(f)(2)(ii). They will also require that funds of hedge funds used with variable products must themselves be diversified–rather than simply be able to “look through” to the portfolios of the underlying hedge funds to satisfy diversification requirements.

Whether these new proposals will be adopted, in what form and how they will be interpreted remains to be seen. The Treasury Department has requested comments from the public. We will keep abreast of these developments and report on them as they take place.

The larger question is, how can the industry use hedge funds with variable insurance products? We believe that hedge funds will continue to be used with private placement variable universal life insurance policies.

We also believe the market is ready to have individual, insurance-dedicated hedge funds, as opposed to the funds of funds structure, as choices under variable insurance products. Such hedge funds will have to be carefully designed and carefully managed to ensure that the variable insurance products using them do not run afoul of federal securities laws.

But, when properly constructed, insurance dedicated hedge funds can become an increasingly important part of the variable insurance market.

Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are attorneys in the Pompano Beach, Fla., office of Blazzard, Grodd & Hasenauer, P.C. You can e-mail them at Norse.Blazzard@bghpc.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, August 11, 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.