by Norse N. Blazzard and Judith A. Hasenauer

The financial and insurance trade press has been publishing articles in the past few weeks regarding final regulations from the Internal Revenue Service regarding whether “publicly available” investments such as hedge funds can be used as underlying investments in variable life insurance and variable annuity contracts.

Unfortunately, many of the articles seem to have created the wrong impressionthat hedge funds can no longer be used as underlying investments in variable products.

For those not necessarily versed in some of the technical aspects of variable product taxation, the term “publicly available,” as used by the IRS in connection with variable annuities and variable life insurance, means an investment vehicle such as a mutual fund or a hedge fund that can be purchased by investors directly, other than through a variable product.

Also, the tax law applicable to variable products [Section 817(h) of the Internal Revenue Code] requires that investments underlying these products must be “adequately diversified.” Failure to be “adequately diversified,” as defined in the Code, means the variable products will have investment gains currently taxed directly to the contract owner; the products, in effect, forfeit tax-deferral on such gains.

In July 2003, the IRS proposed amendments to the diversification regulations under Section 817(h) of the IRC. The proposed regulations (an amendment to Treasury Regulations Section 1.817-5) were intended to clarify some issues regarding use of “non-registered” partnerships and similar entities as investments underlying variable products. Virtually all hedge funds are “non-registered” partnerships in that they are partnerships not registered either with the SEC or with any state regulatory agency.

The regulations in effect at the time the proposed regulations were released seemed to state that, for the purpose of meeting the diversification requirements of Section 817(h), a “publicly available” non-registered partnership, such as most hedge funds, could be used to underlie variable insurance products, and that the required diversification testing would be passed through to the investment portfolio of the underlying hedge fund(s).

Indeed, under those regulations, a look-through to the investment portfolios of underlying hedge funds was required even if the insurers separate account was itself adequately diversified through investments in a portfolio of hedge funds. Thus, under this interpretation, an insurers separate account acting as a fund of hedge funds would not be adequately diversified unless the portfolios of each underlying hedge fund also were diversified in accordance with Section 817(h).

The effect of the new amendments is to level the playing field between hedge funds and other investment vehicles commonly used with variable products, such as registered mutual funds. It means that, for purposes of diversification testing under Section 817(h), look-through is required only to hedge funds that are dedicated solely to variable products in the same way as is common with traditional variable products. Under the long-standing investor control doctrine, variable products using mutual funds as the investment medium have had to utilize only insurance dedicated mutual funds that the general public cannot purchase other than through the insurance products.

The change will alleviate confusion between looking-through to publicly available hedge funds for purposes of diversification testing and the investor control doctrines prohibition on investing directly in publicly available funds.

The amendments also clarify another issue. This regards using hedge funds with variable products that use a “fund of funds” method of investing. Under some of these products, the insurers separate account purchases shares in publicly available (not insurance dedicated) mutual funds as the investments of the separate account. These investments are much like those of any security purchased on the open market for an insurers variable product separate accounts. These “managed separate accounts” test the diversification directly at the separate account level. They do not look-through to the underlying mutual funds for compliance with Section 817(h) diversification requirements.

Under Treasury regulations prior to the new amendments, using publicly available hedge funds required a look-through, even though the insurers separate account was adequately diversified, and the underlying hedge fund had to have its portfolio diversified in accordance with Section 817(h) requirements. The amendments clarify that such a “double look-through” is no longer allowed.

Bottom line: Under these amendments to the Treasury regulations, it is still possible to use non-registered hedge funds to fund variable products. (At least, this is the case insofar as federal income taxes are concerned; additional concerns may exist with respect to using hedge funds for retail, registered variable products.) Using hedge funds merely requires that such funds conform to the same rules as would apply to the use of mutual funds with such products.

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. Their e-mail is: Norse.Blazzard@bghpc.com.


Reproduced from National Underwriter Edition, April 1, 2005. Copyright 2005 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.