The investment diversification rules are a critical element in planning for private placement insurance products. One of the underlying marketing premises for the attractiveness of private placement insurance products is the ability of the policyholder to customize the investment options within the contract to something other than the mutual fund options found in retail variable insurance contracts. It is like anything else, you need to know the rules of the road. I am always amazed how complex these rules and insurance products in general appear to investment managers who engage in the most sophisticated trading strategies.
This article is designed to provide a quick overview of the investment diversification rules. Heretofore, hedge fund of funds have been the primary investment vehicle within private placement insurance contracts but that is changing quickly based upon a few factors- better investment returns in other alternative investment asset classes and greater exposure for managers to private placement insurance as an alternative distribution channel. Needless to say, increased taxation can only help perpetuate the marketing story for private placement insurance contracts.
B.Investment Diversification of Variable Insurance Policies
The taxation of variable insurance products is covered in IRC Sec 817(h). Treasury regulations 1.817-5 provide a detailed overview of the investment diversification requirements of variable insurance products. The regulations address a wide range of investment alternatives that are not found in retail variable life and annuity products such as direct investment in real estate, and commodities.
IRC Sec 817(h) provides that investment diversification is tested separately in each fund within the policy. No single investment may represent more than fifty five percent of the fund; two investments seventy percent; three investments eighty percent; and four investments 90 percent. Therefore, a fund must have at least five investments in order to meet the diversification requirements.
The cliché “the devil is in the details” is a fitting statement to describe the application of the rules. Additionally, pension annuity contracts as defined in IRC 818(a) are not subject to these diversification rules. As a result, a pension annuity contract can have a single investment and meet the tax requirements.
Treasury regulations 1.817-5 provide very detailed guidance on the investment diversification rules. The regulations interpret these rules for investment asset classes that are rarely seen in retail variable insurance products and only recently in private placement insurance products for the high net worth marketplace.
Part of this reason has to do with the limitations of the life insurance non-forfeiture rules in each jurisdiction dealing with death benefit liquidity as well as the liquidity necessary for policy loans and policy surrender. As a result, most retail variable insurance products have registered funds that provide for daily liquidity and daily mark-to-market for investment fund net asset valuation purposes.
The regulations provide that diversification is tested on the last day of each calendar quarter with a 30 day correction period in the event a fund does not meet the diversification requirements on the last day of each quarter. The regulations provide a one year startup period that begins the day a fund receives its initial funding. Real property accounts have a five year period to meet the diversification requirements.
A fund that was previously diversified but for the appreciation or depreciation of securities within the portfolio continues to remain diversified. The regulations provide that all of the securities of the same issuer are treated as a single security for diversification purposes. All of the commodities of the same commodity are treated as a single security for diversification purposes. A portfolio of Treasury bills and treasury securities are considered to be automatically diversified.
An important aspect of the investment diversification rules is the so-called “look through” treatment of certain securities. The rules only provide look through treatment to funds that are exclusively available through a variable insurance company separate accounts. Rev. Rul. 2003-91 and Rev. Rul. 2003-92 were issued in response to a private letter ruling request by Keyport Life (now owned by Sun Life) regarding the look-through treatment of non-registered partnerships.
The prior regulation was interpreted to mean that an investment through the life insurer’s separate account into a hedge fund (a non-registered partnership) would receive look through treatment providing the ability to look through to the underlying securities of the fund.
The Service ruled that these non-partnerships would no longer receive look through treatment under Treas. Reg. 1.817-5(f)(ii) since the ability to invest in the fund was not exclusive available to policyholders of variable insurance products. These so-called “publicly available” securities would be treated as a single security for investment diversification testing purposes. The regulations also look to the investment diversification rules under IRC Sec 851(b)(4) for registered investment companies as well.
Splitting Hairs within the Investment Diversification Rules
While Treasury Reg. 1.817-5 addresses many asset classes, it does not leave all of the stones unturned with respect to some of the investment considerations within PPLI. For example, life settlement contracts are an asset class that could benefit from private placement insurance structuring. Life settlements are effectively investment grade bonds with junk bond yields.
The primary investment activity has primarily been with foreign high net worth and institutional investors. Under Rev. Rul. 2009-14 and Rev. Rul. 2009-14, the investment gain within the life insurance contract is subject to taxation and withholding taxes. Due to the application of most double tax treaties with the U.S., annuity income is not subject to U.S. income and withholding tax. As a result, the life settlement investor might benefit tax-wise from structuring the life settlement investment within the contract as it converts what would otherwise be taxable income into tax-free income.
The U.S. tax exempt investor can also benefit from the structuring but not for tax reasons. The primary obstacle for the lack of investment in life settlement contracts by tax exempt investors has largely been the public perception of profiting from the death of others. This problem is easily overcome as a result of structuring the life settlement investment within the policy. The investment would be recorded as an annuity contract on the financial books of the endowment and foundation and not as an investment in a life settlement fund. The annuity contract masks the investment in life settlement contracts.
However, the investment diversification regulations do not contemplate an investment in life insurance contracts. Under the regulations, all of the securities of the same issuer are regarded as a single investment for diversification purposes. Therefore, all of the contracts of the same life insurer would be treated as a single security for diversification purposes. As a result, a life settlement fund would require life settlement contracts issued by five different carriers in order to meet the diversification requirements.
Another difficult asset class is a futures contract representing different stock indices. In most cases, these contracts are issued by the same issuer. The Service has ruled favorably several times regarding the diversification testing of registered investment companies that a futures contract is a "security" and not a commodity. Those rulings permit the contract holder to look through the contract to the underlying companies comprising the index for diversification purposes.
Unfortunately, none of the rulings have addressed the same issue in the context of variable insurance products. Due to the fact that the contracts are "publicly available", i.e. available to investors other than insurance company separate accounts, the contracts are do not provide a "look-through to the companies making up the index. The technical solution to the investment diversification problem in this case, is the purchase of index contracts from multiple issuers. On the other hand, the diversification rules only require the separate account to meet the diversification requirements on the last day of each calendar quarter. Hence, the fund manager could covert be to cash or T-bills for four days - the last day of each calendar quarter - in order to meet the product diversification requirements.
Timber is another asset class that is neither "fish nor fowl". The life insurer John Hancock's investment subsidiary Hancock Natural Resources has structured several billion dollars worth of timber investments for U.S. tax exempt investors. Why invest in timber through a group annuity contract?
In many cases, the character of the income is unrelated business taxable income (UBTI). The group annuity contract eliminates the UBTI However, in meeting the product diversification requirements, is an investment in a large forest with 100,000 acres across multiple counties and several states a single investment for diversification purposes? Is it a commodity (trees) or is it real estate? No case law or rulings provide any guidance on the issue.
The technical solution for timber is to structure the timber holdings in several different limited liability companies. Presumably, each LLC would be treated as a separate security for investment diversification purposes.
The nature of private placement insurance products is investment customization. The trend is towards more esoteric asset classes that the Treasury regulations never contemplated. While the safe bet might be a private letter ruling, many investment managers do not want to deal with the time delay and expense involved in a ruling request. The Treasury regulations are such that is you understand them, you can reason your way to the high ground.
The current tax environment combined stock market volatility will continue to make private placement contracts a viable consideration for high net worth and institutional investors. At the same time, the tax appeal for foreign investors is something that I am trying to best to bring to the attention of foreign investors and their advisors. As you contemplate and structure investments in private placement insurance contracts, you need to understand the investment diversification rules. If you can, you can achieve great results.