As Clear as Mud! The Investment Diversification Rules for Private Placement Insurance Products

by Gerald Nowotny
Contact

A. Overview

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.

Summary

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.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Law Office of Gerald R. Nowotny | Attorney Advertising

Written by:

Gerald Nowotny
Contact
more
less

Law Office of Gerald R. Nowotny on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.