United States: Hedge Funds As Investment Vehicles For Variable Life Insurance: Liquidity And Diversification*

Co-authored by Mr Andrew B. Mensch

Hedge fund investment managers and life insurance companies have, over the last few years, taken a mutual interest in each other's products and services. Life insurance contracts provide unique tax advantages to U.S. taxpayers. Sophisticated investors have learned that hedge fund investments can be placed inside tax-advantaged insurance wrappers. Life insurers have begun to actively seek hedge fund managers to provide these new options to the high net worth market targeted by insurance agents, brokers and other insurance-licensed intermediaries, such as broker-dealers. Hedge fund managers have reciprocated the attention as a means to increase their assets under management.

Insurance products that employ hedge funds are "securities" for purposes of U.S. securities laws (and not "insurance" within the meaning of the "insurance" exemptions under such laws), but are typically offered pursuant to the exemption from registration under Section 4(2) of the Securities Act of 1933 as amended (the "1933 Act") for any "transaction by an issuer not involving a public offering." Private placement insurance products are sold to wealthy individuals and corporate purchasers - investors who are considered to be financially sophisticated and, therefore, not in need of the 1933 Act's protections. In addition to designing the products and undertaking their distribution so as to qualify for exemption from registration under the 1933 Act and from regulation under the Investment Company Act of 1940 (the "1940 Act"), the design and distribution of private placement life insurance products must also comply with certain requirements of the Internal Revenue Code of 1986 (the "Code") and state insurance laws.

More specifically, the rules that affect private placement insurance products include: (1) state insurance law governing the establishment and operation of the separate account that receives and invests policyholder/investor monies; (2) interme-diary licensing requirements under state insurance law and the Securities Exchange Act of 1934, as amended (the "Exchange Act"); (3) the requirements under the 1933 Act relating to the exemptions from registration for privately placed securities; (4) the requirements under the 1940 Act relating to the exclusions from investment company registration; (5) the requirements under the Code relating to diversification, investor control, the definition of "life insurance," and partnership tax issues; and (6) the requirements under the commodities regulations and exemptions therefrom if the separate account invests directly or indirectly in instruments subject to Commodity Futures Trading Commission ("CFTC") oversight.

This article focuses on some of the legal considerations surrounding two issues that are among the thorniest involved in structuring the separate account's investment in hedge funds: (1) liquidity and (2) diversification.

Private placement insurance products may only be issued by licensed life insurance companies. Life insurers and their operations are regulated primarily by the law of the state in which the insurer is domiciled and the insurance department of that state. As noted, variable insurance products are also securities under federal securities law. Thus, the insurer is subject to dual regulation by state insurance and federal securities regulators with respect to these products and the separate accounts that fund them.

In order to offer private placement variable life insurance ("PPVLI"), the life insurer must establish a separate account under state law. Contract holders make one or more insurance "premium" payments to the insurer, the net proceeds of which are allocated to the separate account and then, in turn, to one or more hedge funds.

From an actuarial perspective, the "cash value" or investment component in an insurance contract is designed to provide an internal fund to pay the cost of insurance so that the premium need not increase as the insured's age increases. This is the basic reason why, in the 89 years since the income tax was first imposed by Congress, the "inside build-up" in cash value life insurance has never been subject to current taxation. However, in the 1980s, in response to concerns that this exemption was being abused to create insurance con-tracts, whose "investment" character predominated over their "insurance" character and whose primary purpose was tax avoidance, Congress enacted legislation that provided that con-tracts whose investment values exceeded the death benefit by certain specified percentages, would not meet the definition of "life insurance" under the Code and thereby would lose all the tax advantages of life insurance, such as deferral of gain on the inside build-up and the general exemption of death benefit proceeds from income taxation.

To qualify as life insurance under Code § 7702, the PPVLI contract must provide a death benefit that is a multiple of the investment values (except that, as the insured approaches age 95, the death benefit requirement diminishes and it need only equal the investment values at age 95). Therefore, before a contract holder's payments are transferred to the separate account and available for investment, the insurer deducts a charge for life insurance (often referred to as a "COI" or "cost of insurance" charge) and also deducts an administrative fee (together often referred to as "mortality and expense" or "M&E" charges). In PPVLI, the M&E charges are typically negotiated with the insurer and are not subject to state law filing and approval requirements.

The mortality risk represented by the excess of the promised death benefit over the contract holders' investment is borne by the insurer. The insurer also bears the risk that its aggregate M&E expenses with respect to its separate account policies will exceed the maximum M&E charges guaranteed under the PPVLI con-tracts. Insurers will often offer a guaranteed minimum death benefit, so that the death benefit will never be less than a specified amount, even if the underlying investments lose some or all of their value. Reserves for such guaranteed minimum death benefits generally must be maintained in the insurer's general account and may not be held in the separate account. Therefore, at any given time, a portion of the reserve underlying a PPVLI policy may be in the general, not the separate, account, and both accounts might be called upon to jointly pay a death claim.

The insurer offers contract holders, through the separate account, hedge fund investment options into which the contract holders may direct the balance of their payment in excess of the M&E charges. Insurers will often invest with hedge fund investment managers, thereby creating a fund of funds as one of the contract's investment options.

In order to meet loan and redemption requests and pay death benefits, the insurer is generally required to maintain within the separate account "sufficient net investment income and readily marketable assets to meet anticipated obligations under policies funded by the account." Although New York does not maintain a "readily marketable assets" requirement, New York, like many other states, requires life insurers to pay interest on unpaid death benefit proceeds beginning from the date of death. Other states require the insurer to pay death benefit proceeds "whenever possible" within 30 days of being notified of an insured's death and/or require the insurer to pay interest on unpaid proceeds after that 30-day period.

The insurer must determine the value of the separate account's assets "at least as often as variable benefits are determined, but in any event at least monthly." Valuation of the separate account's assets is important to state insurance regulators for reasons in addition to determining death benefits. The insurer's general account can be called upon to backstop under-valuation of the separate account to the extent of any guaranteed minimum death benefits. State insurance regulators therefore have an interest related to solvency in being able to access accurate current valuation of the separate account's assets. The insurer must also determine each policy's investment values at least monthly. The staff of the New York Insurance Department has stated that life insurers whose separate accounts' asset values are not determinable with precision on a monthly basis may provide an estimate of the value of such assets based on the investment manager's approximation. In addition, the insurer must set forth in the PPVLI contract the method by which it will determine the amount of insurance payable at death.

The insurer bears the risk of any downturn and reaps the benefit of any upside between the monthly valuation date until the date of death, and between the date of payment until the underlying fund or funds' redemption date. This risk is borne by the insurer's general account. If the insurer's actuaries believe that it presents a net risk to the insurer's general account, the cost of bearing such risk may be included in the M&E charges. If the underlying hedge fund or funds indicate that they will be unable to liquidate holdings sufficient to pay anticipated or actual death claims within the time frame that the insurer desires or requires, the insurer may contribute cash or readily marketable securities to the separate account in order to provide liquid funds with which to pay death benefits, and reimburse itself at the next scheduled redemption date, bearing the risk of any downturn and reaping the gain of any upturn.

All U.S. jurisdictions prohibit any person (with certain exceptions for, e.g., insurance company home office personnel and for purchasers' legal advisors who are not compensated by the insurer based on the sale of insurance) from soliciting insurance without a license. State insurance laws also require that a life insurance company obtain authorization to sell insurance contracts in a particular state. State licensing rules may contain different types of license requirements depending on the type of product and the nature of the offering involved.

Since PPVLI is also a securities product, persons offering PPVLI must be licensed as a registered representative of a registered broker-dealer. State insurance law and federal securities broker-dealer licensing law and administrative interpretation of such laws define "solicit" quite broadly. Therefore, hedge fund organizations who wish to apprise their clients of PPVLI options could solicit their clients' authorization to have a licensed intermediary contact them regarding an unspecified tax-advantaged investment option, but could not provide specific information about the insurer or the insurance product directly to any prospective policyholders, including their existing client base, without obtaining the appropriate licenses.

If the separate account's investments are not "adequately diversified," as described in Code § 817(h) and Treas. Reg. § 1.817-5 (the "Diversification Regulation"), any PPVLI policy based on the account will fail to meet the definition of "life insurance" under the Code. Compliance is tested every calendar quarter. The Diversification Regulation provides some leeway for inadvertent failure to diversify. If the IRS can be convinced that such failure was inadvertent, and if the invest ments are brought into compliance with the diversification requirements within a reasonable time after the discovery of the failure, then the insurer will still be required to pay a penalty based on the "income on the contract" (as defined in Code § 7702(g)(1)(B)) for the period during which the separate account's investments were inadequately diversified. However, the beneficiaries of death benefits under contracts whose investments were inadequately diversified at the time of the insured's death will receive the proceeds of the contract otherwise free from federal income tax (federal estate tax may also be avoided as long as the decedent maintained no "incidents of ownership" in the PPVLI contract at the time of death and for a period of three years prior to death).

If the IRS cannot be persuaded that such failure was inadvertent, or if the investments are not brought into compliance with the diversification requirements within a reasonable time after the discovery of such failure, the PPVLI contract will fail to meet the definition of "life insurance" under Code § 7702, all "income on the contract" for the current taxable year and all prior years will be treated as received during the year of such failure, and any death benefits will be subject to income taxation (any amount by which the death benefit exceeds the premiums paid is ordinary income to the contract's beneficiaries).

Separate account assets are considered adequately diversified only if: (1) no more than 55% of the separate account's asset value is represented by any one investment; (2) no more than 70% of the separate account's asset value is represented by any two investments; (3) no more than 80% of the separate account's asset value is represented by any three investments and (4) no more than 90% of the separate account's asset value is represented by any four investments. Equity and debt issued by the same issuer are aggregated for this purpose.

The Diversification Regulation provides a one-year start-up leeway and also provides an end-of-quarter look-back leeway under which a separate account that is adequately diversified on the last day of a calendar quarter, or within 30 days thereafter, will be considered adequately diversified for the whole quarter. In addition, the Diversification Regulation provides a market value fluctuation leeway under which a separate account that is adequately diversified as of the end of any calendar quarter (or 30 days thereafter) will not be considered non-diversified in a subsequent quarter because of fluctuations in the separate account assets' market values, but rather will only be considered non-diversified if the discrepancy between the asset values and the diversification requirements exists as the result of the acquisition of new assets.

In the case of separate account "investments" which in turn invest in other entities, Code § 817(h)(4) and the Diversification Regulation provide "look-through" rules that allow the separate account to test for diversification at the level of the underlying assets held by a regulated investment company, a real estate investment trust or a partnership owned by one or more insurers in their general accounts or separate accounts, or owned by investment advisers in connection with the creation or management of the regulated investment company or trust. The look-through rule is also available to partnerships, including private equity and hedge funds, that are not registered under Federal or State securities law. If the look-through rule applies, the separate account is treated as owning a pro rata portion of each asset held by the entity in which the separate account invests, rather than an interest in the entity itself.

In the case of a separate account that invests in an unregistered fund of funds, the Diversification Regulation's look-through rule has engendered some uncertainty regarding whether diversification should be tested at the double look-through level of the underlying funds' assets or higher up at the level of the fund of funds investments in unregistered partnerships.

What rule would those charged with diversification compliance prefer? At first glance, one might think that a fund of funds manager would prefer that the diversification analysis look all the way through to the assets held by the underlying funds, as such double look-through analysis would yield a greater likelihood of adequate diversification. Nevertheless, a moment's reflection will suggest, and SRZ attorneys will confirm, that gathering the information necessary to perform the double look-through analysis is an administrative hassle that fund of funds managers are loathe to undertake, if for no other reason than the underlying fund managers regard the identity and amounts of their holdings as proprietary. A manager whose fund of funds is invested, for example, in equal amounts of five different unregistered partnerships can confidently certify compliance with the diversification requirements without harassing the underlying funds to detail their holdings.

Can the separate account choose to test for diversification at the single look-through level of the fund of funds investments in unregistered partnerships if it so desires? Some counsel to insurance companies believe the answer is "yes." In addition, the staff of the Acting Associate Chief Counsel (Financial Institutions & Products) has indicated informally that their reading of the plain language of the Diversification Regulation would in fact require the separate account to test for diversification at the single look-through level of the fund of funds investments in unregistered partnerships. The staff has encouraged a ruling request, since the issue has not been settled by existing law, regulation or other guidance.

Most practioners are wary of advising that the diversification analysis need not look all the way through to the underlying funds' holdings, for the reason that failure to look all the way through could, although highly unlikely, result in an inadvertent concentration of investment in the securities of one or more issuers at the level of the underlying funds, thereby undermining the apparent purpose of Code § 817(h) and the Diversification Regulation, which were presumably designed to ensure that PPVLI policies were adequately diversified at the level where the investment results would impact the policyholder. In other words, a fund of funds that was adequately diversified at the level of the separate account's investment in unregistered partnerships could theoretically be invested in seven funds all of which have 100% of their assets invested in a single issuer's common stock.

SRZ attorneys have worked with clients to implement a system that enables a fund of funds manager to certify diversification compliance on a double look-through basis without requiring the underlying fund managers to identify their holdings. We would be glad to discuss this with you.

The issue of who should bear the responsibility to ensure compliance with the diversification requirements and corresponding liability for non-compliance is frequently one of the major issues in negotiations between a life insurer and an investment manager the insurer is considering hiring to assemble a fund of funds for the separate account's investments.

Although the fund of funds manager may be better situated to gather the factual data regarding the fund's and the underlying funds' holdings, the manager may negotiate to shift responsibility to the life insurer to instruct the manager regarding the diversification requirements, including whether the diversification test should be conducted at the single look-through level of the fund of funds investment in unregistered partnerships or at the double look-through level of the underlying funds' investments. Counsel should ensure that the representation and warranty provisions and the indemnification provisions of the investment advisory agreement between the insurer and the manager reflect the parties' intentions.

Stephanie R. Breslow is a partner in the Corporate Department who concentrates on Investment management, partnerships and securities. Andrew B. Mensch is an associate in the Corporate Department.