Company Seeks Clarity in Proposed Hedge Fund Reinsurance Regs

These comments are submitted by Assured Guaranty Ltd. ("AGL"), the publicly traded holding company for the Assured Guaranty family of companies. AGL is organized under the laws of Bermuda. The Assured Guaranty companies insure and reinsure U.S. municipal bonds, international infrastructure transactions and structured financings. The Assured Guaranty companies include three U.S. incorporated financial guaranty insurers providing primary insurance coverage with respect to bond issuances by U.S. municipalities, infrastructure projects in the United States and abroad and structured finance vehicles. Our Bermuda-based subsidiary, Assured Guaranty Re Ltd. ("AG Re"), is our flagship financial guaranty reinsurance company and currently is the largest financial guaranty reinsurer globally based on net par outstanding and claims-paying resources. AG Re provides reinsurance protection to affiliated companies in the AGL family and unrelated financial guaranty companies.

We welcome the opportunity to comment on the proposed regulations providing guidance on the application of the insurance company exception to the passive foreign investment company ("PFIC") rules (the "PFIC Proposed Regulations"). AGL is a member of The Association of Bermuda Insurers and Reinsurers ("ABIR"), an organization that represents 20 commercial insurers and reinsurers with operations in Bermuda that is separately submitting comments on the PFIC Proposed Regulations. Although we agree with the analysis and suggestions in the ABIR comment letter, we believe that it is important to supplement the ABIR submission with our own comment letter to highlight the unique nature of the financial guaranty business and the unfairness inherent in the application of a bright line test focused on a specified percentage of a non-U.S. insurance company's total insurance liabilities for a given taxable year for determining the assets that should be treated as held to meet obligations under insurance or reinsurance contracts for the year for purposes of the insurance company exception to the PFIC rules.

The insurance company exception to the PFIC rules was a tacit acknowledgement by Congress in enacting such rules that a non-U.S. insurance company should not be characterized as a PFIC simply due to its large portfolio of investment assets. The legislative history underscores that the exception was intended to ensure that income derived by a bona fide insurance company would not be treated as passive income for purposes of PFIC testing, except to the extent such income is attributable to financial reserves (and presumably other assets, although not explicitly stated in the legislative history) in excess of the reasonable needs of the insurance business. This legislative history underscores Congressional concern that the insurance company exception to the PFIC rules could be abused by an overcapitalized non-U.S. insurance company that can generate tax advantaged investment income in excess of the needs of its insurance business for the benefit of its U.S. shareholders.

The use of a test focused on a specified percentage of a non-U.S. insurance company's total insurance liabilities for a given taxable year to determine assets that should be treated as held to meet insurance or reinsurance obligations for purposes of the insurance company exception to the PFIC rules would be inherently unfair to a non-U.S. financial guaranty insurer. Financial guaranty insurance, also known as bond insurance, is a single line of business whereby an insurance company guarantees scheduled payments of interest and principal on a bond or other debt security in the event of a payment default by the issuer of the bond or debt security over its life. Financial guaranty companies are limited from entering other lines of insurance business and, accordingly, are often called monolines. Bond insurance is a form of "credit enhancement" that generally results in the rating of the insured security being the higher of (i) the claims-paying rating of the insurer and (ii) the rating the bond would have without insurance. The financial guaranty insurer's assurance that insured bonds will make timely principal and interest payments to investors must be backed by a very strong claims-paying ability that is rigorously reviewed by major rating agencies and regulators as well as investors. Reinsurers such as AG Re offering reinsurance protection to financial guaranty insurers similarly are providing protection to the insurers on a long term basis and also must demonstrate strong claims-paying ability that will be rigorously reviewed by rating agencies, regulators and investors.

For tax, accounting and regulatory purposes, financial guaranty insurers are not able to establish loss reserves until, for example, the credit of the issuer deteriorates, the probability of default on an insured bond is high or a loss event has occurred. Financial guaranty insurers, unlike other types of property and casualty insurers, do not establish loss reserves based on incurred but not reported events. At the same time, the nature of the financial guaranty product typically means that loss events occur with low frequency yet high severity. Therefore, while in a given year a financial guarantor's loss reserves might be small, it would still hold a relatively substantial amount of assets in order to meet potential high severity claims in the future, especially since financial guaranty policies are often issued with terms of 30 or more years. Throughout the financial crisis, financial guarantors have paid billions of dollars in claims on insurance policies and now hold low ending reserve balances. In reviewing publicly available information for eleven financial guaranty insurers and reinsurers, ten based in the U.S. and one based in Bermuda, more than half would fall below a 25% loss reserve to asset test and three of the eleven would fall below 15% as of the end of 2014. All of the companies below these thresholds are U.S. insurance companies, and the failure to meet these thresholds highlights the unfairness in holding a foreign insurance company in the same line of insurance business to a higher standard.

The business model of bond insurance requires financial guarantors to be highly leveraged. There is typically low probability of loss on any single bond issuance but, in aggregation, significant exposure and risk. The premiums charged for bond insurance are driven largely by what financial markets will allow and the economic benefit of credit enhancement for a security being issued. A viable return on equity for a bond insurer is only achieved through the aggregation of premiums of many policies. This results in the amount of insured debt service (i.e. the principal and interest outstanding on the bonds) far exceeding the amount of premiums charged for the insurance. Thus, the nature of the product is that bond insurers are always highly leveraged when comparing the amount of debt service outstanding to statutory capital or assets. In reviewing capital adequacy, a number of stress environments are applied to evaluate the ability to pay claims not just at one point in time but until a bond matures, which may be in excess of thirty years. This requires a build-up and maintenance of high capital levels over many years to absorb high potential losses but often have low reserve balances. As evidenced by the extreme hardship the financial guaranty industry suffered during the financial crisis, large insured exposures require the maintenance of such high capital levels. In fact, despite having maintained high capital levels prior to the financial crisis (e.g., by holding substantial assets with comparatively low reserves), financial crisis losses left many financial guarantors short of the capacity needed to pay claims. Each of the legacy financial guarantors paid claims exceeding one billion dollars and all sustained multi-notch downgrades from rating agencies. Two were placed into rehabilitation by their state insurance commissioners. These events have only elevated the need for financial guaranty companies to maintain sufficient claims paying resources. Similarly today, bond insurers face credit exposure to public finance debt such as Puerto Rico, which was written years earlier but shows higher risk currently.

Assured Guaranty emerged as the only long-standing financial guaranty company to continue to write new business throughout the financial crisis largely because we avoided insuring collateralized debt obligations backed by RMBS as many of our competitors had done. Still, we continue to hold significant assets not only because of our strong risk management culture, which is designed to protect our franchise, but also because our ability to conduct new business depends on us doing so. A large component of the value that market participants place on our guaranty is that it typically increases the rating of an insured security to the financial strength rating of the Assured Guaranty subsidiary issuing the policy. Maintaining our strong ratings requires we hold a substantial amount of capital, an amount even greater than would have been necessary prior to the financial crisis, as both S&P and Moody's have since revised their financial guarantor rating methodologies. We believe that any tax regulatory definition of assets required to meet a non-U.S. insurer's obligation under insurance or reinsurance contracts for a given calendar year that is linked to the insurer's liabilities for the year is inconsistent with regulatory, rating agency and commercial concerns in the financial guaranty sector. The focus of the definition in the context of a financial guaranty insurer should be placed on net debt service outstanding which is the principal and interest of bonds insured, which provides a more accurate measure of the insurance risk and exposure assumed by the financial guarantor. In looking at the insured net debt service outstanding to assets of the eleven financial guaranty companies mentioned above, a ratio of 15:1 would qualify most with the exception of two US based companies. This benchmark would be indicative of true insurance risk and would prevent well accepted insurance companies such as financial guarantors from being unfairly isolated by any final PFIC regulations. At a minimum any PFIC test linking reserves to assets should be applied to a non-U.S. financial guarantor's assets treated as held to meet its insurance or reinsurance obligations based on a specified percentage of the contingency reserves, unearned premium reserves and other insurance liabilities reflected on the insurer's statutory financial statements. Including such insurance liabilities in a PFIC test will more appropriately reflect the unique accounting rules applicable to the financial guaranty industry, including the required maintenance of contingency reserves for statutory accounting purposes and the inability to book loss reserves under generally accepted accounting principles until such reserves exceed unearned premium reserves.

It should be noted that Congress has recognized the unique characteristics of the financial guaranty industry in enacting legislation in the past, as has Treasury and the IRS in issuing regulations to implement legislation. For example, Section 832(e) of the Internal Revenue Code (the "Code") and the related Treasury regulations allow financial guaranty insurers to deduct an amount set aside as contingency reserves for statutory accounting purposes to the extent the insurer purchases tax and loss bonds and Section 832(b)(7)(B) of the Code provides for a different discount rate applicable to unearned premium reserves in the case of financial guaranty insurers. Consequently, a separate regulatory definition of assets that should be treated as held to meet insurance or reinsurance obligations for purposes of PFIC testing of a non-U.S. financial guaranty insurer would not be a novel concept.

We understand the government's concern with hedge fund/reinsurers that are established to defer and reduce tax that would otherwise be due on investment income for U.S. investors. However, we strongly believe that a "one size fits all" definition of assets that should be treated as held to meet insurance or reinsurance obligations for purposes of the PFIC test is inappropriate and would lead to the improper characterization of commercial insurers as PFICs. Although we may be viewed as holding assets that appear relatively high when compared with our reserves in particular calendar years, these assets are necessary to provide rating agencies, regulators and the commercial markets with comfort that Assured will be able to make claims payments if and when the low frequency/high severity risk occurs. This prudent capital management strategy allowed Assured, unlike most of its competitors, to weather the financial crisis. Further, our investment strategy differs from the investment strategies that have concerned the government in the past, such as investments in hedge fund and alternative asset strategies. The principal objectives in managing our investment portfolio are to support the highest possible ratings and to maintain sufficient liquidity to cover unexpected stress in the insurance portfolio and, consequently, our investment portfolio is largely comprised of investment grade government, municipal and corporate debt. As Treasury has indicated that it does not intend to penalize insurers that assume significant exposures, we respectfully request that consideration be given to a separate regulatory definition of assets considered held to meet insurance or reinsurance obligations for purposes of the PFIC test that reflects the unique nature of the financial guaranty business and its critical importance to the U.S. financial system.