Firm Addresses Concerns With Proposed Hedge Fund Reinsurance Regs

Background

Section 1297(b)(1)¹ generally defines the term "passive income" for purposes of the passive foreign investment company rules as "any income of a kind that would be foreign personal holding company income." When Congress enacted the PFIC rules, it recognized that, under the general definition of "passive income", investment assets that a foreign insurance company holds to support its obligations under insurance or annuity contracts issued or reinsured by the foreign company would be treated as assets that produce or that are held for the production of passive income. Accordingly, Congress provided an exception for income derived by a foreign insurance company engaged in the active conduct of an insurance business. Specifically, under section 1297(b)(2)(B), except as provided in Treasury regulations, the term "passive income" does not include income derived in the active conduct of an insurance business by a foreign corporation that is predominantly engaged in an insurance business and would be subject to tax as an insurance company if the corporation were a U.S. corporation.

Treasury and the Service have issued proposed regulations which define "insurance business" to mean the business activity of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies, together with investment activities and administrative services that are required to support or are substantially related to insurance and annuity contracts issued or reinsured by the foreign corporation.² The proposed regulations further provide that investment activities are required to support or are substantially related to Insurance contracts issued or reinsured by the foreign corporation to the extent that income from the activities is earned from assets held by the foreign corporation to meet obligations under the contracts.³

The proposed regulations do not set out a method to determine the portion of assets of a foreign insurance company that are held to meet obligations under insurance and annuity contracts, and Treasury and the Service have requested comments on appropriate methodologies for making this determination. As an example, Treasury and the Service have suggested that assets could be considered as held to meet obligations under insurance and annuity contracts to the extent a foreign insurance company's assets in the calendar year do not exceed a specified percentage of the foreign company's total insurance liabilities. In this example, total insurance liabilities are defined as the sum of the corporation's "total reserves" (as defined in section 816(c)) plus (to the extent not included in total reserves), the items included in paragraphs (3), (4), (5) and (6) of section 807(c).

The proposed regulations also provide rules for determining whether the insurance company is engaged in the "active conduct" of an insurance business, which is another requirement to qualify for the Insurance Exception. The proposed regulations require that the officers and employees of the company carry out substantial managerial and operational activities. However, unlike the rules in the section 367 area (which the proposed regulations otherwise incorporate), the activities of officers and employees of related entities who are made available to the company are not taken into account in determining whether the company qualifies for the Insurance Exception.

Recommendations

Insurers and reinsurers that provide protection for property risks are often required to post collateral in the form of cash or cash equivalents or provide other credit support (such as a letter of credit) to secure their obligations to counterparties under contracts of insurance and reinsurance. This occurs even if the company has a financial strength rating from an independent rating agency, but particularly where the company does not. In such cases, the unrated company is often required by regulatory bodies and counterparties to fully collateralize its potential exposure under the insurance or reinsurance contract, especially when the contract relates to catastrophe risks. In these circumstances, the assets held as collateral are unquestionably held to support obligations under the insurance contract from a commercial standpoint.

However, because property insurers do not generally book insurance reserves until a loss occurs, a mechanical test that looks solely to measuring a company's insurance reserves (and section 807(c) items) as a percentage of its overall assets would not treat these collateralized amounts as held to support obligations under insurance contracts (contrary to the obvious commercial reality of the situation). In the case of insurers of catastrophic risks, the issue is more acute because such risks have lower incurrence than other property risks but higher volatility, so that such insurers do not typically have a stable level of loss reserves arising from regular claims.

Consequently, we recommend that the final regulations adopt a rule that amounts posted to counterparties to collateralize a company's obligations under contracts of insurance or reinsurance should be viewed as held to support obligations under such contracts, absent a finding that such amounts are excessive relative to the potential exposures or other unusual facts or circumstances indicating that the collateral was not posted for bona fide commercial reasons.

In addition to adopting a specific rule for collateralized contracts, we believe that the final regulations should provide a general rule that the determination of whether amounts are held to support obligations under insurance contracts will be made taking into account all relevant facts and circumstances, including the type and duration of the contracts, the method of sale or distribution of the contracts, capital requirements necessary to obtain a financial strength rating from an independent rating agency, regulatory capital requirements, and whether the foreign corporation's operations are in a start-up phase. Such a rule should be in addition to any mechanical test regarding percentages of assets represented by insurance reserves and other items, which should operate as a "safe harbor" rather than as an exclusive test. Given that a particular insurance company's capital needs are highly dependent on its specific factual situation and type of business, a failure to adopt a flexible facts and circumstances test creates a meaningful risk of treating bona fide insurance companies that are not overcapitalized as PFICs.

Finally, we recommend that the final regulations not adopt the approach of the proposed regulations in excluding the activities of employees of entities related to the company, but instead should provide rules consistent with the regulations in the section 367 area. We do not see any compelling policy reason why different tests should be applied in these two areas. In assessing whether a company is actively conducting an insurance business, we believe that it is more important to analyze the amount of business and number of contracts written by the company, and time spent on underwriting, claims and relationships with counterparties, as opposed to whether the people engaging in these activities are employees of the company itself, employees of a parent of a group or controlling shareholder of the company, or of a service company that employs the employees of all members of a group for the sake of convenience. Such a rule elevates form over substance and does not address the core policy issues at the heart of the Insurance Exception.

² Prop. Treas. Reg. § 1.1297-4(b)(2).

³ Prop. Treas. Reg. § 1.1297-4(b)(2)(ii).