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Some new developments in the private placement life insurance field

By Joel J. Karp, Karp & Genauer, Coral Gables, USA 1

The Internal Revenue Service has recently ruled that an insurance company covering only one insured has not issued an insurance policy within the meaning of the tax law.2 While it is interesting that in two situations covered by the ruling, the so-called insurance company was totally unrelated to the insured. The ruling, in and of itself, seems fairly self-evident, and one wonders why it was promulgated in the first place. A close reading of the ruling together with the promulgation of Notice 2005-49, 2005-27 IRB 14, which was promulgated at the same time, will give us the answer. The ruling states the basics in order to initiate a dialogue concerning what constitutes insurance. The ruling tells us that the definition of insurance is to be found in the application of the principles sets out in Revenue Rulings 2002-89, 2002-90 and 2002-91. They also tell us that for the purposes of determining whether there exists a distribution of risks, as well as the shifting of risks, insureds will be counted with reference to legal entities for tax purposes (in situation no. 3, the insureds involved were a single member LLCs and were disregarded for tax purposes.) While tilted in the direction of dealing with issues arising in connection with captive insurance, Notice 2005-49 raises an issue which touches very strongly on private placement life. Namely, what and when is insurance presented in a financial product.

The first item as to which the Treasury Department invites comments involves the factors to be taken into account in determining whether a separate cell captive arrangement constitutes insurance. The second area as to which comments are invited deals with the degree to which an arrangement involving the loan back of premiums between related parties will constitute insurance. As it happens from a life insurance perspective, these are related issues. The status of separate cell arrangements is of vital interest to private placement life insurance issued by foreign carriers because, in many instances, a separate cell will back an individual policy.3 If a separate cell, in effect, constitutes an independent life insurance company for tax purposes, then possibly the insurance policy fails because it does not constitute insurance for tax purposes lacking adequate distribution of risk. Under the Code, an insurance contract will not constitute a life insurance contract for federal income tax purposes unless it is a life insurance contract under the applicable law and it meets one or the other of two tests.4 Usually, variable policies (and most private placement life insurance policies are variable policies) are structured as life insurance contracts in compliance with “The Guideline Premium/Cash Corridor Test.”5 In order to comply with the cash corridor aspect of the test, it is necessary that the policy require the insurer to assume a certain net amount of risk (excess of death benefit over cash surrender value,) depending upon the age of the insured. Most of the time the insurer retains a minimal amount of risk (sometimes none) and reinsures the balance. Even if the existence of a separate cell cast a dispersions on the policy by which that cell is backed, it may be that a distribution of risk is achieved through the use of reinsurance. In general, the Internal Revenue Service has accepted that an insurance company can reinsure 100% of its risk and nevertheless be an insurance company because vis-à-vis the insured, the primary insurer rather than the reinsurer is at risk.6 In other words, the primary insurer retains the risk that the reinsurer may become insolvent or otherwise fail or refuse to pay the reinsurance. Since this failure does not prevent the insurance company from being liable, one might draw the conclusion that distribution of risk is present through the assumption of this type of risk. On the other hand, the IRS may seek to disregard this element where the private placement life company is under-capitalized and take the position that the exposure to risk is not material.7 This opens the door to an attempt to bifurcate the private placement policy between the investment element and the life element. Such a position is reinforced by the fact under separate cell legislation, very often the insurance company has the option of not being responsible for any amounts in excess of the assets credited to the separate cell.8 Under Cayman law, the legally required capital of an insurer is not subject to claims of separate cell creditors.9

In order for a company to have separate cells, it must register under a separate provision of law. In the Cayman Islands it must register as a segregated portfolio company and have those words or the initials “SPC” in its name. In the Bahamas, where separate cells are called “Separate Accounts”, to have separate accounts, a company must register as a separate account company and utilize those words in its name or the initials “SAC.” A separate cell or segregated portfolio or segregated account is essentially designed to be an accounting entry that backs up one or more policies, but is hermetically sealed against the liabilities of the insurance company to its general creditors and to its policyholders other than the policyholder of the policy to which the separate cell is linked. The separate cell is declared to be an integral part of the company, and the company, and all of its cells, is declared to be an organic whole. However, this is a declaration and not necessarily an analysis of substance. A separate cell may issue shares that are specifically targeted to that cell and do not participate in the profits and losses and fortunes of the company as a whole, or the company may simply create a cell and let the particular policy be backed by that cell and charge its fees to the cell. In the event of insolvency, a separate cell is entitled to its own receiver and the assets held in the cell are protected once again from the claims of liquidators of the company as a whole.10 This, together with the fact that the core or required capital of the company may not be responsible for the debts of a cell, are perhaps the principal distinctions of a “Separate Cell” from what I call “Segregated Account Legislation.”

Under Section 817(d) of the Code, a variable contract is defined as, a contract “which provides for the allocation of all or part of the amounts received under the contract to an account,” which, pursuant to state law or regulation is segregated from the general asset accounts of the company. Also the contract must provide for the payment of annuities or be a life insurance contract. In the case of annuities, the amounts paid in or out must reflect the investment return and market value of the segregated asset account. In the case of a life insurance contract a death benefit (or the period of coverage) must be adjusted on the basis of the investment return and the market value of the segregated asset account.

What then is a segregated account? There are no regulations under Section 817(d). The regulations under Section 817(h) state that a segregated asset account shall consist of all assets, the investment return, and market value, of which must be allocated in an identical manner to any variable contract invested in such assets.11 The examples that are cited together with statutes, itself gives us some specific guidelines.12 The account is an accounting entry or it could be an actual separate entity which by virtue of state law regulation (and probably foreign law) is segregated from the general assets of the insurance company. The state laws, which define segregated asset accounts, or the like vary in form. One element, which is virtually universal, is that under state law, the assets held in the segregated asset account are exempt from the claims of creditors of the insurance company and of the policyholders holding policies not backed by the particular segregated asset account.

The issue of whether a segregated account or a separate cell can back a policy has become vital to investors in Private Placement Policies. The Private Placement Policies have become reliant upon the security that the separate cell legislation provides to insure that the policyholder’s capital is safe regardless of what happens to the insurance company, which is, after all, established in a somewhat exotic domicile, and may appear to the investor to be less than substantially capitalized.

To clarify this analysis is probably best at this point to explain exactly what separate cell legislation is and how it is different from segregated account legislation, which is a backbone of all variable contracts and hence the very beginning of the statutory approval of variable contracts currently set forth under Section 817(d) of the Code. It is probable that separate cell legislation originated in Guerney and spread to the Cayman Islands and the Bahamas and other jurisdictions. The original impetus for separate cell legislation was to accommodate certain financial trends in the mutual fund and offshore fund industry. However, it found particular use with offshore insurance.

What is the Internal Revenue Service is likely to do about this issue? The majority of comments that have reached the Internal Revenue Service thus far urge the Internal Revenue Service not to take a hard and fast line in determining whether the existence of a separate cell as backing a policy, ipso facto, precludes the existence of insurance. The IRS is urged, rather to determine each particular transaction based on its particular facts and circumstances. If the Internal Revenue Service will act at all on the questions it raises, it is likely to provide some guidance. The guidance that it is likely to provide will probably require conformity of separate cells with separate account legislation as it exists in the States. Thus, it would appear that there should be significant exposure of the core capital of the insurer to the debts of the various cells.13

As it stands, several of the offshore jurisdictions not only have separate cell legislation, but also through a segregated account legislation in their insurance laws. It may become wise, after properly explaining the situation to investors or at least those who are U.S. persons, to link U.S. owned policies with segregated accounts for which insurance legislation exists rather than using separate cells. Compare e.g., Cayman Islands Insurance Law (2004 revision) § 7.6(c) with Bahamas External Insurance Act (as amended 2001) § 10. For foreign owned policies, the use of separate cell legislation may be more appropriate.

Investor Control

Prior to the enactment of the Deficit Reduction Act of 1984 (“DRA”), the IRS had promulgated a series of rulings dealing with prohibited self-direction. There were also two court cases dealing with the subject.14 In the rulings, the IRS stated that in situations where the policyholder could choose to allocate his policy premium to mutual funds which were also available to the general public and could cash out his contract at any time (subject to surrender charges), the policyholder was considered to have investment control over the assets and possessed sufficient other incidents of ownership to be considered the owner of the investment for tax purposes.15 Accordingly, investment earnings were attributable to the policyholder. The Christoffersen case concurred with the government’s views. The Investment Annuity case did not concur, but was reversed on a procedural point.

Prohibited self-direction was thought to fall into two areas of perceived abuse. In the first area, the Policyholder was thought to receive the right to direct the specific investments backing the Policy (the “subjective” or “incidents of ownership” test). In another area, the Policyholder was deemed to be “wrapping” a variable life insurance policy or annuity around a publicly available mutual fund or other investment vehicle (“objective” or “wrap around” test).

In either case, the taxpayers who violated the self-direction rules used (sometimes abusive) insurance products to obtain an income tax exemption (through tax-free or deferred inside buildup) not available to persons investing in the underlying investment vehicles directly. Thus, it was perceived that the special tax advantages accorded insurance products were being abused, because the Policyholder was using insurance as an investment vehicle rather than for insurance purposes as intended.

The problem, of course, with generalities and public policy analysis is line drawing. The insurance industry as a whole continued to emphasize the investment aspects of variable products in its marketing (much to the chagrin of the IRS), and the lines between legitimate variable insurance products and “abusive” “self-directed” investment vehicles became blurred. The situation was not improved by seemingly inconsistent PLR’s and lack of general public guidance on the part of the IRS. The IRS did fairly consistently say that the pre-DRA rules survived. The general belief of the Tax Bar, however, was that the diversification rules enacted by the DRA must have had some impact on the pre-existing law. The degree to which that was true was never entirely clear.

Finally, requests for specific guidance on certain narrow issues relating to investments in certain privately held investment partnerships called hedge funds by segregated accounts backing variable insurance products forced the IRS to address that issue as well as the issue of whether and to what extent foreign issued insurance products qualified as variable contracts under IRC § 817(d) and what the consequences would be if they did not. The result was two published rulings and proposed regulations16 providing some guidance but by no means resolving all issues. The proposed regulations were made final effective March 1, 2005, with minor changes. The IRS failed to address various comments relating to the rules on investor control, and stated only that these comments “will receive careful attention in the event of further guidance on investor control”.17

The net effect of these pronouncements is as follows:

The IRS has made it clear that privately placed hedge funds (“non-registered” partnerships) which are publicly available and are used to back a variable contract (life insurance or annuities) will be held to violate the prohibition against self-direction of investments. Moreover, by regulations, the IRS has announced its view that such partnerships should not, as a matter of policy, be accorded look-through treatment for purposes of the diversification rules. However, in PLR 200420017, the IRS takes the position that this problem can be avoided if the Policyholder can only direct his premiums to funds available only through variable contracts (or related vehicles such as qualified pension and profit sharing plans), (“dedicated funds”) notwithstanding the fact that the investment managers of those funds can themselves direct investments to publicly available funds. Therefore, what one cannot do directly, he may do indirectly. All that appears to be lost is an ability on the part of the investor to directly allocate to publicly available funds, the opportunity to participate in them altogether is not apparently lost.

Also, the IRS has made it clear that there may be no communication of any kind, nature or description between the Policyholder and the investment officer of the Insurer or the independent investment advisor (“Advisor”) of any segregated account backing a life insurance policy or annuity once it has been acquired. Rev. Rul. 2003-91 might be read to indicate that such communication is precluded prior to the acquisition of a Policy or contract. However, a close reading of the ruling indicates that the issue is, at least unclear, and that one could justifiably reach a contrary conclusion that prior contact between a prospective policyholder and an independent investment advisor is not precluded. (Compare the description of the product in Rev. Rul. 2003-91 with the “Analysis” supporting the conclusion reached in that ruling.)

That conclusion is also supported by PLR 9752061, in which the IRS approved a policy where:

“Policyholder influence over the way the investments are managed will be limited to selecting an investment manager from a pool of investment managers whose credentials have been evaluated and approved by Taxpayer. These investment managers may be recommended to Taxpayer by one or more Policyholders. Taxpayer will be under no obligation to approve any such recommendations. Moreover, once Policyholder makes an initial selection, the investment manager can only be changed by Taxpayer and not by Policyholder.”

Now, admittedly, this PLR is not binding on the IRS and existed prior to Rev. Rul. 2003-91. However, given that the published ruling ignored the prior communication and recommendation issue in its analysis, after arguably (but not clearly) raising it in the policy description, one may conclude that the PLR is still viable authority.

With all the attention given to investment in hedge funds and the use of dedicated funds, an essential fact is being missed. There is not just one model available for the investment media backing a private placement policy. In point of fact, what Rev. Rul. 2003-91 specifically dealt with was a policy utilizing an investment manager (“Advisor”) model. In other words, it is alternatively possible to suggest an Advisor rather than using the dedicated fund approach. The Advisor model actually has several advantages over the dedicated fund approach. For one thing, it is simpler. For another, the dedicated fund model presupposes investments in hedge funds. Now in the past year, hedge fund performance has not been sterling (admittedly performance appears to have improved in the fourth quarter of 2005 and the first quarter of 2006). One of the major disadvantages of hedge fund investment is that you are generally locked in for an extended time and cannot readily get out if performance deteriorates.

Insurable Interest in Structuring Private Placement Life Policies

Often the issue of whether or not the policyholder has an insurable interest in the life of the insured is often overlooked. The policyholder has an insurable interest when he or she has an interest in the longevity of the insured. Obviously a person has an insurable interest in his own life and it is often (but not always) accepted that members of an immediate family have an insurable interest in the lives of other members of that family. However, after that, the situation becomes a bit murky. For U.S. tax purposes it appears, in general, that in order to have a qualified insurance policy, the policyholder must have an insurable interest at the inception of the policy.18 If the ownership policy thereafter changes, there are cases that hold that insurable interest is no longer an issue. However, these cases are based on state law, which requires only that an insurable interest exist at the inception of a policy. There are states which require that the policyholder have an insurable interest throughout the life of the contract. Also, who has not an insurable interest in the life of an insured may vary from jurisdiction to jurisdiction. For example, in the Bahamas an employer has an insurable interest in a key man without more. On the other hand, in the United Kingdom an insurable interest in a key man on the part of an employer is considered to exist only to the extent of the value of that key man to the business of the employer.19 This becomes, as the English say, “a very sticky wicket”. It is, in general, believed that in order to determine whether a trust which owns a policy has an insurable interest in the life of the insured must be determined by reference to relationship between the insured and the beneficiaries of the trust. However, a court has ruled that the question is not whether the beneficiaries have an insurable interest but rather whether the trust, as policyholder, has an insurable interest and, according to this judge, the answer is no.20 The Circuit Court of Appeals vacated this portion of the judgment not because they found it wrong, but because they found it unnecessary and inappropriate that a Federal Court should decide an important and hitherto undecided point of state law.

The issue of insurable interest has become a rather hot one lately from a tax perspective because several very large organizations such as Wal-Mart have become involved in corporate tax shelters under which they take out insurance on the lives of employees and have used borrowed money to buy the policies. The so-called COLI plans have been attacked vigorously by the courts and the Internal Revenue Service. However, where the policies often fail is that there is no insurable interest and the penalty for that is that the heirs do in fact have a claim against the death benefit of a policy. Thus, in Scott Mayo v. Hartford Life Insurance Company and Wal-Mart Stores, Inc., et al. the 5th Circuit Court of Appeals upheld the right of a deceased employee’s estate to recover the proceeds of a death benefit under one of the policies that Wal-Mart had taken out.21 There was a similar result in Tillman v. Camelot Music in the United States Court of Appeals in the 10th Circuit.22 It should be noted that the United States District Court in Minnesota has recently ruled that, indeed, an employer could have an insurable interest in the life of his employees.23

In the meanwhile, there is legislation pending which will impose an excise tax of 100% of the acquisition cost on certain exempt organizations who acquire policies on their members or parishioners. This type of transaction arises because in some states there is an exemption for exempt organizations with respect to the necessity of an insurable interest.24 This provision is now part of the tax reconciliation bill and its fate will be decided soon.

Diversification

Regulations were finalized on March 1, 2005.25 These regulations precluded look-through treatment in determining diversification for tax purposes for non-registered partnerships where partnership interests are publicly available. The adoption of these regulations based on commentary mean several things. First, the IRS takes the view that an investment is not publicly available if it is available for investment only through investment in a policy. The IRS was not prepared to give any credence to the fact that non-publicly registered partnerships are restricted with respect to transferability by the securities laws. Importantly, the final regulations did not change the requirement that the partnership must be available only to insurance companies or certain qualified deferred compensation plans if it is not to be publicly available. Managers may hold interest in the underlying entity, but only if their return on the interest is calculated in the same way as all other interests in the entity.26 This rule was not changed. It was believed by some that this would significantly limit the interest of hedge fund managers in allowing insurance policies to participate in their funds.

It should be noted that two techniques, which also appear to comply with the investment control rulings, that were available prior to the new regulation, are still available. Segregated accounts of policies can participate in cloned funds which are insurance dedicated funds, that is to say, funds available only to insurance companies, managers or certain deferred compensation plans in accordance with the terms of the regulation. It is also possible for a segregated account of the policy to participate in one or more hedge funds through the use of derivatives, although this may be a little esoteric for the average investor.

Generally speaking, as indicated earlier, the general mode of compliance with the new rules is through the creation of an insurance dedicated fund which itself may invest in investment vehicles. Under the regulations, the only penalty for loss of look-through is that participation in a particular stock or partnership interest is treated as one investment rather than looking to the underlying portfolio to determine diversification.

Thus, it appears that as long as interest in the investment companies or hedge funds are owned through an insurance dedicated fund and the portfolio of the insurance dedicated fund is properly diversified, not only are the diversification rules not violated, but also, apparently, one can have the view that the investor control rules are likewise satisfied.

Conclusion

Singularly among tax important financial products, private placement life has received “in principle” the clearance of the United States Internal Revenue Service.27 There still remains a thicket of complicated rules and unanswered questions which will need to be resolved before the total profile of this profile is known. It is clear that it is unlikely that this profile will be provided by comprehensive legislation. Rather, the issues will be resolved a piece at a time through the unfolding of a series of notices, rulings (published and private) and regulations. The rapid evolution of the product itself and the effect of peripheral legislation or rulings (judicial or administrative) as to the product will likewise cause questions that will have to be dealt with. We anticipate receiving guidance with regard to some of the issues raised in the near future. However, for the time being, practitioners with clients in this area who must service them on a daily basis are going to have to follow their best professional judgment in determining what to do next.