But the IRS has never specified exactly how much is too much.
“The $64,000 question is how big a reserve can you have?” said Robert Cudd, a tax lawyer at Morrison & Foerster LLP in San Francisco. “There’s no easy answer to that.”
The IRS in 2001 disclosed plans to clarify its definition of insurance companies, a move that might prevent abuses by hedge funds, Cadwalader’s Miller said. He said it never followed through.
The fact that Pacre and the other startups trust virtually all their assets to one hedge fund manager may allow them to argue to tax authorities that they can’t afford to take on the extra risk of selling much reinsurance, Miller said.
“Under the current law, so long as Pacre’s reserves are not excessive -- and they probably aren’t -- this probably works,” he said. “I think you need a change in law.”
First Fund
The first prominent hedge fund to set up a large Bermuda reinsurer was Louis Moore Bacon’s New York-based Moore Capital Management LP, in 1999. He originally planned for Max Re Capital Ltd. to invest all its assets in his funds, and shares were marketed in part as a tax-efficient way to invest in a hedge fund, said Cooney, a career insurance underwriter who was Max Re’s first CEO. Forbes estimated Bacon’s net worth at $1.3 billion as of September 2012.
As it turned out, Max never invested more than 40 percent of its assets in hedge funds and now puts less than 5 percent in them. Still, the tax-avoiding aspect of Max Re was highlighted in a 2001 article in Institutional Investor magazine, titled “The Great Hedge Fund Reinsurance Tax Game.” Two years later, the IRS threatened to scrutinize the practice.
Phony Insurance
The IRS said some of the offshore arrangements were shams, either because they weren’t selling enough insurance or because the insurance they reported selling was phony. The IRS “will challenge the claimed tax treatment,” government lawyers wrote.