As the nation recovers from the Great Recession and stability returns to the markets, high-net-worth investors are once again returning to alternative investments-usually hedge funds.
But as they maneuver their way through a low-return market, wealthy investors are becoming ever more conscious of their tax burdens and the impact a good tax management strategy can have on their investment returns.
One tax management solution, in fact, has come to be recognized by some high-net-worth investors as a perfect complement to their hedge fund investments: private placement insurance-in the form of both life insurance and annuities.
These products essentially allow accredited investors to put alternative investments inside a tax-free insurance wrapper. The products take advantage of long-standing tax rules that allow income earned on assets inside insurance or annuity policies to accumulate free of taxes. Moreover, gains remain tax-free when distributed as life insurance proceeds-as a death benefit or the cancellation of loans made to a policy owner-and tax-deferred if distributed as annuity benefits.
These features are of great value to hedge fund investors, who understand the impact ordinary tax rates have on gains derived from short-term trading and credit-oriented investments, phantom income produced by market-to-market elections by fund managers (often to justify fees), and PFIC treatment of offshore fund investments. Hedge fund investors have learned that taxes paid on current gains are not recovered if losses are suffered in later years. Those losses can only be carried over to future years when or if gains are realized.
Old Product, New Strategies
Private placement insurance is not new-insurance products have offered tax-free or tax-deferred benefits for many years. Private placement life insurance is structured as variable universal life insurance. Unlike conventional insurance, however, private placement products are tailored to meet the specific investment objectives of high-net-worth investors. In particular, a policy owner can select the manager of a policy's cash value account from a group of third-party managers selected by the insurance carrier or invest in a hedge fund designed for insurance company accounts.
The number of companies offering these policies is relatively small. The big sellers include MassMutual, the American International Group, New York Life, the Phoenix Companies in Hartford and Boston, Prudential, John Hancock and Crown Global Insurance, according to a recent New York Times article.
The choice of managers is limited among most of the large commercial carriers, but is virtually unlimited through carriers that are focused on private placement insurance. The number of insurance dedicated funds-hedge funds designed for insurance accounts, called IDFs-is growing rapidly.
Private placement policies can offer the same returns as managed accounts or hedge funds with one key exception: The returns inside a policy are tax-free or tax deferred, while the returns of a direct investment are currently taxable, often at ordinary income rates.
Private placement policies are only available through a private placement offering to accredited and/or qualified purchasers, who must meet the suitability standards required under the applicable securities laws. These rules are the same as the rules that apply to an investment in a hedge fund, and in each case, the beneficial owner of the policy must complete a questionnaire establishing suitability. Most carriers require minimum premium commitments of $3 million.
Private placement policies are "variable," which means that the policy owner allocates the assets to one or more third-party asset managers or an IDF. The proceeds of the policy will be a combination of the return on these investments and, in the case of a life insurance policy, the amount of death benefit set forth in the contract. To qualify as life insurance, a certain amount of risk must be borne by the insurance company based on the insured's age, health and sex.