Converting Fund Units into Equity Yields Tax Benefits
Offshore Insurance Companies Provide Possible Advantages to U.S. Fund Investors

Copyright 2000 Barclay Trading Group, LTD.
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If a taxable U.S. investor buys units in a managed futures fund, hedge fund or mutual fund, he/she will have to pay taxes each year on all or some of his profits. Purchases of stock by the same investor, if held for longer than a year, are accorded a more favorable tax treatment: no taxes are incurred until after the stocks are sold. Upon sale, the profits are taxed at the more favorable long-term capital gains rate. The resulting advantages of compounding that accrue to a tax efficient approach are significant to such an extent as to completely overwhelm the strategic rationale underpinning fund investing.

The intellectual basis for granting tax subsidies to supposed long-term investors is based on the rationale that somehow a buy and hold strategy is more conducive to economic growth and capital formation than a short-term trading approach. While a discussion of the macro-economic merits of long-term versus short-term investing and the capital formation process is beyond the scope of this article, there is something in the works that might put fund unit holders on an equal footing with share owners vis-`a-vis tax treatment of their profits.

An offshore insurance company is not taxed on its corporate earnings based on specific exemptions in the U.S. tax code. By owning stock in a well run offshore insurance company whose investment portfolio includes allocations to managed futures and hedge funds, an investor can possibly reap the benefits from these investments on a tax efficient basis. However, the issues are complex. In order to gain a better understanding of the issues involved, we've invited a panel of very knowledgeable participants to answer our questions. Our panel includes:

Thomas F. Basso, Trendstat Capital Management, Inc. Mr. Basso is the CEO and founder of Trendstat, a money management firm founded in 1984. Trendstat manages over 250 million dollars in hedge funds, currencies, futures and mutual funds for clients worldwide. Mr Basso has authored Panic Proof Investing, which is dedicated to helping investors and was one of the traders featured in The New Market Wizards.

Arthur F. Bell, Jr., Arthur F. Bell, Jr. & Associates, L.L.C. Mr. Bell is the founder and President of the CPA firm of Arthur F. Bell, Jr. & Associates, L.L.C. His firm has served the futures and hedge fund industry for over 20 years through audits, tax and consulting services. The firm is a member of the SEC Audit Practice division and is also an approved auditor in the British Virgin Islands and the Cayman Islands.

Joseph K. Taussig, Financial Institutions Group. Mr. Taussig is the President and founder of FIG and of several other financial services firms. The companies are largely involved with corporate finance as financial advisors, as private placement agents, and as underwriters in public offerings, and have participated in more than $5 billion in financings, most of which were for the insurance industry. Other activities in the family of companies involve offshore finance, securities brokerage, trading, banking, life insurance and annuities, and investment funds.

Q: How can an insurance/reinsurance structure superimposed on a managed futures investment alter the tax consequences for the investor?

Basso: The investor would buy shares in the insurance/reinsurance entity. Therefore, the investor owns a stock and would not be taxed on it until he sold it, just like any other stock. If the investor held it long enough and made a profit, it should be treated as a long-term capital gain, like other profitable stocks held for the long term.

Bell: Investing in an insurance company will follow the normal investment consequence of capital gains treatment and avoid the severely negative current taxation of managed futures. This treatment will allow an investor to combine the advantages of an insurance investment with the potentially superior returns of managed futures and experience tax consequences identical to an investment in any other common stock. This should not be seen as managed futures enjoying some new special advantage, but rather the elimination of the current inequitable treatment as compared to other investment opportunities.

Taussig: There is some confusion over the concept of insurance/reinsurance or (re)insurance structures and their use in conjunction with managed futures. Many people interpret this to mean the purchase of a variable life insurance policy or annuity contract, which invests in a managed futures product. The other interpretation of the meaning of (re)insurance structures involves owning shares in an insurance company that invests its assets in managed futures. Any legitimate insurance or reinsurance company could make (and should make) a decision to use managed futures as a major part of their investment strategy. With the exception of AIG, the largest, most profitable, most diversified insurance company in the world, none of the majors make it a cornerstone of their investment strategy. This second interpretation of the concept applies, regardless of what type of (re)insurance the company offers, which is distinct from its investment strategy.

These (re)insurance companies are not funds disguised as insurance companies. Unlike variable life and annuity products, they are not tax-deferral vehicles. They assume (re)insurance risks, but they also manage those risks. Assuming that they break even on their (re)insurance business, the earnings of the (re)insurance company are equal to the investment returns on its capital. However, an offshore (re)insurance company is not taxed on its corporate earnings and its shareholders are not taxed on their shareholdings. (Re)insurance companies are exempt from the PFIC regimes of the U.S. tax code, provided that they are primarily in the (re)insurance business and write enough to justify their capital.

Obviously, the future after-tax returns on an investment in an offshore insurance company that breaks even on its insurance business and has its capital managed by a manager in an untaxed vehicle will be far superior to an identical investment with the same fund manager on a taxable basis.

If the insurance business is profitable, the return on capital is better than the investment returns on the capital of the company. On the other hand, the (re)insurance company can lose money in the (re)insurance business. However, just as investment risk can be managed, this risk can be limited to a maximum annual drag on capital of 60 to 100 basis points over the risk free rate of return. This is far less than the tax drag on future gains.

Assuming that capital gravitates to the highest after-tax return for a given risk, then capital will gravitate to these types of companies instead of to an onshore fund managed by the same manager. This is why so much capital is gravitating to these start-ups.

Q: In addition to tax deferral, are there other benefits that would accrue to investors who seek exposure to managed futures returns through the purchase of shares in an offshore insurance entity?

Basso: Depending on the investment strategy, the investor might get exposure to numerous managers or numerous investment programs if multiple managers were hired to run the insurance company's portfolio. Typically, the insurance company would prefer to generate steady, above average returns. Below average returns would hurt the insurance company's long term viability and too much volatility might put their surplus capital at risk.

In addition, investors get the plus of insurance profits if the company is doing its job right. Based on the success of insuring risks at a fair price, the insurance company should produce a profit from insurance operations. A typical futures investor might view any profits from this part of the company as an added plus to his/her long-term managed futures returns.

Bell: Historically, insurance underwriters have held their investment portfolios in very conservative investments and matched the portfolio duration to the underwriting risk period. This strategy has been examined during the last ten years with some insurance companies, such as Berkshire Hathaway and AIG, establishing an equal or even higher profile for their investing ability than their insurance profits.

The continuing very low interest rates have forced insurance companies to explore opportunities to increase portfolio returns, including allocations to alternative investments. This practice has proven very successful and has redefined the relationship between the underwriters and portfolio managers. Each must develop a better understanding of the other's role and responsibilities so that risks are underwritten to maximize premium flow, portfolio management and participation to the insured.

Bermuda has been a favorable environment for insurance companies for many years and there are now over 1,400 insurance companies domiciled in Bermuda. Like any large group of companies, some are winners and some are not doing so well. Identifying a successful insurance entity will allow an investor to participate in substantial growth and return on investment based on underlying financial value as an alternative to investments in some of the high market value Internet and technology stocks trading at a significant premium to book value and reporting limited or no earnings.

Taussig: There is tax deferral and there is tax deferral. First of all, in the domestic insurance world, there are up front sales loads and taxes in addition to higher frictional costs in life insurance and annuities, which make them require either much higher returns or a longer investment horizon for the tax benefits to kick in.

In annuities and single premium life insurance policies, any payments to the policyholder incur ordinary income tax rates. If the policyholder is less than 59 and 1/2 years of age, there is a 10% surcharge added on. If the policyholder purchases a non-Modified Endowment Contract, the policyholder may borrow the cash values, free of income taxes.

If the insured dies, there are no income taxes on the investment gains within a life insurance policy, but if the insured was the owner of the policy (instead of a trust or a business), then the proceeds are added to the value of the estate for estate tax purposes.In the case of shareholdings in offshore (re)insurance companies, there are no penalties for redemption before age 59 1/2, and when shares are sold they are subject to capital gains treatment, which is a substantially lower rate. In addition, offshore variable products incur a 1% excise tax on purchase, and the policy will cost roughly another 1% per year, both of which drag down performance.

Some of these manager founded (re)insurance companies are either publicly held or expect to go public in the U.S. capital markets. When that happens, capital is locked up for the manager, but the investors obtain daily liquidity. Historically, the Bermuda insurance companies that are publicly traded on NASDAQ or the NYSE have traded at a price to book ratio of 1.5 to 2.0, adding an additional boost in IRR over and above the earnings of the company.

Q: Are there any additional risks to the investor arising from equity participation in an offshore insurance entity? What can an investor do to limit those additional risks?

Basso: There are a number of additional risks that quickly come to mind in these investments. In insurance shares, you have a lot less liquidity than you have in a managed futures account. Bid/Ask spreads can be quite large in the case of a smaller offshore insurance entity. If the investor needs to liquidate, he can expect to sell at a discount to current market value. This is very similar to what tends to happen in closed end mutual funds in the US and, given the expected liquidity, is a normal consequence.

The investor also is risking his money on the profitability of the insurance operations. The company must take insurance risk to meet US requirements. Some insurance companies lose money writing insurance. If that happens, investor returns will be decreased by the amount of the insurance operational losses over the long-term.

Another risk is of the US tax authorities changing their minds, as they often do. If they decide that US investors can't invest in these insurance companies anymore, there could be some adverse consequences to getting out of the them at that time, yielding some potential losses for investors.

One final risk I'd point out is that the insurance company has your cash, not a custodian FCM or bank. If someone wanted to embezzle your cash, they have some ability to do so. You should know the insurance company well and make sure that safeguards are in place to protect the cash you invest. It is possible for a company to come up with a story, raise assets and never run a true insurance company, leaving investors owning shares in nothing.

Bell: It will likely prove very difficult to combine insurance operations with asset allocations to alternative investments and achieve superior results. There are few successful models and the new insurance company offerings plan different strategies. Accordingly, the uncertainty of new structures magnifies the risk to an investor until operations actually yield the potential returns and a winning model is established.

An investor can limit risk in the new products by observing the traditional rules:

Investigate before you invest, never invest more than you can afford to lose, and know the people involved. If the new structure succeeds in achieving superior returns and equitable tax treatment, it will challenge another rule: "If it's too good to be true, it isn't."

Taussig: The major risks to the investor are five-fold: (1) It behaves like an investment fund rather than a (re)insurance company; (2) (Re)insurance risk; (3) Investment risk; (4) A tax or regulatory change; or (5) A finding that the company was doing business onshore. All but the regulatory or tax changes are matters of corporate governance and the investor either has to trust that the Board and Management will behave responsibly, exercise a shareholder's rights to insist on compliance, or sell the shares. Other than lobbying, there is little that can be done about changes in the areas of tax and regulation.

Q: Are tax regulators looking askance at this strategy and potentially relegating it to imminent extinction, or is there reason to believe that the life cycle for this tax deferral is not near its end?

Basso: I have no idea what the regulators are looking at in this area, but as a rule, I try to look at new business deals like this from an economics standpoint, not a tax standpoint. I don't view offshore insurance company investments as a tax deferral. I look at them as an investment in the insurance business with an investment approach that can be based on a far broader portfolio base than US insurance companies are capable of due to regulations. This should give offshore insurance companies a competitive advantage over time.

We in the managed futures industry have been talking for years about portfolio diversification. Offshore insurance companies are a way to create portfolios that combine traditional investments and alternative investments. This concept gives us the chance to put what we talk about into practice and hopefully produce a more steady, profitable return for investors.

Bell: An insurance company allocating to managed futures should have no reason to anticipate an unfavorable change in the tax laws. After all, the management of an investment portfolio is the essence of insurance company operations. However, a commodity fund that attempts to underwrite a minimal amount of insurance to obtain favorable tax benefits can anticipate substantial tax problems. In short, attempting to operate merely for a perceived tax advantage will not succeed; but legitimate combinations of the best of both worlds can achieve success and enjoy a competitive tax consequence.

Taussig: There is a risk that there could be changes affecting the investing in offshore (re)insurance companies. However, there are substantial consequences for doing so. First of all, 30% - 40% of the reinsurance capacity in the world is located in Bermuda. If investors were taxed for their ownership in these companies, the U.S. policyholders will pay more for their reinsurance or will not have any coverage at all and will be totally exposed for certain risks, such as they were in the 1980's.

Secondly, the U.S. is the champion of global investing. It is unlikely that statutes would arise whereby U.S. investors would not be able to invest in companies like AXA , Allianz, Zurich or Swiss Re. Lastly, the business could all relocate to Ireland, which now has an internationally acceptable corporate tax rate of 12.5%.

The most likely scenario for change would be to raise the requirements on what constitutes an insurance company as has been done for offshore banks (which would not affect the publicly held (re)insurance companies, because they already meet them). Other likely scenarios include raising the excise taxes on foreign insurance purchases by U.S. entities or a requirement for higher levels of premiums and/or reserves to define an insurance operation than are generally considered at this time (although this could increase the levels of insurance risk for policyholders as well as shareholders which regulators and rating agencies hate).

Q: A futures fund investor can usually request a redemption at the end of any month. What are the exit strategies for purchasers of shares in these ventures? How much liquidity would be available?

Basso: Investors should be able to sell shares in an insurance company whenever they wish on whatever exchange or market lists those shares. The problem is that the shares will likely sell for a discount when you need the money. The share price and the true value of the portfolio should track generally over time, but over the short-run, the shares could sell for a discount.

Bell: An offshore insurance company has unique attributes that favor listing on an established stock exchange and allowing the investor to buy or sell shares more frequently than the subscription and redemption policies of most funds. Unless or until the company is listed, redemption may not be possible unless there is a secondary market through a feeder fund or private market. Some insurance companies may offer periodic limited repurchase of shares.

Taussig: For those companies that are publicly held in the U.S. capital markets, the exit strategy is to call one's broker with a sell order. One of our affiliates will make markets in any of its client's shares that list on the Bermuda Stock Exchange. Some of the companies will run a Dutch Auction on a periodic basis. Historically, Stockton has offered to repurchase shares once a year. However, to promise to redeem on a regular basis at NAV runs the risk of being accused of being a hedge fund in disguise.

Q: Would you envision any significant changes in the way managed futures products are structured and sold if this novel approach were to become widely accepted? Is there any reason precluding adoption of similar strategies by hedge funds and even mutual funds?

Basso: I don't believe that this approach will change the way managed futures products are structured and sold or that this novel approach will become widely accepted. I do believe many CTAs will become more involved in insurance company projects offshore in the future, but many of our existing clients will prefer the transparency and the ability to notionalize their accounts as they do now. Others will dislike the discounts that will be built into the market on many insurance shares. However, the industry will be able to attract some new clients to the industry with this concept.

Hedge funds will also find insurance companies as excellent candidates for part of their business. With a market in insurance shares, even an illiquid one, the investors would not suffer long lockups required by some funds if they needed to get out. Since many hedge fund investors are longer-term investors they may not find the longer holding period for insurance company shares as negative as traditional futures investors might. Hedge funds, however, will have the problem of dealing with the liquidity of their instruments when money is needed to pay off claims.

Mutual funds are locked on to the smaller investing public now. I believe that some of their well-heeled clients may be candidates for an insurance company investment, but I don't see most investment companies distracting themselves right now from the money machine they've built with the strong stock and bond markets. Perhaps, during the next bear, they'll look at new opportunities like offshore insurance.

Bell: The SEC, CFTC, IRS and state securities laws are not currently responsive to the anticipated new structures and some interpretations and relief will be necessary to allow efficient wide spread distribution. Until these changes occur, offerings will have to be carefully customized to satisfy current rules and regulations with the consequent restrictions on marketing and eligible investors. Uncertainty in these areas will inflate costs, result is less efficient access and inhibit start-ups. However, managed futures have survived worse and will likely proceed to eventually establish an efficient process.

If this combination of underwriter and trading manager proves successful, it could likely become the dominant method of operation for the CTAs and hedge fund managers eligible to participate in this form of operation and the preferred method of investment for qualified investors.

Taussig: We are already seeing a difference in how the products are structured. In the public company arena, Wall Street is uncomfortable with allowing a single manager to manage all of the assets. Consequently, invested returns are a blend of two or more managers. However, even a high performance manager averaged with short duration, high-grade fixed income securities on an untaxed basis yields an after tax return superior to the high performance manager alone on a taxed basis, and this does not even take into consideration the value of deferring the fees on the assets for the manager and compounding them at an even higher rate on a tax deferred basis or the benefits of the premium to book value of the shares.

To reduce some of the investment banker's anxiety, some level of structured product is being considered to either increase the amount of assets for the founding manager or to increase returns on the "less risky" part of the portfolio

In private or semi-public companies, the manager is managing all of the capital assets and various degrees of premium generated assets. This gives the shareholder a purer after-tax return as a function of the investment manager's skills than a mix of several managers.

We can see no reason that a legitimate (re)insurance company would avoid investment in offshore mutual funds or hedge funds. In fact, more of our clients are affiliated with hedge fund managers than with the managed futures business.

Copyright 2000 Barclay Trading Group, LTD.

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