Lovely weather isn't the only reason the world's great hedge fund traders are suddenly turning up in Bermuda.
By Hal Lux
April 2001
Institutional Investor Magazine
Lovely weather isn't the only reason the world's great hedge fund traders are suddenly turning up in Bermuda.
The rich are different from you and me. Come April 15, they can often find a way not to pay their taxes.
Hence the business model of a company called Max Re.
A small, Bermuda-based reinsurance company, Max Re buys up insurance policies written by name-brand insurers in the life, health and property/casualty markets to collect and invest the premiums. In its first nine months of business, through September 30 of last year, the private company lost money, excluding investment income, while taking in $306 million worth of premiums.
Two things make Max Re special: the type of investors it caters to and how it invests those premiums. Of the $511 million Max Re raised in two private placement offerings to capitalize itself last year, $213 million came from wealthy individuals who put up a minimum of $5 million apiece. A rich person might have several reasons for wanting to own shares in a start-up offshore reinsurance company, but for U.S. citizens one incentive stands out: taxes. Or rather, lower taxes. That's where Max Re's investment policy comes in. At the end of last year fully 40 percent of the company's $854 million portfolio was being put to work in a fund-of-funds managed by billionaire hedge fund manager Louis Bacon's Moore Holdings.
When U.S. taxpayers invest directly in hedge funds, they must pay annual taxes on realized profits, usually at the high ordinary income rate. But thanks to special tax treatment for insurers, when individuals buy into an outfit like Max Re that invests in hedge funds, they in effect pay nothing on the trading profits until they sell shares of the company: Then they are taxed at the lower capital gains rate.
The investors' bet is that outsize performance by the hedge fund (compared with, say, an insurer's typical bond-heavy portfolio) will outweigh the risk of insurance losses and inflate the company's share prices so much that, coupled with the tax advantage, the returns will far outstrip those that they might have gained by investing directly in the hedge fund.
"Quite candidly, many investors understood it was an intriguing way to get a tax-efficient play on hedge funds," says Max Re CEO Robert Cooney. And who is the largest shareholder of Max Re? Moore Holdings, of course.
Why insurance? Why Bermuda? Several reasons: Although investing is a core activity, insurers are exempt from registering as investment companies under U.S. securities laws, which means they don't have to make an annual distribution of profits, unlike, say, a mutual fund, and they are not taxed as investment vehicles under the Internal Revenue Service code. Overseas insurers were exempted when Congress, cracking down on tax avoidance in 1986, passed the Passive Foreign Investment Companies, or PFIC, section of the IRS code, mandating that offshore companies that make most of their money from investing be treated for U.S. taxpayer purposes just like domestic investment funds. But a U.S. citizen who invests in a foreign insurance company with a big investment portfolio doesn't pay taxes on his share of the annual investment gains as long as the company's investing is considered a by-product of its core insurance business.
Bermuda offers another advantage: It has no corporate income tax, allowing investment income to build up tax free on the corporate level. Although U.S. and Bermuda tax structures are difficult to compare directly, a recent report by Bear, Stearns & Co. insurance analysts Michael Smith and Brian Wright estimates that the lack of a corporate income tax boosts the average Bermuda-based insurance company's net profit margin by 25 percent annually. That ought to buoy share prices, increasing investor returns when it comes time to sell stock.
"People are not in [the hedge fund reinsurance business] for the insurance play," says Scott Willkomm, CEO of Cayman Islands-based insurer Scottish Annuity & Life Holdings. "It's always sold as a tax-efficient investment play."
Faster than you can say "alternative minimum tax," hedge fund organizations have become smitten with insurance. Perhaps 30 hedge funds, fund-of-funds or commodities trading pools have attempted to launch Bermuda reinsurers in the past couple of years. Though most have not made it off the ground because the related tax regimes, from the Controlled Foreign Corporation rules to the Foreign Personal Holding Companies regulations, are extremely complicated and reinsurance talent is at a premium in Bermuda, a number of major hedge funds and banks have quietly entered the business. Fixed-income hedge fund manager and Bear Stearns veteran William Michaelcheck runs a $200 million Bermuda reinsurer called Select Reinsurance. Futures trading house Commodities Corp., now owned by Goldman, Sachs & Co., manages half the assets of Bermuda reinsurer Stockton Reinsurance. New York hedge fund holding company Asset Alliance is launching a Bermuda reinsurer, Asset Alliance Re, this spring. J.P. Morgan recently helped to form a Bermuda insurance company called Hampton Re Holdings that will focus on alternative investments for high-net-worth clients. And investment bankers says more hedge fund reinsurers are in the works.
In addition, several well-known U.S. hedge fund operations, including Lee Ainslie's Maverick Capital and New York hedge fund adviser Tremont Advisors, have stakes in companies with a separate but related business: selling offshore insurance policies that can be wrapped around hedge fund investments for high-net-worth individuals. Insurance companies see great demand for offshore insurance products that can diminish high hedge fund tax bills. Scottish Annuity, in which Maverick owns an 8.4 percent stake, currently administers $450 million invested in hedge funds through offshore life insurance policies but hopes to have $5 billion under management within three years.
"If I deal with an offshore insurance company, do I have to leave the country to sign the papers?" asks Scottish Annuity, in a piece of marketing literature. Yes, but the weather in Bermuda can be lovely.
The Bermuda reinsurance game is a thing of beauty. High-net-worth investors get the double tax advantage of investing in a Bermuda insurance company while literally capitalizing on hedge fund returns. Institutional investors that might be prohibited from investing directly in hedge funds can do so through an insurance company. And both types of investors obtain leverage from the insurance company balance sheet. For their part, U.S. hedge fund managers can generate additional assets and a more stable form of capital - the capital comes from a source that they own a big piece of, the insurer. What's more, they get a tax advantage of their own from being able to defer management fees, and thus taxes, generated from assets that can now also be classified as non-U.S. "You are effectively taking U.S. assets and moving them offshore," explains one hedge fund manager.
All in all, the benefits promised to investors are pretty snazzy, judging by a January 2000 Max Re private placement memorandum obtained by Institutional Investor. The company, whose shares sold for $15 a pop, assumes that it will put 60 percent of its assets in bonds and 40 percent into hedge funds. (With as much as 5-to-1 leverage, every dollar of equity translates into two dollars of hedge fund investment.) Assuming 20 percent net returns on its alternative investments, Max Re figures that in an initial public offering five years hence, the shares would be worth somewhere between $56.44 and $131.68, given a price-to-book value of 1.5 times to 3.5 times. Sell the shares and pay a 20 percent capital gains tax and you end up with $48.15 to $108.34, or an annual compounded return - after taxes - of 26 percent to 48.5 percent. A 20 percent return on a direct hedge fund investment, assuming all profits were generated by high-turnover, short-term trading, would yield about 12 percent on an aftertax basis. "Many hedge funds are not tax-efficient," says Israel Press, a Grant Thornton tax partner specializing in hedge funds. "For a high-net-worth investor, it's 100 percent advantageous to wrap the investment in insurance."
The game works, of course, only if a few things remain true. Hedge fund managers like Moore Capital must deliver consistently high net returns. The insurers must keep from suffering significant losses, while buying up enough insurance risk to qualify for the PFIC insurance exception. And federal watchdogs have to let this game play on.
How much of this is guaranteed? That's not clear. Max Re earned 4.3 percent on its alternative investment portfolio last year - a respectable figure in a year that saw the Standard & Poor's 500 index drop 10.1 percent, but nowhere near its 20 percent target. And the prospect of insurance losses is real: Stockton Re, a Bermuda reinsurer that invests half its money with the legendary futures trading shop Commodities Corp., suffered insurance-related losses last year, according to people familiar with the company. Stockton Re CEO Daniel Malloy did not return phone calls. Says one hedge fund manager who believes that his colleagues are underestimating the difficulty of the insurance business: "Everybody is supposed to have looked at this, but I think it's fool's gold."
The tax breaks these companies exploit are perfectly legal - Scottish Annuity insurance policies, for example, offer the same break to rich customers that U.S. insurers sell through variable annuities to middle-class Americans. And sponsors are quick to argue that their aim in setting up the new breed of hedge fund reinsurers isn't chiefly tax-related. They say they're after balance-sheet leverage and permanent capital. Moreover, not all investors are U.S. citizens: Max Re has many offshore investors, and Asset Alliance Re says it plans to sell mostly to investors who won't get a U.S. tax break from buying into the company.
"It's another way of diversifying your funding," says Asset Alliance CEO Bruce Lipnick. "Raising capital that's more permanent really helps the results of managers."
Nevertheless, tax avoidance is a big part of this business, and hedge fund managers aren't looking for a lot of publicity about this aspect of their operations. "I would appreciate it if you would keep me out of your story," says one hedge fund CEO who manages money for a Bermuda reinsurer.
Beyond economic and regulatory constraints lies another danger: the Bermuda triangle of politics. A number of big U.S. insurers, including Chubb Corp. and Liberty Mutual Insurance Co., are preparing anew to lobby Congress to shut what they see as a tax loophole that has allowed some American insurance companies to avoid paying federal taxes by moving their headquarters offshore to Bermuda. They aren't concerned specifically about the hedge-fund-related reinsurers, but the lobbying may generate unwelcome attention.
"I think you're going to see something happen," says Robert Marzocchi, the Chubb senior tax executive working on the legislative effort. "These companies trade on New York exchanges. Their balance sheets are in U.S. dollars."
Will Congress act? That's hard to say, though it has clamped down on hedge fund tax plays before. In 1999 Congress closed a tax shelter popular with hedge funds that involved using swaps and derivatives to buy into funds. A greater risk to the hedge fund reinsurance companies is the possibility that the IRS will more clearly define insurance companies under the PFIC rules. "No final regulations interpreting the substantive PFIC provisions have yet been issued," says the Max Re private placement memo. "Therefore substantial uncertainty exists with respect to their application."
Not surprisingly, the hedge fund reinsurance sponsors are quick to emphasize that they are playing by the letter of the law. To avoid being classified as PFIC, companies must demonstrate they are taking sufficient underwriting risk to qualify as insurers. The idea is to dial back somewhat on insurance risk because of the unusually high level of investment risk, but to still take on enough risk to qualify as an insurance company.
Making matters murky: No accepted definition, or "bright line" test, for an insurance company exists in the tax rules. "It's kind of interesting, but if you look in the IRS code, they don't define insurance," says James Riedy, a tax lawyer with McDermott, Will & Emery. "There is case law about it but there is no bright line."
The amount of underwriting risk assumed, however, is a key part of the definition that has evolved through case law. "There is no definition of an insurance company that says you have a problem if you invest in a high-risk portfolio," says Alston & Bird tax lawyer Joe Taylor. "But the Service can come in and say your loss reserves aren't really loss reserves. They're not there for insurance risk. Then you could have a big problem." An IRS spokesman says that the agency has not issued guidance on the insurance exception to the PFIC rules, but it might take up that issue this year.
"A number of groups have tried to form Bermuda-based entities that were really hedge funds dressed up as reinsurance companies, but without significant insurance expertise on the liability, or underwriting, side of the balance sheet," says Zack Bacon, Louis Bacon's brother and business partner and the Moore Capital executive who put together Max Re. "I can promise you that writing $650 million of reinsurance premium, encompassing 17 separate transactions, cannot be done without taking on some insurance risk."
A decade of financial engineering and deal making in Bermuda set the stage for the recent combination of hedge funds and insurers.
Reinsurers are companies that buy up part of the risk in the retail and corporate policies written by brand-name insurers. Reinsurance fits well with hedge fund strategies because it's a wholesale business that doesn't require large staffs for dealing with the public and because it allows companies to very precisely tailor the insurance risks they're assuming. Like regular insurers, reinsurance operations make money by collecting premiums and investing that money until much of it is paid out later in claims. The traditional reinsurance business is dominated by giant companies. In 1999 the four largest companies - Swiss Re Group, Munich Re Group, GE Global Insurance Group and General Re Group/Berkshire Hathaway - together accounted for one third of the global reinsurance market.
Lately, business has been tough. Overcapacity, weak demand for property/casualty reinsurance, soft pricing and bad luck in the form of storms dropped the industry's average return on equity from 10 percent in 1998 to 8 percent in 1999. But reinsurers have generally outperformed insurers on earnings, and recent price increases on several types of reinsurance have many people hopeful that the worst may be over.
Reinsurers typically take on massive risk in their underwriting business, while playing it safe in their investment portfolio with mostly high-grade bonds. In 1999 reinsurers had just 27.4 percent of their total invested assets in equities, up slightly from 26.7 percent in 1995, according to insurance ratings agency A.M. Best Co. In the U.S., even if reinsurers wanted to invest a very large portion of their assets in hedge funds, they couldn't because of the investment policies of state insurance regulators. The rules are more relaxed in Bermuda.
In the late 1980s some reinsurers began experimenting with a business called financial or finite reinsurance, which sets a limit on potential losses while repaying customers part of their premiums, if they do not claim against them. Capping losses on the underwriting side leaves reinsurers free to take more risk on the investing side. It didn't take long for some aggressive traders outside the insurance business to notice the possibilities.
In 1994 Commodities Corp. converted a Bermuda asset management subsidiary into a finite reinsurance company, capitalized at $217 million. The new entity, called Stockton Reinsurance, focused on long-term liabilities such as worker's compensation and general liability and invested in futures trading. Longer-term liabilities give companies more time and flexibility in terms of aggressively investing premiums.
Soon other well-known hedge fund operations were also trying to launch offshore insurance operations. In 1998 Scottish Annuity filed to go public in an offering lead-managed by Prudential Securities. According to a 1998 registration statement, Maverick Capital was to manage a portion of the reinsurer's assets. Another start-up, Gemini Re Holdings - a finite reinsurer based in Bermuda and backed by Willowbridge Associates, a New Jersey-based hedge fund - filed in 1999 for an initial public offering to be lead-managed by Merrill Lynch & Co. A unit of Willowbridge would manage some of the assets in Gemini Re, according to Gemini's Securities and Exchange Commission filings.
Neither company made good on its plans. Scottish Annuity went public in November 1998 raising $251 million, but by the time of the IPO, the company had backed off its plans to invest heavily in hedge funds. Maverick still owns 8.4 percent of the company, which has a side business selling hedge fund investments wrapped in life insurance policies to high-net-worth investors, but the Scottish Annuity's investment portfolio has no money in hedge funds. People familiar with the offering say that the collapse of Long-Term Capital Management around the time of the IPO made it difficult to sell an insurance company that was to have a large portion of its assets managed by a hedge fund.
The Gemini deal was eventually withdrawn, and the following year Willowbridge suffered double-digit trading losses in some months, according to the MAR hedge fund database. Similar trading losses in the reinsurance company would have been even more embarrassing, because the ex-finance minister of Bermuda was slated to be Gemini Re's chief financial officer.
Reinsurance companies have so far capped their hedge fund allocation to 40 percent of investable assets. Bankers and insurance analysts offer different explanations for the seemingly arbitrary number. One banker who has worked on setting up these companies says ratings agencies have set 40 percent as the maximum hedge fund allocation. An insurance analyst at Standard & Poor's says her agency has no maximum but requires insurance companies to reserve much more capital against hedge fund investments than traditional bond investments, effectively setting a cap on the percentage of assets that can be invested in hedge funds.
Bankers estimate that dozens of hedge fund managers have tried to launch Bermuda reinsurance companies in the past couple of years. Most have failed. One of the rare successes has been Michaelcheck's Select Re; it is considered one of the largest hedge-fund-backed reinsurance companies. Former Goldman Sachs mergers co-head Willard (Mike) Overlock is a Select Re director, and hedge fund investors say that a number of former Goldman partners are investors in the company. Michaelcheck and Overlock decline to comment.
Max Re is the poster child for a successful hedge fund reinsurance operation. Its successful launch last year ignited a new wave of interest in hedge fund reinsurance companies. Sometime this spring the $2.1 billion New York-based hedge fund holding company Asset Alliance will start Asset Alliance Re, a Bermuda-based reinsurance company. J.P. Morgan last year helped to form a Bermuda-based reinsurer called Hampton Re. "It's a relatively new idea, but it's definitely an emerging trend," says Tremont Advisers president Robert Schulman. "Some managers are considering turning their funds into insurance companies. People are doing it to take advantage of appropriate tax benefits."
Max Re has already told insurance analysts that it may try to go public this year. If the company can pull it off, an even larger group of hedge fund managers will soon be swarming Bermuda beaches. "Is it that much different than what Warren Buffett did with Berkshire Hathaway or what Larry Tisch did with CNA?" asks Joseph Taussig, a banker with Bermuda-based First International Capital, which specializes in creating reinsurance companies for hedge funds. "I don't think it is. It's a new group of innovators concentrating on a huge pile of underperforming assets."
Max Re is a colorful mixture of the Bermuda insurance and New York hedge fund cultures. CEO Cooney is an old and highly regarded insurance hand, who previously served as CEO of Bermuda-based XL insurance. Hedge fund Moore Capital is the company's largest shareholder; and one banker in on Max Re's initial private placement was Geneva-based Arpad Busson, not an insurance expert, but a well-connected hedge fund veteran famous for having helped launch Louis Bacon and futures trader Paul Tudor Jones (and for being the companion of supermodel Elle McPherson).
Moore Capital's Zack Bacon is given much of the credit for getting Max Re off the ground against very long odds. And analysts who have studied the company say that it has gone to great lengths to build an active insurance business. "It's definitely an insurance company," says Morgan Stanley insurance analyst Alice Schroeder. "There are companies out there that take less risk and are considered insurance companies." Says competitor Scottish Annuity's Willkomm: "It's the one hedge fund insurance company that I know about that would satisfy U.S. securities regulators."
Adds Laurence Cheng, an executive with Capital Z Partners, a private equity firm specializing in financial services investments that co-founded the reinsurer: "If Max Re is a tax play, then any insurance company is a tax play. Anybody who invests in an insurance company gets tax-efficient investing."
Max Re believes that structural changes in the insurance industry, such as the desire of newly demutualized life insurance companies to unload blocks of old business from their balance sheets, will present opportunities. The company will also write policies in the the so-called "alternative risk transfer market," a new type of insurance product that combines traditional policies, such as protection against weather catastrophes, with financial-related insurance, such as protection against interest-rate fluctuations. By writing a small number of very large reinsurance transactions, Max Re will run with very low overhead and only half the expenses of the average Bermuda insurance company. A big attraction for potential insurance company clients will be the ability to participate in Max Re's hedge-fund-style investing by structuring reinsurance deals with the company.
All of this very complicated and intricate insurance work, however, is still designed to build a leveraged balance sheet that can accommodate hedge fund trading aggressive enough to generate the 20 percent net annual returns. "After all the intricacies of Max Re's complex operating platform are considered, the business boils down to a spread business," says a December 2000 Fitch IBCA, Duff & Phelps report affirming its single-A rating. "The company's primary profit driver is higher-than-average investment returns." In other words, if the Bacon organization can't deliver huge trading profits, the wealthy individuals will end up owning a regular insurance company, and a conservative one at that.
Moore Capital has one of the best long-term investment records in the hedge fund business. But after all the intricate financial engineering, tax lawyering and high-level fundraising required to put together Max Re, its wealthy investors could still fall prey to one immutable law of finance: It's hard for anyone to make superior returns, let alone net 20 percent returns, while running a lot of money.
Just ask Warren Buffett, another reinsurance guy who basically runs the stock portfolio for his giant reinsurance company, General Re Corp. In his March 10 annual letter to Berkshire Hathaway shareholders, Buffett promised investment returns that would "modestly exceed the gain from owning the S&P 500." As for equities going forward, wrote Buffett, perhaps the greatest long-term investor of all time: "The long-term prospect for equities in general is far from exciting."
If Buffett is right, Max Re's wealthy investors may have to forget about collecting their big hedge fund profits. As will Uncle Sam.
