Private Placement Life Insurance Planning

LESLIE C. GIORDANI
MICHAEL H. RIPP, JR.
AMY P. JETEL

Compliments of Giordani, Swanger, Ripp & Phillips, LLP

© 2007 Giordani, Schurig, Beckett & Tackett, LLP

IRS Circular 230 Disclosure: Any tax information contained herein was not intended or written by the authors to be used and it
cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. Any tax information
contained herein may be held by Treasury or the IRS to have been written to support, as that term is used in Treasury Department
Circular 230, the promotion or marketing of the transactions or matters addressed by such information because the authors have
reason to believe that it may be used or referred to by another person in promoting, marketing or recommending a partnership or
other entity, investment plan or arrangement to one or more taxpayers. Before using any tax information contained herein, a
taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
 Table of Contents

A. Introduction: “Big Picture” Estate and Tax Planning .................................................. 1

B. Private Placement Variable Universal Life Insurance.................................................. 1
1. Introduction ......................................................................................................... 1
2. What PPVUL is Not.............................................................................................. 2
3. The U.S. Client ..................................................................................................... 3
4. Foreign Trusts with U.S. Beneficiaries.............................................................. 4
5. Tax Considerations ............................................................................................. 6
a. U.S. Federal Income Tax Benefits .......................................................... 6
b. Other Potential Tax Benefits................................................................... 7
c. Transfer Tax Planning ............................................................................. 7
d. Irrevocable Life Insurance Trust ............................................................ 8
6. Investment Considerations ................................................................................ 9
7. Pricing Considerations ....................................................................................... 9
8. Legal Considerations: Asset Protection ......................................................... 10
9. Other Considerations........................................................................................ 11
10. Product Design Issues...................................................................................... 12
a. IRC § 7702 Compliance ......................................................................... 12
b. Diversification under IRC § 817(h) and the Investor Control
Doctrine .................................................................................................. 13
c. Insured Lives.......................................................................................... 19
d. Loan Spread and Loan Provisions....................................................... 19
e. Extended Maturity Option ..................................................................... 19
f. Cost of Insurance .................................................................................. 19
g. Investment Return Issues (“Force-Outs”)........................................... 20
11. Practical Realities.............................................................................................. 20
a. Solicitation ............................................................................................. 20
b. Underwriting........................................................................................... 20
c. Policy Servicing ..................................................................................... 21
12. Selection of Jurisdiction and Carrier Due Diligence...................................... 21
13. Professional Involvement ................................................................................. 21
a. Legal Advisor ......................................................................................... 22
b. Insurance Broker ................................................................................... 22

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C. Hedge Funds ................................................................................................................. 23
1. Introduction: Why Hedge Funds?.................................................................... 23
2. Benefits and Risks of Hedge Funds ................................................................ 24
3. Superior Risk-Adjusted Returns ...................................................................... 24
4. Types of Hedge Funds and How They Produce Investment Returns.......... 25
a. Long/Short Equity Market Neutral........................................................ 25
b. Merger Arbitrage.................................................................................... 25
c. Convertible Arbitrage ............................................................................ 25
d. Relative Value Arbitrage ....................................................................... 26
e. Event Driven........................................................................................... 26
f. Regulation D........................................................................................... 26
g. Fixed Income Arbitrage......................................................................... 26
h. Distressed Securities ............................................................................ 27
i. Long/Short Equity Directional .............................................................. 27
j. Emerging Markets.................................................................................. 27
k. Macro ...................................................................................................... 27
5. Tax Characteristics of Hedge Funds ............................................................... 28
6. SEC Issues ......................................................................................................... 28
7. Coordination with Private Placement Variable Life Insurance...................... 29
8. Conclusion ......................................................................................................... 30

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 Private Placement Life Insurance Planning +

A. Introduction: “Big Picture” Estate and Tax Planning

This article will examine two strategies that fall outside the bounds of a traditional
estate planning framework, although they are well within the “big picture” that clients
wish their estate planners to address; and in many ways, these two strategies go hand-
in-hand. The first is private placement variable universal life insurance (“PPVUL”), an
investment-oriented strategy that can dramatically improve the tax efficiency of a client’s
investment portfolio. The second is hedge fund investing, an investment strategy that
has rapidly gained popularity among taxable investors in today’s equity market
environment due to its ability to deliver superior risk-adjusted returns in both bull and
bear markets.

B. Private Placement Variable Universal Life Insurance

1. Introduction

As the investment power of high-net-worth individuals continues to grow, legal

and financial advisors are frequently asked about tax-advantaged structures for passive
investments. A life insurance policy that is U.S.-tax compliant, especially one offered by
an established carrier, presents a conservative and cost-effective investment
opportunity. By virtue of the substantial lobbying influence of powerful interest groups,
including the U.S. life insurance industry, life insurance as a financial product has had a
long history in the United States as a tax-advantaged investment vehicle with minimal
legislative risk. Certain carriers with well-established operations both inside and outside
of the U.S. offer “private placement” (or, more appropriately, “customized”) policies that
are fully compliant with U.S. tax rules and are, therefore, fully entitled to the preferential
tax treatment that life insurance enjoys. With proper policy design, an investor can
place wealth in a tax-free investment environment at a low cost, achieve protection
against future creditor risk and local economic risk, gain financial privacy, and enjoy
superior flexibility with regard to the policy’s underlying investments.

Despite the long-standing availability of variable universal life insurance products

in the retail market, the PPVUL market is still in its growth and development phase, and
there are significant traps for the unwary. Accordingly, it is important for the advisor
who counsels high-net-worth clients for whom private placement life insurance planning
is advantageous to understand the tax, investment, and pricing aspects of life insurance
generally, and to be able to weigh the advantages and disadvantages of an offshore
private placement policy against a domestic private placement policy or a domestic

+
© Copyright 2007 Giordani, Schurig, Beckett & Tackett, LLP. Ms. Giordani, Mr. Ripp, and Ms. Jetel gratefully
acknowledge the valuable contributions of Lawrence Brody, a partner of Bryan Cave, LLP, Timothy P. Flaherty, co-
founder/principal of Silver Creek Capital Management LLC, and John B. Lawson, a principal in Insurance
Distributors International (Bermuda) Ltd.
retail policy. It is equally important for the advisor to be attuned to jurisdictional issues
when planning the life insurance ownership structure and for the advisor to engage the
services of a knowledgeable intermediary, such as an experienced insurance broker
that dedicates itself to the private placement marketplace, to be involved in the design
of the product, the selection of the carrier (and the attention to related due diligence
issues), and the ongoing service and compliance matters related to the policy itself.

2. What PPVUL is Not

There are currently two insurance structures other than PPVUL on the market
that have recently come under a significant amount of scrutiny by the Internal Revenue
Service (the “Service” or “IRS”). These structures are Internal Revenue Code
(“IRC”) § 501(c)(15) insurance companies and equity acquisitions of offshore insurance
company stock. It is essential to understand that these structures are unrelated to the
PPVUL structure discussed in this article.

The first structure mentioned, an IRC § 501(c)(15) insurance company, is

statutorily defined in the Internal Revenue Code. IRC § 501(c)(15) was originally
passed as a way to assist farmers who lacked easy access to the insurance market.
The goal of IRC § 501(c)(15) was to allow these farmers to set up small insurance
companies that would be considered tax-exempt, provided that they collected less than
$350,000 in premiums a year and did not underwrite life insurance. Recently, however,
ultra-high-net-worth investors, seeking to shelter assets from income taxation, have
availed themselves of the tax benefits available to IRC § 501(c)(15) insurance
companies. That is, as long as such an insurance company does not collect more than
the $350,000 premium limit per year, it is allowed under IRC § 501(c)(15) to accumulate
earnings on its investments income tax-free. Moreover, appreciated assets may be
transferred to the corporation in exchange for stock when the company is initially
capitalized. These insurance companies are legal under the letter of the law, and
several of them have accumulated millions of dollars of tax-free earnings for their
investors. However, the IRS apparently now perceives the use of IRC § 501(c)(15)
insurance companies to be investor abuse in some cases. Accordingly, the IRS issued
Notice 2003-35 in May 2004 to remind the public that an IRC § 501(c)(15) insurance
company’s primary purpose is to provide insurance, not investment opportunities.1
Notice 2003-35 also advises that the IRS will begin active investigation of these entities
in the near future.

The other insurance structure attracting the IRS’s attention has as its purpose the
conversion of hedge fund earnings from ordinary income and short-term capital gain
income into long-term capital gain income. As mentioned above, hedge funds have
become increasingly popular over the last several years due to their consistent
outperformance of other investment strategies. This performance has driven investors
to seek ways to avoid paying the high level of income tax typically attributed to hedge
fund returns. The strategy involving the acquisition of offshore insurance company

1
IRS Notice 2003-35, I.R.B. 2003-23, May 9, 2003.

2
stock, sometimes referred to as the “equity transaction,” involves a hedge fund manager
or other investment service provider setting up an offshore insurance company. The
organizer then seeks equity investors for the insurance company (i.e., investors
interested in hedge funds), promising to allocate the investor’s equity to a specified
investment account, typically the investor’s preferred hedge fund(s). The primary
argument made by the IRS in connection with this structure is that the insurance
company is not actually taking on insurance risk and therefore does not meet the
definition of an insurance company.2

Both IRC § 501(c)(15) insurance companies and the equity transaction differ
greatly, in design and purpose, from a PPVUL structure. Potential PPVUL purchasers
may hear the buzzwords “offshore insurance company” and “hedge fund” and
immediately worry that PPVUL policies issued by offshore carriers are subject to the
IRS scrutiny they have read about in recent newspaper articles.3 This, however, is not
the case.

3. The U.S. Client

PPVUL insurance offers to U.S. qualified investors4 the ability to select asset
management beyond the limited asset-management choices offered in retail variable life
insurance products. This is attractive to high-net-worth clients who may have
investment mandates that involve more sophisticated strategies such as hedge funds.
Due to the expense associated with regulatory pressures imposed by federal and state
securities laws and by state insurance boards, some domestic companies have more
limited investment platforms than their offshore counterparts. Because offshore
insurance companies are not subject to the same bureaucracy and regulations imposed
within the U.S., they are able to engage investment managers with greater ease.

Generally, the client’s motivations for investing in a PPVUL policy differ quite a bit
from the reasons that U.S. persons typically purchase life insurance. Its value in the
high-net-worth market is as an investment vehicle, optimally used for the most tax-
inefficient asset classes in an investor’s portfolio. The purchase of death benefit is
secondary. Usually, therefore, the core goals for acquiring a PPVUL insurance product
are to take advantage of the income-tax and possible estate-tax savings, to maximize
investment choices, and to incur as little cost as possible in doing so. There are

2
See IRS Notice 2003-34, I.R.B. 2003-23, May 9, 2003.
3
See, e.g., Johnston, David Cay, Insurance Loophole Helps Rich, N.Y. TIMES, April 1, 2003; McKinnon, John D.,
U.S. May Curtail Hedge-Tax Haven Tied to Insurance, WALL S. J., September 12, 2002.
4
Many offering memoranda for offshore PPVUL policies reference "qualified purchaser" or "accredited investor"
standards, as used in U.S. securities law, to describe suitable investors. In the offshore context, this should be
considered merely a guideline and not a strict requirement because offshore policies are not actually subject to SEC
regulations. However, if the premiums of an offshore PPVUL policy are to be invested in funds that do require
investors to be “qualified purchasers,” then the policy owner must be a “qualified purchaser” for that purpose. In the
domestic context, because private placement products in the U.S. are subject to SEC regulations, each purchaser
generally must be a “qualified purchaser” under section 2(a)(51) of the Investment Company Act of 1940, 15 U.S.C.
§80a-2(a)(51), and an “accredited investor” under section 501(a) of Regulation D of the 1933 Act, 17 C.F.R.
230.501(a).

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additional advantages of investing in a PPVUL insurance policy issued offshore that will
be discussed in detail below.

4. Foreign Trusts with U.S. Beneficiaries

Private placement life insurance products offered by offshore carriers are also
beneficial for other types of clients, such as foreign persons who have created foreign
trusts with U.S. beneficiaries. Prior to the enactment of the Small Business Job
Protection Act of 1996 (the “1996 Act”),5 a foreign person could, with relative ease,
establish a grantor trust with one or more U.S. beneficiaries. As with all grantor trusts,
the foreign grantor was essentially treated as the owner of the trust for U.S. federal
income tax purposes.6 This was advantageous for several reasons. First, as long as
the trust’s assets were invested in property producing income from foreign sources or
capital gain income from domestic or foreign sources, the income derived by the trust
would generally be treated, for U.S. income tax purposes, as that of the foreign person
who was the grantor and would not be subject to U.S. federal income tax. Second,
distributions from the trust to U.S. beneficiaries were classified as distributions from a
grantor trust, so U.S. beneficiaries who received distributions from the trust were not
subject to U.S. federal income taxation on such distributions. Finally, under the terms of
the trust, there was usually no requirement for trust income to be distributed each year,
so monies could accumulate in foreign grantor trusts as long as desired and be
distributed to the beneficiaries income-tax-free at some later time.

The 1996 Act effectively eliminated the grantor trust status of these foreign trusts
by treating a person as owning assets of a trust only if that person is a U.S. citizen, U.S.
resident, or domestic U.S. corporation.7 As a result, a foreign person who creates a
trust is no longer considered the owner of the trust’s assets, and the trust is classified as
a non-grantor trust for U.S. federal income tax purposes.8 When a trust has been
classified as a foreign non-grantor trust, it is possible for the trust to defer U.S. federal
income taxation because, ordinarily, the earnings of such a trust would not be taxed
directly by the U.S., with certain exceptions.9 However, when income is distributed from
the trust to a U.S. beneficiary, it is taxable to such U.S. beneficiary. Specifically, a U.S.
beneficiary is taxable on amounts of income currently distributed from the trust’s

5
The Small Business Job Protection Act was signed by President Clinton on August 20, 1996. The 1996 Act
changed income tax law and reporting related to foreign trusts in two significant areas: (1) for U.S. beneficiaries
who receive distributions from trusts created by foreign persons, and (2) for U.S. persons who create foreign trusts.
6
If a trust is classified as a grantor trust, the trust is essentially viewed as a pass-through entity, because the grantor is
deemed to be the owner of part or all of the trust for U.S. federal income tax purposes. See IRC §§ 671-679.
7
Any foreign grantor trust that was in existence prior to September 20, 1995, is “grandfathered” and will continue to
be a grantor trust as to any property transferred to it prior to such date provided that the trust continues to be a
grantor trust under the normal grantor trust rules. Separate accounting is required for amounts transferred to the
trust after September 19, 1995, together with all income and gains thereof.
8
There are exceptions to this rule that are beyond the scope of this article. See Treas. Reg. § 1.672(f)-3.
9
Exceptions include certain income, dividends, rents, royalties, salaries, wages, premiums, annuities, compensations,
remunerations, and endowments or other “fixed or determinable annual or periodic gains, profits, and income” (“FDAP”
income) derived from the U.S. and income that is effectively connected with the conduct of a U.S. trade or business.

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worldwide distributable net income (“DNI”).10 The character of the income on trust
assets when distributed to the U.S. beneficiary is determined at the trust level, even
though the trust itself may not pay U.S. income tax on such income or gain.11

Furthermore, distributions from foreign non-grantor trusts of undistributed net

income (“UNI”) are classified as accumulation distributions and taxed according to the
“throwback” rules. In general, the throwback rules tax accumulation distributions to a
U.S. beneficiary at the tax rate that would have been paid if the income had been
distributed in the year that the trust originally earned such income. The net result is
that, at the time of distribution, a U.S. beneficiary would be subject to tax first on the
trust’s current year DNI and, if current year distributions exceed DNI, then on the trust’s
UNI. Additionally, when a distribution is made that is classified as UNI, an interest
penalty is assessed and applied to the tax on the accumulation distribution. The effect
of the interest charge can cause an effective tax rate of 100 percent to apply after
several years of accumulation.

Despite the effective elimination of foreign grantor trusts (created by foreign

persons) and all of the attendant benefits, all is not lost. When planning on behalf of a
trust to which these rules apply, the goal is to reclassify trust income as something that
is exempt from income tax in order to mirror the structure of the old foreign grantor
trusts. Life insurance achieves this goal because income earned inside the policy is not
taxed currently to the owner of the policy. Moreover, income distributed from the policy
during the life of the insured is generally nontaxable under current law, if properly
structured.12 Finally, all amounts paid out of the policy to the policy beneficiary as death
benefit proceeds are not subject to U.S. income tax.

For existing foreign non-grantor trusts with undistributed net income (and
previously classified foreign grantor trusts with income accumulated after the 1996 Act),
offshore PPVUL insurance can be an effective tool to stem the ever-increasing
accumulation of taxable income inside these trusts. In a typical situation, trust assets
are used to pay life insurance premiums. As trust assets are gradually depleted by
annual premium payments, the further accumulation of distributable net income ceases.
Note that the trust may still contain pre-existing undistributed net income that is taxable
to the U.S. beneficiary (and subject to the interest penalty) whenever the trustee makes
a distribution in excess of DNI. Over time, however, cumulative distributions to the
beneficiaries may exhaust this pre-existing UNI. Thereafter, the trustee may generally
withdraw or borrow funds from the policy on a tax-free basis and then distribute those
proceeds (also on a tax-free basis) to the U.S. beneficiary.

10
This situation applies to discretionary distributions from foreign complex trusts; the situation would be somewhat
different for U.S. beneficiaries of foreign simple trusts or foreign complex trusts with mandatory distribution
provisions.
11
Capital gain income is included in determining DNI, and retains its character in the hands of the U.S. beneficiary if
distributed in the year that it was earned by the trust.
12
In general, this means making withdrawals from a non-modified endowment life insurance policy up to the policy
basis, then switching to policy loans. See note 14, infra.

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 5. Tax Considerations

a. U.S. Federal Income Tax Benefits

The U.S. federal income tax advantages of life insurance are the same whether
the policy is acquired onshore or offshore. First, earnings on policy cash values,
including dividends, interest, and capital gains, are not taxable to the policy owner as
they accumulate within the policy.13 Because earnings on policy cash values are
generally not taxable, the policy’s cash value grows much quicker than when compared
to a taxable investment portfolio. Consider the following example of a taxed investment
versus accumulation inside a private placement life insurance policy. The hypothetical
example assumes single-life coverage on a 45-year-old male, with a $2.5 million annual
premium for four years, a 10 percent rate of return net of investment management fees
(all of which is taxed as ordinary income [at 40 percent, which represents a hypothetical
federal-plus-state income-tax rate] in the taxed scenario, as would be the case with a
hedge fund investment).

End of Taxed Life Insurance Life Insurance

Year Investment Cash Value Death Benefit
1 2,650,000 2,681,609 44,251,900
5 12,288,296 13,459,717 44,251,900
10 16,444,512 20,820,235 44,251,900
20 29,449,617 50,682,027 61,832,073
30 52,739,779 127,259,381 136,167,537
40 94,448,912 319,917,484 335,913,358

In addition to the tax-free accumulation of the policy’s cash value, withdrawals

and policy loans by the policyholder can be used to access policy assets during the
lifetime of the insured. Generally, such withdrawals and loans are received income-tax-
free.14 Finally, the proceeds payable at the death of the insured are excluded from the
taxable income of the beneficiary,15 and with proper structuring, may also be excluded
from the taxable estate of the owner insured.16

13
See IRC § 72; IRC § 7702(g)(1)(A). Some income (e.g., dividends) attributable to policy assets may nevertheless
be subject to taxation (e.g., by source withholding).
14
Note that if a policy is a modified endowment contract ("MEC") as defined by IRC § 7702A, proceeds of a loan or
withdrawal are taxed as ordinary income to the extent of any gain in the policy cash value before the loan or
withdrawal. To avoid this taxation, therefore, it is crucial that MEC status be avoided when it is intended that the policy
cash value be accessible during the insured's lifetime through loans or withdrawals. On the other hand, due to the
higher insurance-related costs of non-MECs, MEC status does not need to be avoided when a policy is designed to
pass wealth from one generation to the next without a need to access policy cash value during the insured's lifetime.
Generally, non-MECs are characterized by a premium paid over five or six years, while MECs are characterized by a
one-time, up-front premium payment.
15
See IRC § 101(a)(1).
16
See IRC § 2042. Generally, as long as the premium payor does not retain "incidents of ownership," the policy
proceeds will be excluded from his or her estate for estate tax purposes.

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 b. Other Potential Tax Benefits

Enhanced tax advantages are available to a client who, by completing all

aspects of the transaction offshore,17 acquires a PPVUL policy issued by an offshore
carrier. First, no state premium tax is payable when a PPVUL insurance policy is issued
offshore. This results in a savings, in most states, of approximately two to three percent
of the premium. Second, the federal deferred acquisition cost (“DAC”) tax and/or
federal excise tax that is assessed on the premium of a policy issued by a foreign
company will be less than the DAC tax paid on a similar policy issued onshore. The
DAC tax on a policy issued onshore is generally about one to one and a half percent of
premiums paid. The overall tax paid on a policy issued offshore will be less; however,
the actual amount of the tax will depend on whether the policy is issued by a company
that has elected to be taxed under IRC § 953(d) as a domestic corporation (the “953(d)
election”). If the insurance company has made the 953(d) election, a reduced DAC tax
of less than one percent of premium will normally apply. If the insurance company has
not made the 953(d) election, no DAC tax will apply; however, a one percent U.S.
federal excise tax on premium payments will be payable.18 Overall, the absence of the
state premium tax and reduced or no federal DAC tax offshore, along with no or low
premium sales loads, contributes to the substantially improved yields compared to
taxable investments, as illustrated above.

c. Transfer Tax Planning

In addition to the considerable income tax benefits of life insurance

planning, many clients also desire a flexible framework for transferring wealth to their
children or multiple future generations in a transfer-tax-efficient manner. For example, a
senior generation can pass assets in a leveraged manner to the next generation with
minimal transfer-tax liability by creating an irrevocable life insurance trust and by
funding the insurance purchase through an alternative premium-paying arrangement,
such as an intrafamily loan.19 When a client’s net worth suggests the need for removing
substantial assets from the estate tax base, private placement life insurance, a
traditional irrevocable life insurance trust, and an alternative premium-paying
arrangement can be a very effective combination.

17
Most states in the U.S. impose a premium tax on life insurance policies. However, as long as the policy is negotiated,
applied for, issued, and delivered offshore, state insurance taxes should not apply to an offshore PPVUL purchase.
Nevertheless, state laws applicable to the policy owner, insured, and beneficiary must be carefully examined on a
case-by-case basis. Furthermore, although the constitutionality of such statutory provisions might be questionable,
some states impose a "direct procurement tax" to collect the premium tax for transactions on the lives of state
residents that take place out-of-state. Domestic producers have tried to capitalize on the fact that Alaska and South
Dakota assess very low levels of premium tax, and thus offer prospective purchasers a low-cost alternative to offshore
PPVUL. Recently, however, a major carrier reported that the Texas insurance authorities assessed a premium tax on
premiums paid for an Alaska PPVUL policy issued on the life of a Texas insured and then successfully collected that
assessment. As a result, the tax-savings opportunity offered by Alaska and South Dakota PPVUL policies has already
been limited in Texas and is likely to see further limitation in other states.
18
See IRC § 4371.
19
A number of other transfer tax planning opportunities exist utilizing life insurance, but a full discussion of all of such
opportunities is beyond the scope of this article.

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 d. Irrevocable Life Insurance Trust

An irrevocable life insurance trust (“ILIT”) is a commonly used estate

planning technique. When the ILIT will receive completed gifts which are in turn
invested in an offshore private placement policy, the trust should be a foreign trust for
legal purposes (because it is important that the policy have a foreign owner due to state
regulatory concerns). Also, it may be best to structure the trust as one that is domestic
for tax purposes in order to avoid the onerous foreign trust reporting requirements, and
more importantly, to avoid the potential negative application of IRC § 684.20 The
classification of a trust as domestic for tax purposes can be accomplished by satisfying
the definitional requirements set forth in IRC § 7701.21

Because it is important for the settlor’s gift to the irrevocable life insurance trust
to be a completed gift for gift tax purposes, the settlor should not retain a testamentary
power of appointment.22 In addition, the settlor should retain no powers under the trust
agreement that would cause the trust assets to be includible in the settlor’s estate for
estate tax purposes.23 Moreover, the allocation of generation-skipping transfer (“GST”)24
tax exemption (if available) to the initial funding (as well as ensuring that additional
assets contributed to the trust also are GST tax exempt) permits the policy proceeds to
be received and passed free of GST tax as well.25 This planning effectively removes the
death proceeds from the estate of the settlor/insured and exempts the assets in the trust
from the GST tax as well.

As noted above, it is important that the trust, as owner of an offshore life policy,
be foreign for ownership purposes to reduce the nexus between the policy and the U.S.

20
Under some circumstances, a U.S. person transferring property to a trust that is considered a foreign trust for tax
purposes may be required to pay income tax on the transferred property. Specifically, IRC § 684 treats a transfer of
property by a U.S. person to a foreign trust as a sale or exchange for an amount equal to the fair market value of the
property transferred. Thus, the transferor is required to recognize gain on the difference between the fair market value
of the transferred property and its basis. The rules set forth in IRC § 684 do not apply to the extent that the transferor
or any other person is treated as the owner of the trust under section 671, which will typically be the case with a
foreign trust with U.S. beneficiaries. See IRC § 679. However, upon the death of a U.S. person who was treated as
the owner of a foreign trust during that person's lifetime, gain will be recognized under IRC § 684 (unless that foreign
grantor trust's assets receive a step-up in basis under IRC § 1014(a), which would not be the case in a traditionally
structured irrevocable life insurance trust to which completed gifts have been made.) See Treas. Reg. §1.684-3(c).
21
Under the regulations to IRC § 7701(a)(31), a trust is a foreign trust unless both of the following conditions are
satisfied: (a) a court or courts within the U.S. must be able to exercise primary supervision of the administration of the
trust; and (b) one or more U.S. persons have authority to control all substantial decisions of the trust. See Treas. Reg.
§ 301.7701-7.
22
See Treas. Reg. § 25.2511-2(b).
23
See IRC § 2036 to 2041.
24
The GST tax is a transfer tax (in addition to the estate tax) that is imposed on transfers that skip a generation and at a
rate equal to the highest marginal estate tax rate. The purpose of this tax is to prevent the avoidance of estate tax at
the skipped generation. That is, in the absence of GST tax, clients could, for example, leave property directly to their
grandchildren, without subjecting that property to a transfer tax at their children's generation.
25
See IRC § 2642.

8
jurisdiction where the client resides. This should negate an argument that the policy
was acquired onshore and could possibly therefore be subject to state premium tax.

6. Investment Considerations

As mentioned above, policy owners purchasing PPVUL are typically offered

investment platforms by the issuing carrier that include a wide array of typical equity and
bond fund choices. Many carriers also offer extensive alternative investment choices
such as hedge funds, hedge funds of funds, private equity, commodity funds, etc. Once
premiums have been contributed to the policy, a policy owner may later shift part or all
of the cash value to another investment choice without tax consequences. Generally,
the investment fund must be managed by a professional investment advisor, and the
insurance company will perform due diligence to determine the fund’s suitability as a
selection available to policy owners. Note that some carriers may charge a fee over
and above their normal administrative fee against the policy cash value for the
administrative work required to establish a new relationship with an investment
manager.

In some part due to reduced industry regulation in the offshore insurance market,
a very broad universe of managers and investment styles is available to investors who
purchase offshore PPVUL insurance. The variety of investment choices and flexibility to
add managers have also improved recently in the domestic market. Currently, hedge
fund and fund of fund strategies are the most frequently selected investment vehicles in
the PPVUL market because they have had consistent returns in up and down markets
and are usually tax-inefficient due to the investment strategies they employ.26 Investors
find that these investment choices work extremely well in a life insurance policy
because of the policy’s tax-advantaged nature. Moreover, policy owners receive
protection of their investments through separate account legislation that exists in
jurisdictions where offshore carriers typically reside as well as within the U.S.27

7. Pricing Considerations

Generally speaking, there are three principal insurance-related fees associated

with PPVUL insurance products: the premium load, the mortality and expense (or
administration) charge (“M&E”), and the cost of insurance charge (“COI”). The non-
insurance-related fees are asset management and, if applicable, custodial fees.

One of the deterrents to using domestic life insurance as a tax-advantaged

investment vehicle for large premium amounts is the high level of fees associated with

26
For more detail on hedge funds see Section C, infra.
27
In the event of a company default, the policy's cash values generally are not subject to the claims of the insurance
company's creditors. In Bermuda, for example, the Segregated Accounts Companies Act permits any company to
apply to operate segregated accounts, thereby enjoying statutory division between accounts. The effect of such
statutory division is to protect the assets of one account from the liabilities of other accounts. Thus, the accounts will
be self-dependent, with the result that only the assets of a particular account may be applied to the liabilities of such
account.

9
insurance products in the U.S. retail market, and in some cases, this remains true for
domestic private placements. Although commissions vary greatly throughout the
industry, purchasers can be charged sales commissions of greater than 10 percent of
their premium commitment.28 Ongoing charges against a policy’s cash value also vary,
but often exceed charges against cash value in the offshore market due (in part) to the
asset management fee component, which is generally higher for domestic private
placements. Finally, domestic policyholders usually incur a surrender fee if they
surrender a policy within a certain time-frame. Many offshore carriers do not assess
such a fee.

The premium load in the offshore market is typically modest, approximately one
percent of premiums paid or less. The M&E charge varies widely among carriers,
depending on the carrier’s pricing and profit strategy. The insurer also assesses the
COI charge against the policy’s cash value. This COI charge varies from year to year
based on the “net amount at risk,” and on the age, gender, and health status of the
insured at the time of medical underwriting. On average, over the life expectancy of the
insured and depending on the earnings of the separate account, the combination of the
M&E and COI loads on a single life product should be less than one percent per year.
Generally, cost efficiencies exist offshore because carriers can offer lower
administrative charges than domestic carriers due to lower overhead and franchise
costs, lower or nonexistent entity-level taxes, and reduced operating costs due to less
governmental regulation.

Because the federal tax advantages of life insurance are the same onshore and
offshore, it is the increased investment flexibility, the reduction in costs resulting from
state-premium-tax savings and lower sales loads and administrative charges, and
opportunities for enhanced asset protection that set offshore PPVUL transactions apart
from their domestic counterparts.

8. Legal Considerations: Asset Protection

High-net-worth clients in the U.S. often desire to globalize their holdings in a

manner that protects them from future creditor risk as well as local political and
economic turmoil. By virtue of its preferred status under certain state exemption
statutes, life insurance presents an excellent asset-protective vehicle for the high-net-
worth client, especially when coupled with sophisticated offshore planning. As a
consequence of the separate account protection that typically exists in the jurisdictions
where carriers reside, the insurance company must segregate the assets inside a
private placement policy from its general account, which then protects the policy assets
from the claims of the creditors of the life insurance company.29 In addition, some U.S.
states exempt not only the debtor’s interest in a life insurance policy’s cash surrender
value, but also the death proceeds themselves from the claims of creditors.30 However,

28
Onshore, additional loads against premiums are state premium tax and a 1 to 1.5% federal DAC “tax.”
29
See note 27, supra.
30
Premiums paid with express or implied intent to defraud creditors, however, generally are not protected. Such

10
the exemption statutes vary from state to state, and in some cases, the domestic
exemption statute is inadequate or restrictive as to the allowable exemption amount or
the class of persons entitled to benefit from the exemption.31

Many offshore jurisdictions offer legislation related to life insurance contracts that
is comparable to, or better than, similar legislation under U.S. state law. Such offshore
legislation may include specific exemption language and a pro-debtor protection regime.
In addition, the laws of an offshore jurisdiction might allow the inclusion of spendthrift
provisions in the policy itself, which limit the policy owner’s rights in the policy, thereby
affording another level of asset protection to the policy. If invested with an offshore
manager, the assets inside the separate account of the policy will not only receive
protection from creditors by virtue of the exemption statute, but it will also be harder for
a U.S. creditor to reach the policy’s assets because they are located offshore. The
client will also enjoy investor confidentiality and financial privacy under the laws of many
offshore jurisdictions, to which similar laws in the U.S. generally do not compare.

9. Other Considerations

The PPVUL life insurance market, and in particular the offshore PPVUL market,
is marked by the absence of high-pressure marketing that plagues the domestic retail
life insurance market. In addition, offshore companies in smaller markets enjoy lower
regulatory oversight and reporting obligations. Generally, offshore insurers pass on
their reduced marketing costs, regulatory compliance, and reporting requirements to the
policy purchaser in the form of lower fees. When insuring their risks, offshore carriers
have the choice of contracting with any one or more of the world-class reinsurers
participating in the worldwide life insurance market. Finally, offshore life insurance
carriers should be able to offer a wider variety of products and a greater death benefit
capacity as the client market expands.

Although U.S. clients typically draw from existing pools of cash or easily
liquidated investments to fund a private placement policy, unique planning opportunities
exist in the offshore market due to the absence of regulatory oversight. For example,
clients usually can make in-kind premium payments of property other than cash when a
client prefers to invest noncash assets. Additionally, it is possible for a client to
exchange an underperforming domestic or foreign policy for a more cost- and tax-
efficient policy on a tax-free basis.32

premiums, plus interest, are usually recoverable by a defrauded creditor out of insurance proceeds.
31
For a complete state-by-state treatment of the exemption statutes relating to life insurance and annuities, see DUNCAN
E. OSBORNE AND ELIZABETH M. SCHURIG, ASSET PROTECTION: DOMESTIC AND INTERNATIONAL LAW AND TACTICS, Ch. 8 (four
volumes, West Group, updated quarterly, 1995).
32
In the foreign context, the rules governing such an exchange under IRC § 1035 should be closely examined due to
statutory uncertainty in some circumstances.

11
 10. Product Design Issues

Although some investors regard the life insurance component (i.e., the death
benefit payable in excess of cash value) as an independently important feature, most
investors are drawn to PPVUL insurance for its tax benefits, investment flexibility, and
price structure. Nevertheless, the life insurance component of the product is absolutely
critical with regard to its tax treatment—if the product fails to qualify as life insurance
under applicable U.S. tax rules, the U.S. tax benefits are lost completely. Moreover, if
the cost of insurance and other fees assessed against the assets within the policy are
too high, the client loses the tax benefit as a practical matter by virtue of poor
performance over time attributable to those high costs and fees.

Generally, planners design PPVUL insurance policies in a way that maximizes

cash accumulation and also reduces the death benefit, so that the cost of insurance
affects the cash value to the smallest extent possible. In other words, the policy design
provides for the largest up-front infusion of cash with the correspondingly smallest death
benefit purchase possible. There are also certain other product design issues that must
be addressed in each case.

a. IRC § 7702 Compliance

In order to receive the U.S. tax advantages afforded to life insurance products,
any policy issued by a carrier (including a foreign carrier) after December 31, 1984,
must meet the definition of life insurance under IRC § 7702; that is, the policy must be a
contract which is a life insurance contract under the applicable law, but only if such
contract meets the cash value accumulation test (the “CVAT”) or the two-pronged test
composed of the guideline premium test (“GPT”) and the cash value corridor test
(“CVCT”). The purpose of these tests is to disqualify policies created for their
investment component without regard to the actual relationship between the cash value
and the contractual death benefit. The two methods of testing for IRC § 7702
compliance will have significantly different results in any given client situation. The
availability of actuarially tested products using both tests varies from carrier to carrier.
Some carriers have products that meet both tests; others have products that meet only
one of the tests. It is important for an experienced insurance professional or actuary to
determine which test works best for a particular case.

CVAT. Under IRC § 7702(b), a contract qualifies as a “life insurance policy” if

the cash surrender value, at any time, does not exceed the net single premium that a
policyholder would have to pay at such time to fund future benefits under the contract
assuming a maturity no earlier than the insured’s age 95 and no later than the insured’s
age 100. The CVAT is generally applied to test whole life contracts.

GPT and CVCT. IRC § 7702(c) sets forth the guideline premium test and
IRC § 7702(d) describes the cash value corridor test. If the policy design implicates this
alternative over the CVAT, it must satisfy both tests. A policy will satisfy the GPT if the
sum of the premiums paid under the contract does not at any time exceed the “guideline

12
premium limitation” at that time. A contract falls within the cash value corridor if the
death benefit at any time is not less than the applicable percentage of the cash
surrender value. At age 40, the applicable percentage is 250 percent, decreasing in
increments to 100 percent at age 95.

MEC Testing. Frequently, the design of life insurance planning is to maximize

the growth of policy cash values without jeopardizing the policy owner’s ability to have
tax-free access to those values during the insured’s lifetime. If the policy owner funds
the policy too heavily, thereby causing it to be classified as a modified endowment
contract (“MEC”), he or she will pay tax on policy values that she accesses during the
insured’s lifetime at ordinary income rates to the extent of any gain in the policy assets
before the loan or withdrawal.

Pursuant to IRC § 7702A, a contract is a MEC if it was entered into after June 21,
1988, and it fails to meet the 7-pay test under IRC § 7702A(b). A contract fails to meet
the 7-pay test if the accumulated amount the policy owner pays under the contract at
any time during the first seven contract years exceeds the sum of the net level
premiums that the policy owner would have paid on or before such time if the contract
provided for paid-up future benefits after the payment of seven level annual premiums.
Generally speaking, non-MECs are characterized by a premium paid over four or five
years and MECs are characterized by a one-time, up-front premium payment. Of
course, if the purpose of the policy is to pass wealth from one generation to the next
without requiring access to policy cash values, MEC status is inconsequential, and a
MEC structure is therefore preferable due to the superior tax-free compounding effect
achieved by a one-time, up-front premium payment.

b. Diversification under IRC § 817(h) and the Investor Control

Doctrine

In addition to IRC § 7702 compliance, variable life insurance policies must also
comply with the diversification requirements of IRC § 817(h), which requires that they be
invested in an “adequately diversified” mix of investments. “Adequately diversified”
means that a life insurance separate account must contain at least five investments,
and no one investment may represent more than 55 percent of the value of a separate
account’s assets; no two investments may constitute more than 70 percent; no three
investments may comprise more than 80 percent; and no four investments may make
up more than 90 percent of the separate account’s value. Failure to meet these
diversification requirements will cause the separate account to not be considered “life
insurance,” and consequently, the “policy” owner will be deemed to directly own all of
the policy’s assets, making the policy owner currently taxable on the policy’s income.

Before 2003, the Treasury Regulations allowed a life insurance separate account
to “look through” a nonregistered investment partnership (such as a hedge fund or fund
of funds) to its underlying investments to determine whether it met the diversification
rules outlined above. In other words, the nonregistered partnership was not treated as
a single investment, but as an investment in the various funds in which the partnership

13
itself was invested, thereby making it easier for the separate account to satisfy the
diversification requirements. By contrast, for a registered partnership (or other
investment company or trust) to have received the same “look-through” treatment of
nonregistered partnerships, it had to meet both of the following requirements:

(i) all of the beneficial interests in the partnership must be held by one or
more segregated asset accounts of one or more insurance companies; and

(ii) access to the partnership must be exclusively through the purchase of a

variable contract.

In other words, a registered partnership had to be an “insurance-dedicated fund”

(or “IDF”) to receive look-through treatment, but a nonregistered partnership did not. An
amendment to the Treasury Regulations, proposed in 2003 and effective
March 1, 2005, removed this “special” treatment for nonregistered partnerships. This
means that a nonregistered partnership must now meet the above two requirements of
an insurance-dedicated fund to be looked through to its underlying investments for
purposes of the diversification rules.

Thus, under current Treasury Regulations, as long as a nonregistered

partnership is organized as an IDF (and as long as that IDF is invested in an adequately
diversified mix of investments), a separate account invested only in that partnership will
be considered “adequately diversified,” and thereby maintain its status as a tax-
advantaged investment vehicle.33

“Double Look-Through” Allowed for Second-Tier IDFs. During the period in

which those Regulations were proposed, the IRS extended the principles of those
Regulations to fairly common real-world structures involving IDFs. In Revenue Ruling
2005-7, the IRS allowed a separate account to not only look through an IDF that is its
direct investment, but also to look through any other IDFs in which the first IDF is
invested. In other words, if IDF #1 holds an investment in IDF #2 that makes up more
than 55 percent of IDF #1’s investments (and would, therefore, seem to cause the
separate account to fail the diversification rules), the separate account can still look
through IDF #2 to its underlying investments to determine whether it is adequately
diversified (and presumably any IDFs in which IDF #2 is invested, and so on). Thus,
this favorable ruling allows a life insurance separate account to look through multiple
levels of IDFs to determine whether it is adequately diversified under IRC § 817(h).

IDF May Invest in Non-IDFs. Although the preceding conclusion seems to be a

fairly obvious extension of the final Regulations, many insurance professionals
remained concerned about an IDF’s diversification when it invested not in other IDFs

33
Although the amendment became effective March 1, 2005, nonregistered partnerships in existence at that time
that were not IDFs but otherwise complied with IRC § 817(h) had until December 31, 2005, to comply with the new
rules.

14
but in one or more non-IDFs. This was of particular concern for insurance-dedicated
hedge funds of funds. The source of these professionals’ concerns was their
interpretation of the IRS’s activity in this area as eventually leading to a complete
disallowance of a separate account’s direct or indirect investment in publicly available
funds.

In Private Letter Ruling 200420017, the IRS alleviated at least some of those
concerns by confirming that an IDF established as a fund of funds may, in fact, invest in
one or more non-IDFs as long as it meets the requirements listed below.

(i) Although the owner of the life insurance contract may direct the separate
account to be invested in one of the IDFs offered by the insurance company, the owner
may not direct the IDF’s investment in any particular underlying fund, and there must be
no investment agreement or plan between the contract owner and the life insurance
company or the investment manager.

(ii) All decisions regarding the IDF’s investment in the underlying non-IDFs
must be made by the insurance company’s investment manager in its sole and absolute
discretion.

(iii) The IDF’s investment strategies must be defined broadly (such as

“conservative,” “moderate,” or “aggressive”) so that the contract owner is unable to
make specific investment decisions by directing the separate account to be invested in
one of the available IDFs.

(iv) Only the life insurance company may add or remove investment options
under the life insurance contract.

Note that these requirements address the contract owner’s actual control over
the separate account’s investment, rather than mandating that the separate account
have no direct or indirect contact with a non-IDF.

Lingering Issues: Can a PPVUL Separate Account Invest in an Adequately

Diversified Mix of Non-IDFs? As outlined above, the final regulations have now made
it clear that a life insurance separate account may invest in a single insurance-dedicated
fund and be allowed to look through that fund to its underlying investments to determine
whether it is adequately diversified. But the question that remains in the minds of some
practitioners is whether a PPVUL separate account may directly invest in an adequately
diversified mix of non-IDFs (i.e., at least five non-IDFs in the right proportions). The
logical answer to this question is yes. However, many practitioners are not confident
that the IRS would take the logical position when it comes to this issue.

This lack of confidence in the IRS’s reasoning abilities stems from a long history
of apparent IRS hostility toward life insurance separate accounts. It has consistently
been the IRS’s view that, when a separate account is invested in funds that are
available to the public, it allows the account holder to exhibit control over the separate

15
account because he could effectively dictate an investment strategy for the separate
account in the same way that he could choose investments for himself personally, but in
a tax-free environment. Or, in the words of the IRS, account holders make the
insurance company “little more than a conduit between [themselves] and their mutual
fund shares,” and their “position [is] substantially identical to what it would have been
had the mutual fund shares been purchased directly.”34

In short, although the logical interpretation of the statutes and regulations would
lead to a conclusion that a PPLI separate account may invest directly in an adequately
diversified mix of non-IDFs, a more conservative approach would be to avoid non-IDFs
as direct investments of separate accounts until such an investment strategy is formally
blessed by the IRS.

Can Foreign Policy Owners Invest in IDFs? As stated above, in order for a
fund to qualify as insurance-dedicated, it must restrict access to owners of variable
contracts. IRC § 817(d) defines a “variable contract” as one: (1) that provides for the
allocation of all or part of the amounts received under the contract to an account
segregated from the insurance company’s general asset accounts; (2) that either
provides for the payment of annuities or is a life insurance contract; and (3) whose
contract benefits—whether annuity payments or policy death benefit—reflect, or vary
based upon, the investment return and the market value of the segregated account. For
owners of contracts issued by certain foreign insurance companies, their ability to invest
account assets in IDFs is subject to some uncertainty because IRC § 817(d)(1) requires
that the account be segregated “pursuant to State law or regulation.”35

In a 2002 private letter ruling dealing with issues unrelated to IRC § 817(h) or
investor control, the IRS raised this definitional issue with respect to the segregated
accounts of a foreign insurance company that had elected, under IRC § 953(d), to be
taxed as a domestic insurance company.36 After interpreting the word “State” to refer
only to the 50 states and the District of Columbia for purposes of IRC § 817(d), the IRS
stated that, had the insurance company not made the 953(d) election, then contracts
issued by the company would not have qualified as variable contracts under
IRC § 817(d), notwithstanding that the contracts otherwise met its definition. By
interpreting “State” in this manner, the IRS has called into question whether the owner
of a contract issued by a non-953(d) company may avail itself of the apparent investor
control safe harbor offered by IDFs and whether an IDF manager may accept
investments from such foreign-contract owners without jeopardizing both its fund’s
continuing qualification as an IDF and, theoretically, the continuing life insurance status
of its existing investors’ variable policies.

Is the Asset Allocator Model Viable? Many private placement variable life
insurance and annuity contracts are structured to permit the policy owner to select from

34
Rev. Rul. 81-225.
35
Emphasis added.
36
PLR 200246022 (August 13, 2002).

16
a group of asset management choices, among which is one or more independent “asset
allocators” who have an account management agreement with the insurance company
to construct and manage with full discretion one or more separate accounts consisting
of non-insurance dedicated hedge funds, and in which the number and proportion of
funds meet the IRC § 817(h) diversification test. The account managed by the manager
(i.e., allocator) is available only to insurance companies in connection with their variable
contracts. This arrangement is generally known as a privately managed separate
account, or “the allocator model.” In Rev. Rul. 2003-91, the Service appeared to
confirm generally the validity of this model, but the statement of facts in the ruling
provided that the contract holder in that situation “may not communicate directly or
indirectly with [the insurance company] concerning the selection or substitution of [the
independent investment advisor].” Because an allocator might sometimes be brought to
the attention of an insurance carrier by a policy owner or a policy owner’s advisor, this
language in the ruling has caused some practitioners to become a bit concerned about
whether the policy owner’s selection of an allocator might give rise to a finding of
investor control. Adequate diversification of the separate account does not prevent the
Service from finding that the contract holder should still be treated as the owner of the
assets in the account due to his control over the investments.37

The Service has consistently held that a contract holder may freely allocate the
investments of the separate account among the insurance company’s available choices
without being deemed the owner of the separate account for federal income tax
purposes.38 If the contract holder instead selects an independent party that has been
approved by the insurance company as a separate account management option to
make investment decisions, it seems unlikely that the Service would find that the
selection of an allocator is a form of control, unless there is an “arrangement, plan,
contract, or agreement” between the contract holder and the allocator with regard to the
investments of the separate account.39 One qualification, therefore, is that the allocator
(i.e., investment advisor) should be selected from a list of available allocators provided
and previously approved by the insurance company, and the contract holder should not
mandate that his or her own allocator be used. The Service has provided guidance on
this issue by approving an arrangement under which the contract holder’s “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 [the insurance company]. These investment managers may be
recommended to [the insurance company] by one or more [contract holders]. [The
insurance company] will be under no obligation to approve any such recommendations.
Moreover, once [the contract holder] makes an initial selection, the investment manager
can only be changed by [the insurance company] and not by [the contract holder].” 40

37
Rev. Proc. 99-44, 1999-48 I.R.B. 598 (“[s]atisfiying the diversification requirements does not prevent a contract
holder’s control of the investments of a segregated account from causing the contract holder, rather than the
insurance company, to be treated as the owner of the assets in the account”).
38
See, e.g., Rev. Rul. 2003-92; Rev. Rul. 2003-91; PLR 200244001; PLR 9752061.
39
Rev. Rul. 2003-91, I.R.B. 2003-33 (July 23, 2003).
40
PLR 9752061 (Sep. 30, 1997).

17
Presumably, however, a policy owner can change from one investment manager
approved by the insurance company to another investment manager approved by the
insurance company under authority of the line of rulings previously discussed.41

In summary, a finding of investor control depends on “all of the relevant facts and
circumstances.”42 The recommendation of an allocator by a policy owner or her advisor
to the insurance company, without other factors, arguably should not support a finding
of investor control. It seems that, as long as the contract holder has no actual control
over the allocator’s investment decisions and the allocator may be selected by other
policy owners to manage their separate accounts, the allocator model should not run
afoul of the investor control doctrine.

A final note of caution in connection with the allocator model may be warranted,
however. It is entirely possible that, due to the Service’s apparent public policy stance
of limiting (wealthy) taxpayers’ ability to invest in hedge funds within life insurance
contracts, the IRS could take a very inflexible approach when it comes to allocations to
hedge funds. This approach would involve an absolute prohibition of subscriptions by
insurance carriers to hedge funds that are not “insurance-dedicated.” Thus, under the
allocator model, even though the policy owner selects only the allocator, and does not
select the underlying non-insurance-dedicated hedge funds among which the allocator
invests separate account assets, the IRS might nonetheless find that investor control
exists under the rationale of Rev. Rul. 2003-92 simply because the insurance company
(albeit at the direction of the allocator) has subscribed to a non-insurance-dedicated
hedge fund. Therefore (the IRS’s argument would go), despite the fact that the
separate account is adequately diversified within the meaning of IRC § 817(h) among
the non-insurance dedicated funds, the policy owner has indirect investor control for the
mere fact that the separate account holds as one or more of its investments a fund that
is not available exclusively through the purchase of a variable contract, and access to
which is not limited to insurance company segregated accounts. Although the IRS has
not made this argument—and it is a weak argument at best—the possibility, however
remote, that the Service will attempt to use it underscores the fact that the tax
consequences of using the asset allocator model remain unclear.

Conclusion. Hedge funds or hedge funds of funds as an investment of a private

placement life insurance contract should not pose investor control concerns (assuming
the funds are independently selected by the insurance company) as long as the
investment structure of the fund is a limited partnership that meets the following two-part
test:

(i) all the beneficial interests in the partnership must be held by one or more
segregated asset accounts of one or more insurance companies; and

41
Rev. Rul. 2003-92; Rev. Rul. 2003-91; Rev. Rul. 81-225; Rev. Rul. 82-54.
42
Rev. Rul. 2003-91.

18
 (ii) access to the partnership must be exclusively through the purchase of a
variable contract.

If the partnership meets these requirements, it will be “looked through” to its

underlying investments for purposes of applying the IRC § 817(h) diversification test,
and investor control will not be a concern due to the absence of public availability. De
facto investor control, however, is still a significant consideration in the design,
implementation, and administration of any private placement life insurance structure,
and practitioners should carefully monitor their clients’ actions to prevent a scenario that
could lead to a finding of investor control. The hedge fund industry has responded to
the IRS’s recent activity by creating many insurance-dedicated funds and funds of
funds. The continuation of this trend will sustain the viability of private placement life
insurance as an attractive planning tool for high-net-worth investors who desire the
superior risk-adjusted return characteristics of hedge funds and funds of funds.

c. Insured Lives

It is important in the illustration process to determine whether it is better from a

planning perspective to purchase a single-life or joint and survivor product. Joint and
survivor coverage is less frequently available in the offshore market, but availability
should increase with market demand. The life being insured and the person funding the
policy can be different persons, depending on age and health concerns, and assuming
always that there is an “insurable interest” relationship as defined under applicable law.

d. Loan Spread and Loan Provisions

A sometimes overlooked detail in policy design is the client’s ability to access

policy cash values on a cost-advantageous basis. Many carriers offer competitive
charges for the accumulation of values inside the contract, but then charge a high
spread on loan values. As mentioned previously, careful attention should be given to
non-MEC qualification if a client desires access to policy cash values through
withdrawals up to basis or loans.

e. Extended Maturity Option

As life expectancies gradually increase, it is important to understand what

happens to the policy beyond the normal policy maturity age of 95 or 100. Some private
placement life insurance contracts omit provisions related to this possibility. A forced
return of cash values at an advanced age before death would result in a disastrous
income-tax liability.

f. Cost of Insurance

Competitive COI rates are essential to good policy performance but are often not
a clearly identified cost. As discussed above, COI rates vary depending on the age,
gender, and health of the insured. In general, U.S. insureds can expect significantly

19
lower COI rates than non-U.S. insureds. Some offshore carriers have obtained
reinsurance based on a blend of U.S. and non-U.S. lives, which results in higher costs.
Other carriers (both domestic and offshore) mark up the reinsurance cost of their COI
rates to provide a higher profit margin, especially in early policy years, in what they
hope will be an overlooked cost item. Finally, the bargaining power of the carrier in the
global reinsurance market often will be reflected in COI pricing, with superior pricing
being obtained by larger carriers that can promise their reinsurers higher volume.

g. Investment Return Issues (“Force-Outs”)

One of the most important nontax design issues relates to whether a carrier will
warrant against “force-outs” of cash value when the cash value grows more quickly than
expected, thereby pushing up the required net amount at risk. Policyholders must pay
tax at ordinary income rates on force-outs of cash. Accordingly, the optimal result is for
the carrier to negotiate with the reinsurer to guarantee that the “at risk” portion will
always remain sufficiently ahead of the cash value without the need to force cash out of
the policy. If this is not possible, the insurance broker must pay careful attention to
policy performance each year and pre-plan against this result.

11. Practical Realities

a. Solicitation

If an offshore life insurance company or its agents have solicited an offshore life
insurance contract within the U.S., such solicitation may subject the transaction to a
potential claim by the government of the state where the client resides for a state
premium-tax payment. Some offshore carriers are more permissive than others in what
they believe is allowable activity. The conservative approach is for the carrier and its
agents to have no contact whatsoever with the client in the U.S. The client should travel
outside the U.S. to negotiate the contract, take a physical examination, complete other
aspects of the underwriting process (such as the inspection report), and sign
applications. Once the policy has been issued, the insurer should deliver the policy to
its owner offshore. Finally, premiums should be paid by the offshore owner of the policy
(typically a trust) and not directly by the U.S. person who is funding the purchase of the
policy.

b. Underwriting

Planners must pay careful attention to the “insurance” nature of the life insurance
contract, despite its desirable tax and investment purposes. The insurance company
must assume risk in the transaction, and the client must go through financial and
medical underwriting that allows the carrier to assess such risk. Carriers typically
require clients to divulge enough financial information to establish an insurable interest
as well as the need for insurance. Clients also must submit detailed medical
information and undergo an insurance-specific medical examination by a qualified
physician, typically a board-certified internist. Even after these disclosures are made, a

20
client could have medical or financial issues that will prevent her from acquiring the
contract on an economical basis. An experienced life insurance professional can add
tremendous value to the underwriting process.

c. Policy Servicing

Affluent clients are not accustomed to dealing directly with insurance carriers,
and some of the companies that offer PPVUL insurance contracts do not have
personnel with the experience in the high-net-worth market to provide client service at
the desired level. For these reasons, it is preferable for a qualified professional who
does have such experience to work as an intermediary between the client and the
carrier to provide annual policy servicing, to explain and confirm information received
from the insurance company, and to evaluate the continued and long-term market
competitiveness of the carrier and the product that the client has selected.

12. Selection of Jurisdiction and Carrier Due Diligence

In addition to policy design, it is imperative that advisors think about issues

related to the jurisdiction that will govern the life insurance policy and its issuer.
Countries where offshore carriers are resident, such as Bermuda, the Bahamas, the
Cayman Islands, and Guernsey, have separate account legislation that protects policy
assets from claims against the carrier, whereas the Isle of Man and Liechtenstein
(countries that also have resident carriers there) do not have such statutes. As is
evident among the various state jurisdictions in the U.S., some of the offshore
jurisdictions have specific creditor exemptions for life insurance while others do not.
Additional jurisdictional issues include the level of regulatory oversight that the
jurisdiction’s governing bodies have over the insurance industry, the relative political
and economic stability of the jurisdiction, the jurisdiction’s international reputation, and
the availability of professional resources in that jurisdiction.

In addition to jurisdictional issues, there are several carrier-related issues that a

client’s advisors should analyze as part of the due diligence process. Because this
endeavor is properly undertaken by a qualified insurance broker, it will be discussed in
the section related to brokers below.

13. Professional Involvement

Although reduced regulatory controls and taxation offshore provide a wonderful

environment for creative insurance structures, it is also this lack of regulatory oversight
that demands the involvement of knowledgeable professional advisors in every offshore
PPVUL insurance transaction. Similarly, in the case of a domestic private placement
transaction, the carrier’s ability to discriminate between policyholders and the unique
nature of each transaction also suggests the advisability of engaging third-party legal
and insurance advisors. The legal advisor will work with the client to plan and
implement the life insurance structure in relation to the client’s overall tax and estate

21
plan, and the insurance broker will oversee product design, pricing issues, and carrier
selection.

a. Legal Advisor

The legal advisor’s role is fairly broad. The advisor will first educate the client on
the various aspects of the life insurance planning and may recommend further estate-
planning vehicles such as an irrevocable life insurance trust structure. In addition, the
advisor will analyze the structure with an eye toward tax compliance, negotiate contract
points with prospective carriers, and work with the insurance broker to implement the
policy while ensuring that the client’s financial, medical, and personal information are
processed with the highest degree of confidentiality. The legal advisor will also typically
act as a communications liaison between the client and the insurance professionals.
Finally, it should be the legal advisor who confirms the financial solvency of the client
before any transfers are made into a private placement policy.43

b. Insurance Broker

A knowledgeable insurance broker should ensure tax compliance and

competitive pricing of the policy. It is also the broker’s responsibility to make product
recommendations, to select the appropriate carrier, and to assist with negotiating the
contract and associated fees. Keeping jurisdictional issues in mind, the broker should
perform extensive due diligence on carrier candidates. Careful examination of the
carrier helps ensure that it will be capable of fulfilling its obligations over the term
contemplated by the policy.

Although carrier due diligence is important in the case of any private placement
transaction, it is particularly critical when contemplating an offshore transaction. The
offshore market is a mixed bag of smaller, newer carriers with very little capital on one
hand, and wholly-owned subsidiaries of large U.S. or multinational companies on the
other. The carrier, its parent, and/or its principal reinsurer should have a good credit
rating from A.M. Best, Moody’s, Standard & Poor’s, and/or Duff & Phelps. If the carrier
is not substantial in its own right, it should have a guarantee from a parent corporation
with regard to satisfying any carrier claims. The financial condition of the company (and
its parent, if applicable) should be examined carefully. In the case of a subsidiary, the
broker should evaluate the parent company’s commitment to the offshore market, as
some large U.S. carriers have aborted their recent attempts to enter the offshore
marketplace.

The broker should also understand and assess the reinsurance treaties between
carrier candidates and their reinsurers. Reinsurance treaties are contractual
arrangements in which the carrier places some or all of the policy’s “at risk” amount (i.e.,

43
Owing to the asset-protective nature of life insurance and the high-dollar amount of the typical premium, it is
possible for a client to inadvertently make a fraudulent transfer when funding a policy. This is true irrespective of
whether the policy is issued by a domestic or offshore carrier.

22
the death benefit in excess of cash value) with other insurance companies or reinsurers.
Because most private placement policies have relatively large face amounts, most, if
not all, of the death benefit will be covered by reinsurance. A skilled broker must
evaluate this issue to ensure that the carrier has the capacity to issue the death benefit
required in a particular case and that the carrier has competitive reinsurance rates.

The broker will determine from the carrier its process and requirements for
underwriting. The broker also will analyze the carrier’s mortality costs and assumptions,
and the carrier’s servicing and administration capabilities. The carrier should have in-
force illustration capability and resources for adequate reporting to the policyholder.
The broker will also fulfill an ongoing role in annual reviews and will continue to oversee
the policy from a tax-compliance standpoint.

C. Hedge Funds

1. Introduction: Why Hedge Funds?

Although the unprecedented bull market of the 1990s led to tremendous

accretions in wealth for many investors, the bursting of the tech bubble brought about
an equal measure of lost fortunes. In the investment world, stock market volatility is
expected, but the roller-coaster ride that many investors have experienced in recent
years has given them a whole new concept (and fear) of “volatility.” Although hedging
strategies44 have always been acknowledged as a way to reduce portfolio volatility,
recent market conditions have highlighted market-neutral hedge funds as a way to
achieve positive yearly returns with much less risk and significantly lower correlations to
market movements. In particular, market-neutral hedge funds of funds, which are
diversified groups of hedge funds overseen and monitored by a “manager of managers,”
have become the investment product du jour for high-net-worth investors.

Although estate planning attorneys will not typically be called upon to

recommend hedge funds of funds to their clients or to know their technical intricacies,
they may receive questions about their legal structures and tax implications. Moreover,
some uninformed advisors, including lawyers, have a knee-jerk reaction to the mention
of hedge funds, thinking only that they are terribly risky. Many immediately recall Long
Term Capital Management, the grossly over-leveraged fund whose default nearly
collapsed financial markets in 1998. At a minimum, legal advisors to the high-net-worth
client market should not automatically dismiss hedge funds as risky. In an ideal
situation, advisors should understand the role that hedge funds can play in improving
the risk/return profile of an investment portfolio, know the various types of hedge funds,
and have a general familiarity with how hedge funds produce their investment returns.

44
“Hedging” is any investment that is taken in conjunction with another position in order to reduce directional
exposure, which is the amount of risk that an unhedged position faces in the market as compared to the net
exposure of positions involving long and short hedged relationships. A classic example of hedging is a farmer who
enters into a futures contract for grain to lock in a particular price. The farmer removes any uncertainty about the
price she will receive for grain, but she foregoes the possibility of receiving a higher price.

23
 2. Benefits and Risks of Hedge Funds

The incorporation of market-neutral hedge-fund-of-fund strategies in investment

portfolios yields three primary benefits. First, it allows investors to access the highest
level of investment management talent in the industry. Many of the most successful
investment managers have left larger firms to join (or form their own) smaller firms that
offer hedge fund products and embrace a wider array of trading strategies that enable
them to deliver superior risk-adjusted returns to their customers. Second, it has been
demonstrated in recent studies that “adding hedge funds to traditional stock and bond
portfolios significantly improves overall returns at equivalent levels of risk.”45 Third,
hedge funds can improve returns and reduce risk particularly well at times when
markets are excessively volatile.

The most commonly cited risk of hedge-fund investing is that hedge-fund

products are not typically subject to the high level of regulation associated with mutual
funds, for example. Most hedge funds are organized as private investment partnerships
and investors must meet minimum net-worth or income criteria to invest.46 In addition,
reporting standards are less stringent for hedge funds than for mutual funds or
separately managed accounts. For this reason, many hedge fund investors employ an
investment consultant to perform due diligence on prospective hedge-fund managers.
Investors also typically will prefer highly diversified hedge-fund-of-fund products over
single-manager products to minimize the specific risks associated with a single
manager. Another potential risk in hedge-fund investing is the over-use of leverage and
derivatives. Again, hedge-fund investors typically will look to their investment consultant
to monitor the appropriate use of leverage and derivatives by their hedge-fund-of-fund
managers.

3. Superior Risk-Adjusted Returns

By far the most compelling benefit of hedge-fund investing is that it produces

superior risk-adjusted returns compared to traditional stock and bond asset classes.
Over the past decade, hedge funds as an asset class have produced equity-like returns
in both rising and declining markets, while maintaining the limited volatility of a bond
portfolio. The following chart compares hedge funds to stocks and bonds in the
1990s.47
Asset Class Return Volatility
Hedge Funds 14.6% 4.4%
Stocks 17.2% 13.7%
Bonds 7.5% 4.4%

45
R. McFall Lamm, Jr. & Tanya E. Ghaleb-Harter, Do Hedge Funds Belong in Taxable Portfolios?, J. OF WEALTH
MGT., 1, 1-16 (Summer 2001).
46
See Section 6, infra.
47
Lamm, supra note 45 at 1-2.

24
 One of the hottest debates among investment consultants is what percentage of
a taxable investor’s portfolio should be allocated to hedge funds. Although some
investment consultants limit their suggested allocations to hedge funds to the traditional
15-20 percent range, others suggest allocations consistent with portfolio optimization
research indicating that a 50 percent allocation to hedge funds may be appropriate.48

4. Types of Hedge Funds and How They Produce Investment

Returns

There are estimated to be more than 8,000 hedge funds representing more than
$1.0 trillion in assets. The following list of principal categories of hedge funds is ordered
from least to most volatile, and from lowest to highest expected returns. The first eight
categories are considered “market neutral,” while the remaining three categories are
not.

a. Long/Short Equity Market Neutral

This investment strategy seeks to profit by exploiting pricing inefficiencies

between related equity securities, neutralizing exposure to market risk by combining
long and short positions. One example of this strategy is to build portfolios made up of
long positions in the strongest companies in several industries and taking corresponding
short positions in those companies showing signs of weakness.49

b. Merger Arbitrage

This strategy is sometimes called “risk arbitrage.” It involves investment in event-

driven situations such as leveraged buy-outs, mergers, and hostile takeovers.
Normally, the stock of an acquisition target appreciates while the acquiring company’s
stock decreases in value. These strategies generate returns by purchasing stock of the
company being acquired, and in some instances, selling short the stock of the acquiring
company. Managers may employ the use of equity options as a low-risk alternative to
the outright purchase or sale of common stock. Most merger arbitrage funds hedge
against market risk by purchasing S&P put options or put option spreads.

c. Convertible Arbitrage

Convertible arbitrage involves purchasing a portfolio of convertible securities,

generally convertible bonds, and hedging a portion of the equity risk by selling short the
underlying common stock. Certain managers may also seek to hedge interest rate

48
See Lamm, supra note 45 at 11.
49
Short selling involves the sale of a security not owned by the seller and is a technique used to take advantage of
an anticipated price decline. To effect a short sale, the seller borrows securities from a third party in order to make
delivery to the purchaser. The seller returns the borrowed securities to the lender by purchasing the securities in
the open market. If the seller can buy that stock back at a lower price, a profit results. A short seller must generally
pledge other securities or cash with the lender in an amount equal to the market price of the borrowed securities.
This deposit may be increased or decreased in response to changes in the market price of the borrowed securities.

25
exposure under some circumstances. Most managers employ some degree of
leverage, ranging from zero to 6:1. The equity hedge ratio may range from 30 percent
to 100 percent. The average grade of bond in a typical portfolio is BB-, with individual
ratings ranging from AA to CCC. However, because the default risk of the company is
hedged by shorting the underlying common stock, the risk is considerably better than
the rating of the unhedged bond indicates.

d. Relative Value Arbitrage

This investment strategy attempts to take advantage of relative pricing

discrepancies between instruments, including equities, debt, options, and futures.
Managers may use mathematical, fundamental, or technical analysis to determine
misvaluation. Securities may be mispriced relative to the underlying security, related
securities, group of securities, or the overall market. Many of these funds use leverage
and seek opportunities globally. Arbitrage strategies include dividend arbitrage, pairs
trading, options arbitrage, and yield curve trading.

e. Event Driven

Event-driven investing is also known as “corporate life cycle” investing. This

involves investing in opportunities created by significant transactional events, such as
spin-offs, mergers and acquisitions, bankruptcy reorganizations, recapitalizations, and
share buybacks. The portfolios of some event-driven managers may shift in majority
weighting between risk arbitrage and distressed securities, while others may be broader
in scope. Instruments include long and short common and preferred stocks, as well as
debt securities and options. Some managers may use leverage. Fund managers may
hedge against market risk by purchasing S&P put options or put option spreads.

f. Regulation D

Regulation D managers invest in Regulation D securities, sometimes referred to

as “structured discount convertibles.” The securities are privately offered to the
investment manager by companies in need of timely financing, and the terms are
negotiated. The terms of any particular deal are reflective of the negotiating strength of
the issuing company. Once a deal is closed, there is a waiting period for the private
share offering to be registered with the SEC. The manager can only convert into private
shares and cannot trade them publicly during this period; the investment is therefore
illiquid until it becomes registered. Managers will hedge with common stock until the
registration becomes effective and then liquidate the position gradually.

g. Fixed Income Arbitrage

This market-neutral hedging strategy seeks to profit by exploiting pricing

inefficiencies between related fixed income securities, while neutralizing exposure to
interest rate risk. Fixed income arbitrage is a generic description of a variety of
strategies involving investment in fixed-income instruments, which are weighted in an

26
attempt to eliminate or reduce exposure to changes in the yield curve. Managers
attempt to exploit relative mispricing between related sets of fixed income securities.
The generic types of fixed-income hedging trades include yield-curve arbitrage,
corporate versus Treasury yield spreads, municipal bond versus Treasury yield
spreads, and cash versus futures.

h. Distressed Securities

Managers who strategically invest in distressed securities invest in, and may sell
short, the securities of companies in which the security’s price has been, or is expected
to be, affected by a distressed situation. This may involve reorganizations,
bankruptcies, distressed sales, and other corporate restructurings. Depending on the
manager’s style, investments may be made in bank debt, corporate debt, trade claims,
common stock, preferred stock, and warrants. Strategies may be subcategorized as
high-yield or “orphan” equities. Some managers may use leverage. Fund managers
may also run a market hedge using S&P put options or put options spreads.

i. Long/Short Equity Directional

These non-market-neutral funds consist predominantly of long equities, although

they have the ability to hedge with short sales of stock and/or index options. These
funds are commonly known as stock-pickers. Some funds employ leverage to enhance
returns. When market conditions warrant, managers may implement a hedge in the
portfolio. Funds may also opportunistically short individual stocks. The important
distinction between “Long/Short Market Neutral” and “Long/Short Equity Directional” is
that equity directional funds do not always have a full hedge in place. In addition to
equities, some funds may have limited assets to invest in other types of securities.

j. Emerging Markets

These non-market-neutral hedge funds invest in securities of companies or the

sovereign debt of developing or “emerging” countries. Investments are primarily long.
“Emerging Markets” include countries in Latin America, Eastern Europe, the former
Soviet Union, Africa, and parts of Asia. Global emerging markets funds will shift their
weighting among these regions according to market conditions and manager
perspectives. Some managers invest solely in individual regions.

k. Macro

Macro funds invest by making leveraged bets on anticipated price movements of

stock markets, interest rates, foreign exchanges, and physical commodities. Macro
managers employ a “top-down” global approach and may invest in any markets using
any instruments to participate in expected market movements. These movements may
result from forecasted shifts in world economies, political fortunes, or global supply and
demand for resources, both physical and financial. Exchange-traded and over-the-

27
counter derivatives are often used to magnify these price movements. These are the
riskiest hedge funds.

5. Tax Characteristics of Hedge Funds

For taxable investors, investing in hedge funds is a mixed blessing. On one

hand, the previously discussed improvement that hedge funds bring to the risk/return
profile of an investor’s portfolio is a positive factor; on the other hand, the impact of
hedge-fund investing on an investor’s effective tax rate is generally negative. Due to
the trading methodologies and types of transactions employed by hedge fund managers
to generate their returns, nearly all hedge fund returns are taxable as ordinary income
or as short-term capital gain, both of which are subject to the highest income-tax rates.
For investors who are also subject to state income tax, this typically results in a tax rate
on the investment earnings of hedge funds in excess of 40 percent. There are some
hedge funds that produce returns taxable at long-term capital gain rates, but these
funds are the exception rather than the rule.

For non-taxable vehicles that may comprise part of a high-net-worth client’s

estate plan, such as charitable remainder trusts (“CRTs”) and private foundations,
hedge fund investments can also prove to be problematic from a tax standpoint.
Because most hedge funds and hedge funds of funds have as their legal structure a
limited partnership, earnings of the fund typically constitute “unrelated business taxable
income (UBTI)” to a CRT or private foundation. In the case of either a CRT or private
foundation, UBTI can be detrimental to its intended non-taxable status.50

The way that CRTs and private foundations can nevertheless invest in hedge
funds or hedge funds of funds is by electing to invest through the fund manager’s
“offshore feeder” fund. Because such funds are typically organized as companies
rather than limited partnerships, they do not usually generate UBTI. Hedge fund
managers organize these entities under the laws of an offshore jurisdiction in order to
avoid the registered investment company rules and their accompanying SEC
regulation.51

6. SEC Issues

A hedge fund manager is exempt from the provisions of the Investment Company
Act of 1940 (the “Act”) if the fund can remain outside of the statutory meaning of an
investment company subject to registration. These exclusions fall primarily under two
sections of the Act.

50
In the case of a Charitable Remainder Trust, any amount of UBTI in any taxable year will cause all trust income for
that year to be subject to income taxation as if the trust were a regular non-exempt trust. Treas. Reg. § 1.664-1(c).
See also, Leila G. Newhall, Unitrust v. Comr., 104 T.C. 236, 241-45 (1995). Private Foundations, on the other
hand, are taxed only on their UBTI.
51
See also PLRs 200315028 (Jan. 13, 2003), 200315032 (Jan. 14, 2003), and 200315035 (Jan. 14, 2003), where
four charitable remainder trusts employed a controlled foreign corporation for investing in a leveraged hedge fund.

28
 Section 3(c)(1): A fund need not register as an investment company if it
has fewer than 100 beneficial owners and they are “Accredited Investors.”

Section 3(c)(7): Alternatively, a fund may avoid registration if it has fewer

than 500 owners and they are Qualified Purchasers (i.e., “super-accredited”
investors with higher net-worth and higher income requirements).

Both Sections 3(c)(1) and 3(c)(7) of the Act also stipulate that the fund must neither
make nor intend to make a public offering. There is no exemption if the hedge fund
manager holds itself out to the public as an Investment Advisor.

An “Accredited Investor” within the meaning of rule 501(a) of Regulation D

promulgated under the U.S. Securities Act of 1933, as amended, is defined as one of
the following:

(i) an individual with at least a $200,000 annual income or a net worth

of at least $1 million; or

(ii) a corporation, partnership, LLC, business trust, or tax-exempt

organization not formed for the purpose of investing in the hedge fund and
having total assets in excess of $5 million.

A “Qualified Purchaser” is defined in section 2(a)(51) of the Act as one of the

following:

(i) an individual with investable assets of at least $5 million; or

(ii) a corporation, partnership, LLC, business trust, or tax-exempt

organization not formed for the purpose of investing in the hedge fund and
having investable assets of at least $25 million.

As a practical matter, hedge fund investors generally will need to qualify as

Qualified Purchasers due to limitations imposed in a fund’s offering documents.

7. Coordination with Private Placement Variable Life Insurance

Investing in hedge funds within a private placement variable life insurance

contract enables the investor to have her cake and eat it too. Because of the favorable
tax characteristics of life insurance, clients can choose hedge fund investments for their
positive risk/return characteristics without fear of the significant income-tax burden they
often incur.

29
 Most insurance carriers that offer private placement products not only permit
hedge funds as investments of separate accounts, they expect it. Moreover, in the non-
SEC regulated environment that exists for offshore PPVUL products, the regulatory
hassles that accompany admitting a hedge fund as an investment choice within a
domestic policy are a non-issue.

Hedge funds or hedge funds of funds as an investment of a PPVUL insurance

contract should not pose diversification concerns under IRC § 817(h) as long as the
investment structure of the fund is a limited partnership, since limited partnerships are
“looked through” to their underlying investments for purposes of applying the
diversification test. Although investor control is still a significant consideration,
especially in light of recent rulings issued by the IRS,52 many hedge fund managers
have responded to these rulings by creating insurance-dedicated funds or funds of
funds. This should help reduce the risk of an IRS finding of investor control.

Two issues of concern in the context of an investment in a hedge fund within a

separate account of a private placement policy are valuation and liquidity. Although
offshore carriers typically can administer policies when receiving monthly valuation data,
domestic carriers may have problems with this because state insurance regulators may
require more frequent valuation of policy assets. Although some hedge funds have
systems that would allow them to provide daily valuation, most do not, making the less-
regulated offshore insurance environment preferable in such cases.

Liquidity is a more difficult issue. Most hedge funds and hedge funds of funds
provide in their organizing documents that part or all of the fund can be liquidated on no
more than a quarterly basis. More importantly, many have “lock-up” periods that
prevent any liquidation in the first investment year. Insurance carriers have a problem
with year-long lock-up periods because if the insured dies, the carrier will want to pay
the death benefit in cash. Accordingly, it is normal for a carrier to negotiate with a
hedge fund manager in an effort to persuade the fund manager to waive its lock-up
requirement in the case of the death of the insured in the first investment year.

8. Conclusion

The compelling risk/return benefits that hedge funds bring to a taxable investor’s
portfolio are sometimes perceived to be offset by the tax inefficiency of hedge fund
earnings. Using private placement life insurance products as the investment chassis for
an investor’s allocation to hedge funds can successfully meet a client’s otherwise
seemingly conflicting goals of investing in hedge funds and investing tax-efficiently.
That is, with proper policy planning and design and carefully chosen hedge fund
products, a client can enjoy the “best of both worlds,” tax efficiency and superior risk-
adjusted investment returns.

52
See, e.g., Rev. Rul. 2003-92; Rev. Rul. 2003-91; Pvt. Letter Rul. 200244001.

30