By Jonas Katz and Cameron Vail
The Insurance-Dedicated Fund (IDF) marketplace has grown rapidly in terms of both investment manager participation and assets under management. Despite the market’s rapid growth, Private Placement Life Insurance (PPLI), Private Placement Variable Annuities (PPVA) and the IDFs that they invest through remain generally clouded by a multitude of misconceptions. Fortunately, a growing body of law, an increasing number of capable market participants and expanding distribution channels have served to broaden acceptance of these structures and simplify the education process for those entering or exploring this market. By addressing some of these misconceptions, we hope to offer advisors a more accurate look at the IDF marketplace landscape.
Common Misconceptions
An investment manager may not communicate with current or prospective Policyholders about its IDF in any way, shape or form.
While the Internal Revenue Service (IRS) has yet to codify the collection of Private Letter Rulings (PLRs) and Revenue Rulings (generally referred to as the “Investor Control Doctrine”), insight from the IRS’s pronouncements and tax court rulings provides clear guidance regarding the spectrum of communication pre- and post-IDF launch that may or may not be considered a violation of the Investor Control Doctrine.
Pre-Launch: Prior to IDF launch, investment managers are often concerned (and rightfully so) with the degree of permissible communication with prospective investors (i.e., PPLI policyholders and PPVA contract owners, collectively “Policyholders”). In reality, how can an investment manager attract initial capital for an IDF if they are unable to present the investment objective, strategy and terms to their prospective investor base? PLR 9433030, dated May 25, 1994, outlines a scenario whereby the insurer, not the Policyholder, was treated as the owner of the assets underlying the separate account despite the Policyholder and the insurer agreeing to broad investment guidelines related to underlying investments prior to policies being purchased. A key point made within PLR 9433030 is that the Policyholder did not have the right to select any particular investments within the funds and that discussions were in fact limited to “broad investment guidelines” (e.g., total rate of return for the funds, duration, primary investments, investment objectives, etc.). In summary, investment managers should limit discussion to investment parameters and the risk return profile of the overall strategy and avoid reference to specific securities when speaking with potential Policyholders.
Post-Launch: Once an IDF has launched, investment managers are often confronted with the question of what should or shouldn’t be provided to Policyholders in terms of routine reporting. PLR 201417007, dated April 25, 2014, outlines a fact pattern where asset holding reports from underlying IDFs were made available to Policyholders “on a delayed basis (about five days after the end of each month)” and the Policyholders in question were not deemed to be owners of the IDF interests for federal income tax purposes. As a result, the general industrywide consensus is that portfolio transparency can be provided to underlying Policyholders so long as such transparency is shared a reasonable amount of time after the close of a given investment period and reflects the holdings as of the close of the investment period (e.g., 10 days after month end).
While a PLR may not be relied upon as precedent by anyone other than the taxpayer who applied for it, such rulings do provide guidance and a measure of comfort to professional advisors who are called upon to express their understanding of the IRS’s views on the Investor Control Doctrine. The Investor Control Doctrine should always be approached conservatively; therefore, it is highly recommended that third-party insurance brokers and/or insurance company representatives be consulted and/or involved in discussions concerning investment strategy and other potentially sensitive subjects.
Passive Equity Owners of an investment management company cannot invest in an IDF managed by that same investment management company.
PLR 20152003, dated May 1, 2015, illustrates a fact pattern in which a Taxpayer’s passive ownership of equity and revenue stream interests in a “Taxable Fund” (i.e., a non-IDF) managed by an investment management firm did not result in an Investor Control Doctrine violation for the Taxpayer’s allocation to an IDF managed by the same investment management firm. For clarity, PLR 20152003 cites specific criteria that led to the ruling: (i) the portfolio management team for the IDF was a different team than the one that managed the portfolio for the Taxable Fund; (ii) the IDF and Taxable Fund could invest in some of the same stocks, but the IDF and Taxable Fund were “substantially different”; (iii) the Taxpayer did not directly or indirectly influence the selection of investments within the IDF; and (iv) the IDF did not invest in the Taxable Fund itself. Through this PLR, the IRS further indicated that a violation of the Investor Control Doctrine requires that a Policyholder take an action to directly or indirectly influence the portfolio management team of an IDF with respect to the selection of investments within the IDF.
The ruling in PLR 20152003 may present interesting opportunities for growth in the high-net-worth (HNW) IDF channel, because some founders of large, well-established investment management firms (e.g., hedge fund and private equity firms) are moving away from any day-to-day management activities and have become completely passive owners of such investment management firms or are seeking prospective investment managers of IDFs with which they only have a passive interest. However, the PLR was issued with respect to a very specific set of events and circumstances and it is again recommended that the Investor Control Doctrine always be approached conservatively. For example, fact patterns contemplating insured spouses (potential “prearranged plan” concerns), nongrantor trusts set up for the benefit of descendants, or founders/policyholders receiving an economic benefit from an IDF via management and incentive fees (indirect benefit to the family group of the investment manager) should be avoided.
An IDF’s investment strategy cannot be similar to a “taxable” strategy that an investment management firm currently operates.
When investment management firms look to enter the IDF marketplace, they often look to do so with a flagship product or investment strategy that has had fundraising success in the past. Selling prospective investors on the idea of purchasing a PPLI policy or PPVA contract to access an IDF can be difficult enough, so the obvious preference for most investor relations teams is to keep the IDF product as similar as possible to the taxable, flagship product in order to minimize the amount of new content involved in the sales process. Assuming an investment management firm possesses the operational capabilities to mimic a taxable strategy pari-passu, it could be argued that a gray area is being encroached upon with respect to the Investor Control Doctrine as the optics eliminating the possibility of a prearranged plan are less than perfect. Fortunately, the IRS has issued PLRs on the topic of IDF investment strategies mimicking taxable investment strategies.
PLR 201436005 dated May 29, 2014 analyzes such a scenario whereby an “Insurance Fund” (i.e., available exclusively to the segregated asset accounts of life insurance companies) has an identical investment objective and strategy and makes investment decisions and trades at the same time as a “Retail Fund” (i.e., a publicly available fund). In this analysis, the IRS ultimately determined that the underlying policyholders did not possess sufficient incidents of ownership over the assets of the separate account despite the similarity in investment strategies between the two investment vehicles. Note, PLR 201436005 also acknowledges that investment returns of the Insurance Fund and Retail Fund may deviate due to differing exposures to U.S. Treasury securities, current or expected cash flows, AUM amounts in each fund, and other operational or financial circumstances. Nonetheless, PLR 201436005 demonstrates that Investment Management firms should not be intimidated by the idea of leveraging one of their current taxable strategy offerings in a new IDF offering, as long as the investment decisions of the IDF are made by the advisor of such IDF in their sole and absolute discretion.
Insurance Companies will not approve “illiquid” investment strategies within an IDF.
The IDF marketplace has evolved dramatically over the years. Insurance companies have gone from only accepting “typical” hedge fund liquidity (e.g., a one-year lockup with quarterly liquidity upon 90 days’ notice) to now accepting much more restrictive liquidity terms often associated with private markets strategies (e.g., a three-year (or longer) initial lockup with annual withdrawals subject to an investor-level gate). Growth in the issuance of institutionally owned policies has also led to carriers approving closed-ended, evergreen structures. This trend of structural innovation and movement toward acceptance of illiquidity in search of yield is likely to continue as IDFs originally designed for the institutional marketplace continue to make inroads at HNW insurance companies, enabling potential distribution opportunities.
The current roster of IDF investment options is limited and unattractive.
As of April 2019, the number of funded IDFs in the market was approximately 165, up from just 66 IDFs at the end of the first quarter of 2011. On average, this equates to roughly 12 new IDFs added to the market each year since 2011. Since the beginning of 2014, the number of single manager IDFs has tripled. IDF investment strategies include, but are not limited to, long-short equity, event-driven, multistrategy, fund of funds, multiasset, private credit, MLPs, systematic, fixed income, global macro, private equity and real estate. Furthermore, the size and number of participants in the IDF market have increased significantly. Today’s IDFs are administered, distributed and managed by some of the largest financial services institutions in the world, with investments from various distribution channels and Policyholders, including insurance companies, banks, corporations, HNW individuals, sovereign wealth funds, endowments, foundations and pensions.
To the extent a Policyholder is not interested in one of the many IDF investment options currently available, with the help of a capable service provider, an IDF can often be constructed and brought to market in parallel to a Policyholder’s underwriting process (a process that typically takes two to four months). The maturation of the IDF marketplace and growing amounts of premium have led to a proliferation of investment options and a cadre of participants capable of efficiently building and attaching IDFs to one or multiple insurance company platforms. Out of the 165 IDFs in the market, 84 are available at three or more insurance companies, 42 have over $50 million in assets under management, and 30 have over $100 million in assets under management.
The IDF marketplace could be shut down tomorrow by a change to tax laws.
The provisions of the Internal Revenue Code governing PPLI, PPVA, and IDFs are the same rules that regulate the $2.1 trillion retail variable life insurance and retail variable annuity markets in the U.S. So, while the rules governing PPLI, PPVA and IDFs are clear and established, the IDF market is also strongly backed by a retail market of substantial size and history.
In fact, in recent years the IRS has further substantiated the IDF industry with increased guidance through IRS Revenue Rulings, Private Letter Rulings, tax court rulings, and pronouncements relating to the reporting on and structuring of IDFs. This guidance is focused on the appropriate level of transparency in IDF reporting (see PLR 201417007), the ability to structure an IDF that replicates a taxable vehicle (see PLR 201417007) and the enforceability of the Investor Control Doctrine (see Webber v. Commissioner (T.C., No. 14336‐11, 144 T.C. No. 17, 6/30/15)).
Furthermore, in the case of a material change to the Internal Revenue Code, the insurance industry has a longstanding history of “grandfathering” pre-existing policies. An example of this can be seen in the Pension Protection Act of 2006 (the “Act”) under which new rules relating to Employer Owned Life Insurance (EOLI) were applied only to EOLI policies issued or materially changed after the effective date of the Act. Generally, the industry expectation in the face of any material tax law changes is that existing PPLI policies or PPVA contracts would retain the current benefits associated with such policies or contracts.
The Tax Cuts and Jobs Act of 2017 (TCJA) diminishes the value proposition associated with PPLI and PPVA.
While the federal government passed TCJA in 2017 and reduced federal income tax rates, a $10,000 cap was also placed on the amount of State and Local Taxes (SALT) that taxpayers can deduct, a benefit that was previously uncapped. Residents of states with high state income tax rates such as California, Connecticut, New Jersey and New York, will likely bear a higher net income tax burden due to the TCJA, as opposed to any sort of tax relief. Consequently, in considering residents of high-tax states, the “structural alpha” or tax-eliminating and tax-deferring benefits of PPLI and PPVA are bolstered, not diminished, as a result of the TCJA.
In addition to capping the SALT deduction, TCJA also eliminates a taxpayer’s ability to deduct investment expenses such as custodial fees, investment management fees, costs related to trust administration, etc. With an increasing drag on net returns ultimately received by investors, investment managers would be wise to seek arbitrage for their clients in the form of more tax mitigation through an IDF offering.
Finally, many of the provisions within the TCJA, including the new income tax rates and brackets, are set to expire in 2025. It would be shortsighted for a family or individual to formulate their tax-planning strategy and long-term investment or inheritance goals around a potentially short-term political landscape. The compounding benefits of tax elimination and/or deferral are most impactful over time. PPLI and PPVA remain powerful tools for insulating one’s multigenerational assets or charitable bequests from tax-rate risk regardless of the current political environment, given the compounding benefits of tax deferral over the long run will likely far outweigh the cost of the PPLI and/or PPVA.
Individuals and institutions looking to acquire PPLI or PPVA will need to engage with a qualified insurance broker. Insurance brokers often play a critical role in providing policy design and marketplace education, as well as helping investors understand the common misconceptions outlined above.
Investment managers seeking to enter the IDF marketplace can leverage a turnkey IDF solutions provider. Partnering with an experienced IDF solutions provider can help investment managers efficiently create an IDF with minimal expense, effectively understand the IDF approval process with multiple life insurance companies and avoid certain pitfalls associated with the common misconceptions described above.
To survey a list of available IDF investment options, please consider visiting the SALI IDF Portal, which provides a dashboard for IDF market information along with relevant publications and source documents, at https://www.saliportal.com/.
Cameron Vail is the director of fund development and Jonas Katz is a principal and the chief marketing officer, both at SALI Fund Services.