Types of Hedge Fund Investors

combined with hedge funds, whose returns are generally taxed immedi-
ately at the maximum individual income tax rate. Whole-life insurance
policies allow the cash value to grow free from income tax and can be
structured to avoid estate tax. Deferred annuities can also allow invest-
ment balances to grow without being taxed until the return is distributed
years later. These insurance products are expanding the range of allowable
investments to include hedge funds, extending their favorable tax treat-
ment to hedge fund returns.
One new development that is being used to fund tax-favored hedge
fund investments involves reinsurance.
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Investors buy shares in a reinsur-
ance company in a location with low corporate income taxes. Most rein-
surance companies involved in hedge funds have been located in Bermuda,
which has no corporate income tax.
It is important that the reinsurance company is located outside
the United States and other locations with corporate income taxes to
avoid the double taxation of the investment returns. It is important,
also, that the business is an insurance company, because they alone are
exempted from special provisions designed to prevent U.S. taxpayers
from placing investments in an offshore company to avoid or postpone
recognizing income. It is, therefore, important that the reinsurance com-
pany actually operates as an insurance company to receive this special
treatment.
The business is diagrammed in Figure 3.2. Investors deposit cash as
equity investments in the company. The company receives insurance pre-
miums in return for sharing liability on insurance contracts. The reinsur-
ance company holds the premiums until a claim or claims are made.
Typically, the reinsurance company pays out all of the premium income
or more but keeps the investment returns on the money while it held
the reserves.
The reserves plus much of the reinsurance company surplus are in-
vested in hedge funds. The returns on the hedge funds accumulate tax-free.
The underwriting profits (premiums minus payouts) or losses (payouts mi-
nus premiums) accumulate along with the hedge fund returns. The reinsur-
ance investors expect that when they sell their shares, the investment
returns and the underwriting gains or losses will be taxed as long-term cap-
ital gains.
The reinsurance companies that invest in hedge funds have generally
been closely associated with particular hedge fund managers. MaxRe re-
cently held 40 percent of its investment portfolio in Louis Bacon's Moore
Holdings. Stockton Reinsurance invests in affiliated Commodity Corpora-
tion (owned by Goldman Sachs). Hampton Re (organized by J. P. Mor-
gan) invests in J. P. Morgan products. Hirch Re invests in the Hirch funds.
Asset Alliance Re invests in Asset Alliance hedge funds. These hedge fund
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HEDGE FUND COURSE
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