Considerations When Using Hedge Funds In Variable Products

The underlying hedge funds used most often are fund-of-funds, or hedge funds that invest in other hedge funds. Assuming the IRS requirements for looking through the first layer of funds are met, this helps to easily achieve the requisite diversification for the policy to receive tax-deferred treatment. Additionally, use of a fund-of-funds may provide investment diversification among different management styles while avoiding the complications of dealing directly with multiple hedge fund managers.

In any event, the contract between the hedge fund manager and the insurance carrier, whether structured as some sort of participation agreement or otherwise, should be carefully considered, especially with respect to indemnification and other provisions relating to compliance by the hedge fund manager with any applicable investment guidelines, valuation procedures or other restrictions.

Unlike mutual funds used in variable insurance products, currently there are no specific disclosure requirements applicable to hedge funds that are exempt from registration under the Investment Company Act of 1940. Likewise, many hedge fund managers are themselves exempt from registration and ongoing regulation by the SEC under the Investment Advisers Act of 1940 (although they remain subject to the anti-fraud provisions of the Act).

However, because the premise inherent in a variable insurance product is that the investment risk is shifted to the policyholder, such products are securities for purposes of the federal securities laws. Therefore, the anti-fraud provisions of Rule 10b-5 under the Securities Exchange Act of 1934 still apply, for example, as do the anti-fraud provisions of state securities laws.

Similarly, because (unlike a mutual fund-based policy), these products are privately placed and are not registered under the Securities Act of 1933 (the "Securities Act"), all of the usual requirements for a valid private placement apply. This typically means that the safe harbor provisions of Regulation D under the Securities Act must be met.

Insurance carriers therefore need to be particularly careful in their diligence efforts regarding prospective hedge fund managers for variable insurance products. Thoughtful consideration also should be given to the amount and quality of disclosure about the underlying hedge funds and managers that will be provided to policyholders.

Furthermore, while these types of policyholders often are sophisticated, or at least very wealthy, proper manner of offering and suitability controls are nevertheless important to avoid potential securities laws problems.

The attraction of these products for an insurance carrier is clear: These types of polices are likely to be written only for substantial amounts where even institutional asset-based pricing can be significant, or in connection with a relationship with an important client.

However, there are risks over and above those of a more traditional mutual fund-based variable product that must be well managed. This is particularly the case given the explosive growth, and therefore wide range in quality, of hedge fund managers in the last few years and the increasing SEC scrutiny of the hedge fund industry.

Attorney Gregory T. Pusch is an Associate in the Insurance and Reinsurance Practice Group of Edwards & Angell, LLP, a national law firm focusing on financial services, private equity and technology. He may be reached at: [email protected].

Reproduced from National Underwriter Life & Health/Financial Services Edition, May 26, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.