Hedge Funds Still OK For Variable Policies

Indeed, under those regulations, a look-through to the investment portfolios of underlying hedge funds was required even if the insurers separate account was itself adequately diversified through investments in a portfolio of hedge funds. Thus, under this interpretation, an insurers separate account acting as a fund of hedge funds would not be adequately diversified unless the portfolios of each underlying hedge fund also were diversified in accordance with Section 817(h).

The effect of the new amendments is to level the playing field between hedge funds and other investment vehicles commonly used with variable products, such as registered mutual funds. It means that, for purposes of diversification testing under Section 817(h), look-through is required only to hedge funds that are dedicated solely to variable products in the same way as is common with traditional variable products. Under the long-standing investor control doctrine, variable products using mutual funds as the investment medium have had to utilize only insurance dedicated mutual funds that the general public cannot purchase other than through the insurance products.

The change will alleviate confusion between looking-through to publicly available hedge funds for purposes of diversification testing and the investor control doctrines prohibition on investing directly in publicly available funds.

The amendments also clarify another issue. This regards using hedge funds with variable products that use a "fund of funds" method of investing. Under some of these products, the insurers separate account purchases shares in publicly available (not insurance dedicated) mutual funds as the investments of the separate account. These investments are much like those of any security purchased on the open market for an insurers variable product separate accounts. These "managed separate accounts" test the diversification directly at the separate account level. They do not look-through to the underlying mutual funds for compliance with Section 817(h) diversification requirements.

Under Treasury regulations prior to the new amendments, using publicly available hedge funds required a look-through, even though the insurers separate account was adequately diversified, and the underlying hedge fund had to have its portfolio diversified in accordance with Section 817(h) requirements. The amendments clarify that such a "double look-through" is no longer allowed.

Bottom line: Under these amendments to the Treasury regulations, it is still possible to use non-registered hedge funds to fund variable products. (At least, this is the case insofar as federal income taxes are concerned; additional concerns may exist with respect to using hedge funds for retail, registered variable products.) Using hedge funds merely requires that such funds conform to the same rules as would apply to the use of mutual funds with such products.

Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are attorneys in the Pompano Beach, Fla., office of Blazzard, Grodd & Hasenauer, P.C. Their e-mail is: [email protected].

Reproduced from National Underwriter Edition, April 1, 2005. Copyright 2005 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.