Reinsurance: Considerations for Hedge Fund Managers evaluating forming reinsurance vehicles in the Cayman Islands
By Tim Frawley and Karey B. Dearden, Maples and Calder; Ernst & Young
From the Hedge Fund Law Report Volume 7, Number 33
There has been much talk recently about the formation of reinsurance companies by hedge fund managers. Indeed, in the Cayman Islands (Cayman), there has been significant increase of interest in the establishment of reinsurance vehicles. The first open market reinsurance vehicle with a physical presence was established in Cayman in 2004, and now, several
years later, conditions are such that others are following suit. Anecdotal evidence shows that many service providers across the financial services community in Cayman have been advising or otherwise speaking with fund manager clients about setting up reinsurers in Cayman. This article highlights some key reasons driving interest in Cayman as a domicile for the establishment of reinsurance vehicles. For background on the opportunities and risks associated with hedge fund managers establishing reinsurance vehicles, see “How Can Hedge Fund Managers Use Reinsurance Businesses to Raise and Retain Assets and Achieve Uncorrelated Returns? (Part Two of Two),” The Hedge Fund Law Report, Vol. 6, No. 3 (Jan. 17, 2013)
Regulation
The Cayman Islands government is committed to the continuing development of the Cayman insurance and reinsurance industry. In that respect, legislation
streamlining the licensing of reinsurance vehicles was enacted in 2010. This legislation provides a clear regulatory framework for the general licensing of insurance vehicles, including dedicated licenses for reinsurers (class D licenses), captive insurers (class B licenses) and special purpose insurers (class C licenses). Capital and solvency regulations were also passed into law pursuant to the principal statute in order to provide greater transparency in regulatory standards. While those regulations prescribe capital and solvency margins, there are no statutory restrictions on investment strategy for licensed reinsurers.
Security of Tenure
Some reinsurers have sought to build out their busi- nesses by establishing physical presences in their jurisdictions of domicile. However, encouraging sen- ior executives and management to relocate can be a challenge if there are concerns about security of tenure under local residency rules. In 2012, the Cayman Islands government recognised the increased interest in Cay- man as a reinsurance domicile by designating various key management roles in the industry as being eligible for the grant of ten-year work permits. This was introduced to overcome concerns about the “roll-over” requirement which applied to permit holders at the end of the seventh year unless they could be categorised as key employees. However, in 2013 further changes were introduced to the immigration laws to remove entirely.
As a separate initiative, the immigration law was also changed to introduce additional categories of residency such as:
- Residency Certificate (Substantial Business Presence).
A holder of this residency right may be allowed to work in the Cayman Islands. A person may apply under (a) business ownership; or (b) as an employee in a senior management capacity. To qualify for this by virtue of business ownership, the applicant must own, or propose to own, either directly or indirectly, a minimum of 10 percent of the shares in a specified business (which includes captive insurance or reinsurance management or reinsurance underwriting). To qualify for this type of residency certificate by virtue of holding a senior management capacity, the applicant must provide proof of employment in a senior management capacity in a specified business and submit a letter of employment with certain required information.
- Certificate of Direct Investment. This residency right allows a person to reside in the Cayman Islands
and work in a business in which he has invested. To qualify for this type of residency certificate,
the applicant must have (amongst other criteria): (a) made or will make a minimum investment of CI$1,000,000 (US$1,220,000) in a licensed business that generates employment within the Cayman Islands and in which the applicant will exercise substantial control; and (b) has substantial business experience or an entrepreneurial background including specific professional or technical knowledge pertinent to his business investment in the Cayman Islands.
- Certificate of Permanent Residency for Persons of Independent Means. This residency right affords the holder residency for life. The holder of this type of certificate may also apply to have the certificate varied to allow the holder the right to work for any employer in the Cayman Islands. Ordinarily, permission is restricted to a particular occupation. To qualify for this type ofresidency certificate, the applicant must (amongst other criteria) have invested a minimum sum of CI$1,600,000 (US$1,951,000) in developed real estate in the Cayman Islands. There is a quota of 250 such certificates in total that may be granted per annum.
In each case above, the applicant must show good health and adequate health insurance coverage and have a clean police record.
Taxation
Cayman Taxation
There are no forms of direct taxation in the Cayman Islands, and accordingly, a reinsurer is not subject to corporation tax or any other tax on earnings or capital gains in Cayman. In addition, there are no withholding taxes imposed in Cayman when distributions are made from a Cayman reinsurer to its shareholders.
U.S. Federal Income Taxation
A Cayman reinsurer not engaged in a U.S. trade or business and that does not have effectively connected income is generally not subject to direct taxation by the U.S. However, certain types of income (e.g., interest, dividends, royalties, etc.) received from U.S. sources may be subject to U.S. withholding taxes when such amounts are paid to a Cayman reinsurer that does not have effectively connected U.S. income. Exemptions from withholding may apply to specific types of interest income, such as portfolio interest, certain types of deposits with a bank or an insurance company and short-term original issue discount obligations. (A discussion regarding the Foreign Account Tax Compliance Act (FATCA) is provided later in this article.)
Taxation of U.S. Persons
A U.S. person that owns shares in a Cayman reinsurer is generally not subject to tax on the income of a Cayman reinsurer until the U.S. person receives a dividend or the U.S. person has a gain on the sale or redemption of its stock. These principles are generally not applicable if a Cayman reinsurer is a controlled foreign corporation (CFC) or a passive foreign investment company (PFIC). Controlled Foreign Corporation
A U.S. Shareholder that owns (directly or indirectly) stock of a foreign corporation classified as a CFC for an uninterrupted period of 30 days or more on the last day of a Cayman reinsurer’s taxable year must include its portion of a Cayman reinsurer’s income in its current year taxable income. A “U.S. Shareholder” is a U.S. person that owns (directly, indirectly, or constructively) 10 percent or more of the total combined voting power of all classes of stock of a Cayman reinsurer.
In general, a Cayman reinsurer (for this purpose, we are assuming a Cayman reinsurer is in the business of “insurance” for U.S. federal income tax purposes) is considered to be a CFC if a “U.S. Shareholder(s)” owns (directly, indirectly, or constructively) more than 25 percent of the vote or value of a Cayman reinsurer.
Passive Foreign Investment Company
A U.S. person that owns (directly or through attribution) stock in a PFIC can generally defer an inclusion until certain events occur (e.g., an excess distribution or a disposition). Gain recognised on disposition of PFIC stock is generally treated as an excess distribution. Under the excess distribution regime, distribution amounts applicable to the current year and pre-PFIC years are included into income; and taxes on prior year PFIC income and interest on such taxes are calculated to establish a deferred tax amount applicable to the excess distribution. Alternatively, a U.S. person can elect out of the excess distribution regime to include its portion of a PFIC’s annual ordinary and net capital gain income in its current year taxable income (Qualified Electing Fund or QEF). A mark-to-market election is also available, in certain situations, to elect out of the excess distribution regime.
A Cayman reinsurer could be considered a PFIC if: (1) 75 percent or more of its gross income is considered “passive income”; or (2) the average percentage of assets held by a Cayman reinsurer during the taxable year which produce passive income, or which are held for the production of passive income, is at least 50 percent. Certain look-through rules apply in determining if the foregoing tests apply.
At first blush, one may think all Cayman reinsurers are PFICs.
An exception to the definition of “passive income,” however, is provided. This exception provides that “passive income” does not include any income derived in the active conduct of an insurance business by a corporation which is predominately engaged in an insurance business and which would be subject to tax as an insurance company if such company were a U.S. domestic insurer. This exception is intended to ensure that income derived by a bona fide insurance company is not treated as passive income, except to the extent such income is attributable to financial reserves in excess of the reasonable needs of the insurance business.
A Cayman reinsurer’s business and activities are generally intended to meet the insurance exception to passive income; however, each set of facts must be reviewed and evaluated to determine if the insurance exception to passive income applies.
The share ownership of a Cayman reinsurer is generally held to avoid being within the scope of the CFC rules (e.g., by limiting the number of U.S. persons owning 10 percent or more of its voting shares). For these reasons, as noted above, a U.S.person owning shares in a Cayman reinsurer should not generally be subject to tax on the income of a Cayman reinsurer.
Excise Tax
If U.S. risks are insured or reinsured by a Cayman reinsurer, U.S. federal excise tax on insurance or reinsurance premiums may be applicable. The excise tax for U.S. property and casualty risks and the excise tax for direct U.S. life, sickness, or accident and health insurance or an annuity contract is one percent. The excise tax for reinsurance on the foregoing risks is one percent.
Domestic Election
A Cayman reinsurer meeting certain requirements could elect to be taxed as a U.S. domestic insurance corporation. This is known as the “Domestic Election.” If such an election were made, a Cayman reinsurer would be subject to the U.S. corporate level tax, and the excise tax on insurance premiums would not apply.
Relevant Changes Proposed By Former Chairman Baucus and Chairman Camp
Several relevant changes to the U.S. international tax rules discussed above were proposed by former Chairman Baucus. The release was described as a staff draft to solicit comments; and a press release said the proposal was not a final plan, but rather intended to spur discussion about these matters. We do not know if such changes will be enacted; however, knowing what considerations have been proposed is helpful for planning purposes. The portions of the release relevant to this discussion and a Cayman reinsurer include the following: the portfolio interest exception arising from interest income on corporate obligations is eliminated; a U.S. shareholder will also include a U.S. person that owns 10 percent or more of the total value of shares of all classes of stock of a foreign corporation; and the uninterrupted period of 30 days or more of being a CFC is eliminated for purposes of a U.S. shareholder including its portion of CFC income.
Several changes are proposed to the PFIC rules, including the definition of a PFIC, e.g., dropping the asset test and lowering the passive income test from 75 percent to 60 percent; eliminating the excess distribution regime; eliminating the election to include an annual amount into income; i.e., QEF; and adding a provision for holders of non-publicly-traded PFIC stock to include in income annually a deemed return on PFIC stock. The PFIC look-through rule and the PFIC mark-to- market election are also proposed to be modified.
The current insurance exception to the PFIC provisions, described above, is eliminated. The proposal, however, does provide an exception to investment income received from an unrelated person earned by a qualifying insurance company (QIC) provided the QIC meets certain criteria. In pertinent part, these criteria include that more than 50 percent of the QIC’s gross receipts are treated as earned by the QIC in its home country for purposes of the tax laws in the QIC’s home country; and the QIC’s insurance liabilities constitute more than 35 percent of the QIC’s total assets as reported on the QIC’s financial statements for the year with or within which the taxable year ends.
Premium income is not passive income for purposes of determining whether an entity is a PFIC. As such, a Cayman reinsurer that does not meet the 60 percent passive income test should not be a PFIC.
Chairman Camp’s proposal amends the current insurance exception to the PFIC provisions such that “passive income” does not include any income derived in the active conduct of an insurance business by a corporation if: (1) the corporation would be subject to tax as an insurance company if such corporation were a domestic corporation; (2) more than 50 percent of such corporation’s gross receipts for the taxable year consist of insurance premiums; and (3) the applicable insurance liabilities of such corporation constitute more than 35 percent of its total assetsas reported on the corporation’s applicable financial statements for the year with which or in which the taxable year ends.
The Baucus and the Camp drafts also propose to eliminate the deduction for reinsurance premiums paid to affiliated foreign corporations by U.S. insurance companies. These proposals would allow the deduction for reinsurance premiums if the foreign reinsurer elects to treat the premium income as effectively connected income. This proposal does not apply to a Cayman reinsurer with unrelated insureds, but the proposal should be considered if an affiliation exists between the U.S. reinsurer and the Cayman reinsurer.
Other Jurisdictions
The tax rules of other jurisdictions may also apply to owners of a Cayman reinsurer. This article provides an overview of the Cayman rules and the U.S. principles
in this article, given the close proximity of the U.S. to Cayman and the number of registered hedge funds and private equity funds domiciled in Cayman that have U.S. investors.
International Standards
The Cayman Islands is consistently ranked as a leader for its compliance regime and regulatory protocols, offering compliance with the FATF Global Standards, as well as an established and strong record of transparency and cooperation with international regulators, such as the OECD and the International Monetary Fund (IMF). When the IMF conducted a review of insurance regulatory standards in Cayman in 2005, it found that of the 17 International IAIS core principles, 11 were observed or largely observed. For the other six principles, they were found to be materially non-observed as a result of lack of staff or lack of documentation of existing rules or practices. Against that, the IMF also noted, “the shortage of resources for insurance supervisory functions is almost universal, and CIMA is certainly not unique in this respect.”
Unlike other jurisdictions, Cayman has not chosen to pursue regulatory equivalence with Europe’s Solvency II Directive (Solvency II). This has proven to be of particular interest to North American-focused fund managers who are not pursuing insurance strategies that other- wise require a Solvency II framework. For example, in the annuities business, economic viability and success face more significant challenges when working with Solvency II capital models. Consequently, for investment managers who see opportunities to raise permanent capital through managing reinsurance company assets, Cayman will give them greater flexibility on investment strategy and objectives than Solvency II compliant juris- dictions.
Conclusion
In recent years, at least four companies have obtained reinsurance licenses in Cayman. Initial reports sug- gest that a number of other applications are currently being worked on by various market participants, some with plans for initial public offerings in due course. An insurance/reinsurance sub-committee of Cayman Finance has also been formed to ensure that efforts are coordinated within the financial services community. In the current “hunt for yield” market environment, the expectation is that fund managers will continue exploring these structures in Cayman.
Tim Frawley is a partner in the Cayman Islands office of Maples and Calder. Tim has extensive experience in the use of off- shore finance vehicles. While most of his practice is focused on funds (principally alternative investment funds, but also structured products, such as CLOs), his practice also includes general corporate work as well as insurance and other alter- native risk transfer work, such as captives, insurance linked securities and fund sponsored reinsurance vehicles.
Karey B. Dearden is an Executive Director in Ernst & Young LLP’s Financial Services Office, International Tax Services prac- tice in New York City where he primarily focuses on insurance related matters, including captives. His practice includes domestic insurance companies with an international footprint, foreign insurance companies with activities in the United States, foreign insurers and reinsurers with international op- erations, and companies who have a domestic and/or foreign captive insurance company. The views expressed herein are those of the authors and do not reflect those of Ernst & Young LLP or Maples and Calder.
IMAGE: www.canstockphoto.com
