Last year, about $450 million belonging to top executives at billionaire hedge fund manager John Paulson’s New York firm made a quick round trip to Bermuda. In April the executives sent the money to a reinsurance company called PaCRe they’d set up on the island. By June, PaCRe had sent all the cash back to New York, to be invested in Paulson & Co. funds. By recycling the funds through Bermuda, which doesn’t levy a corporate income tax, the Paulson executives are positioned to exploit a little-known loophole, reducing their personal income taxes and delaying paying the bill for years.
At a time when the Obama administration and congressional leaders are calling for a corporate tax overhaul that would eliminate some loopholes, the tax dodge of using reinsurers—which provide coverage for other insurers rather than the general public—is gaining popularity among hedge funds. Steve Cohen of SAC Capital Advisors and Dan Loeb of Third Point have started Bermuda reinsurance ventures in the past two years. Other top money managers, including some in London, are hiring advisers to explore setting up reinsurance companies there, according to Timothy Faries, an insurance lawyer at Appleby, one of the island’s largest law firms. David Miller, a tax lawyer at Cadwalader, Wickersham & Taft, says the law should be changed. “These types of reinsurance companies are permitting U.S. taxpayers to defer—indefinitely—U.S. tax,” he says.
Ordinarily, hedge fund investors pay either the 39.6 percent rate for ordinary income on their profits or the 20 percent long-term capital gains rate, depending on how frequently securities are traded, plus an extra 3.8 percent surcharge stemming from the Affordable Care Act. If they put money into a Bermuda-based reinsurer and have it invested in the hedge funds, any profits go to the reinsurer, which doesn’t owe tax on them. That allows the investors to defer taxes until they sell their stake in the reinsurer. Meanwhile, the money grows tax-free and the savings add up. Investing $100 million in a hedge fund that returns 10 percent annually for five years and paying the top marginal ordinary income rate on profits results in an after-tax gain of $50 million. If a Bermuda reinsurer holds the same investment, the gain is $77 million.
Simply basing a hedge fund in Bermuda or another tax haven would not provide the same advantage, because the fund would incur IRS penalties on what the agency calls “passive foreign investment companies.” The IRS doesn’t penalize earnings from insurance companies, which it considers “active” businesses. To qualify as active and avoid the penalty, firms can’t have a pool of capital far greater than what they need to back the insurance they sell, according to the IRS. The agency has never specified how much is too much. “The $64,000 question is, how big a reserve can you have?” says Robert Cudd, a tax lawyer at Morrison & Foerster in San Francisco. “There’s no easy answer to that.”
The first prominent hedge fund to set up a large Bermuda reinsurer was Louis Moore Bacon’s New York-based Moore Capital Management, in 1999. In a 2003 report, the IRS said some offshore reinsurance arrangements were shams, either because they weren’t selling enough insurance or because the insurance they reported selling was phony. The IRS “will challenge the claimed tax treatment,” government lawyers wrote. But the agency has rarely if ever done so. Tax lawyers and insurance executives interviewed by Bloomberg said they were unaware of any company that’s been targeted by the IRS. “Nobody’s been challenged” on the arrangement, says Faries, the Bermuda lawyer. “So nobody knows whether it’s ironclad or not.” The IRS didn’t return calls and e-mails seeking comment.
The companies set up by Paulson, Cohen, and Loeb are all located within a half-mile of each other in the narrow streets of Hamilton, Bermuda’s capital and the global center of the reinsurance industry. The three put a combined $1.7 billion back into the fund managers’ hands last year. Paulson and other principals at his hedge fund declined to say whether they plan to get a tax benefit from PaCRe. “That’s never been a portion of the business we’ve ever commented on,” says Armel Leslie, a Paulson spokesman. Third Point Re said in a statement last year that it chose to locate in Bermuda because of the country’s good regulations, service providers, and talented reinsurance workforce. It hired John Berger, a career insurance executive, as chief executive officer. As for the tax advantage, Berger says, “Anybody in Bermuda has a tax advantage.” A spokesman for SAC declined to comment.
Paulson’s reinsurance company has no employees, and its listed legal address is actually the office of another reinsurer to whom it outsources its underwriting, which is extremely limited even compared with the other two firms. PaCRe sold about $8 million of reinsurance coverage from April to December, according to a Jan. 31 disclosure by PaCRe’s underwriting contractor. When it was established in April, PaCRe’s startup capital included $450 million from the principals of Paulson’s hedge fund, according to A.M. Best, which rates insurers. Although A.M. Best didn’t name the principals, Paulson himself owns about 53 percent of his firm’s assets under management, according to data compiled by Bloomberg, and at least 75 percent of the firm itself. The other $50 million for PaCRe came from an established Bermuda reinsurer, Validus Holdings. PaCRe invested the entire $500 million in startup capital in four Paulson & Co. hedge funds. Through December, those investments have lost about $19 million in value, driven by a 19 percent decline in a fund that bet the price of gold would rise. Because the funds lost money, investors wouldn’t have owed income taxes anyway.