A Financial Times survey of hedge funds has focused on Max Re as a “tax-efficient” investment vehicle, but pointed to worries that the US may clamp down on a “tax loophole” that allows these entities to exist.

The article, called “Rise of the hedge fund haven” by Paul Taylor, said that if the US clamps down then the attraction of hedge funds setting up as insurance operations in Bermuda would disappear.

The article said: “The US Congress has clamped down on hedge fund tax schemes before. In 1999 Congress closed a tax shelter popular with hedge funds that involved using swaps and derivatives to buy into funds, but many believe the greater risk to the hedge fund reinsurance companies is the possibility that the tax authorities will more precisely define insurance companies under the Passive Foreign Investment Companies rules.

“If that were to happen the attraction to hedge funds of setting up Bermuda-based insurance operations would probably evaporate.”

The publication stated that the convergence of insurance and hedge funds in Bermuda has begun to attract attention, not least because of the decision of one of these insurers, Max Re Capital, to go public in August last year.

It said that Max Re was both an insurance company and a hedge fund investment vehicle and one of a growing number of Bermuda-based companies which acted as a vehicle for hedge fund investments and “a way to recycle hedge fund investors' highly taxed ordinary income into lowly taxed capital gains”.

It said that other hedge funds that have also set up offshore insurance vehicles include Mariner Investments and Tremont Advisers.

It states that : “Because they operate offshore, these companies are not limited by US regulations and can put more into hedge funds than US-based insurers - a strategy that should in theory boost investment returns, although Max Re's first quarter results, reported earlier this month, were somewhat disappointing.”

But it said that despite this, Max Re was “undoubtedly a pioneer”. The company was originally set up by a group of investors led by the brothers Louis and Zak Bacon, the principals of the global macro hedge fund, Moore Capital. Moore Capital makes up about 11 per cent of Max Re's investment portfolio.

It cites other investors included Capital Z, the alternative investment firm affiliated to the Zurich Group, Citigroup, Bank of America, and Western General Insurance, which is indirectly owned by Chicago's Pritzker family, the owners of Hyatt Hotels.

“Max Re's structure was designed from the outset to provide a tax-efficient investment vehicle for investors in Moore Capital. When US taxpayers invest directly in hedge funds, they must pay annual taxes on realised profits, typically at the highest ordinary income tax rate,” it said. “But thanks to the special tax treatment afforded insurers, Max Re enables US hedge fund investors to reinvest those gains in the offshore insurer before paying taxes. When Max Re's shares are paid inside the US, investors have to book their gains but they are taxed at the lower capital gains rate.”

It said that effectively high-net-worth investors get the double tax advantage of investing in a Bermuda insurance company while reducing the tax that would otherwise be paid on their hedge fund returns.

“Meanwhile, institutional investors that might be prohibited from investing directly in hedge funds can do so through an insurance company. Investors also benefit from the leverage inherent in an insurance company's balance sheet,” the article states.

It adds that under US securities laws, insurers are exempt from registering as investment companies, which means they do not have to make an annual distribution of profits, unlike, say, a mutual fund, and they are not taxed as investment vehicles under the Internal Revenue Service code. And it quotes an article in Institutional Investor magazine published last year, which states that as many as 30 hedge funds, fund-of-funds or commodities trading pools have attempted to launch Bermuda reinsurers in the past couple of years.

“Although many have failed to materialise because of the complex tax regimes and regulations involved, a number of major hedge funds and banks have quietly entered the business,” the article adds.

But it says that a number of questions and uncertainties hang over the business model and cited several Bermuda-based reinsurers including Stockton Re who have reportedly suffered insurance-related losses in recent years. As well as this, Max Re's initial public offering and subsequent share price performance has been somewhat disappointing, it added.

It added: “Other investors expressed concerns that the US government might decide to close the tax loophole that allows these companies to exist.

“While hedge fund managers are reluctant to draw attention to the tax avoidance benefits of using Bermuda-based insurers, pressure for US-based insurers for more equitable treatment of their Bermuda-based counterparts could close what they see as a loophole.”