News Analysis date published New: 
Tuesday, May 7, 2013 - 11:30
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Tuesday, May 7, 2013 - 11:30
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Tuesday, May 7, 2013 - 11:30

A Billionaires' Tax Shield You Can Use

Tuesday, May 7, 2013 - 11:30am

Billionaires such as hedge fund manager John Paulson have found a neat way to slip the tax man. It's also one you can take advantage of. Paulson, you may remember, made a fortune betting against subprime mortgages in 2007. Last year, he took $450 million to Bermuda.

Paulson's idea was to start a reinsurance company. (A reinsurer sells insurance to other insurers.) But the beauty is how you can use it to shelter profits.

Current tax laws allow the reinsurer to shelter profits and defer taxes for years, perhaps indefinitely. But it has a special appeal for hedge fund managers. A hedge fund manager can enfold his or her fund in a reinsurance wrapper and get the same tax shield. Here's how they make it work:

Step 1: Put a lot of money in the reinsurer to start.

Step 2: Risk only a small part of that capital base writing reinsurance and earning premiums. The hedge fund manages the capital.

For example, Paulson's reinsurance firm, Pacre, won't risk more than about one-third of its capital base. He's not the only billionaire doing this.

Dan Loeb's Third Point and Steven Cohen's SAC also started reinsurance companies in Bermuda. There are others...

The Grandaddy Of Reinsurance
The granddaddy of this movement was David Einhorn, one of the best investors working today. He buys stocks, and he also shorts them. The market has great respect, even fear, for his abilities. The mere whisper that he is short a stock can send it tumbling 15% in a day.

Now you have an easy in to invest alongside him. He started Greenlight Re (Nasdaq: GLRE) and put all of its assets under Greenlight Capital, the hedge fund. He opened it in the Cayman Islands.

This allows you enjoy the same tax advantages the billionaires crave. You just buy Greenlight Re -- which pays virtually no taxes. In some ways, your investment is better off there than in the Greenlight hedge fund itself, which is fully taxed.

Fifty years ago, the Cayman Islands were just malarial swamps. Today they're the world's fifth-largest financial center, housing 9,400 hedge funds.

The Caymans are one of a handful of "flags of convenience" for financial companies looking to lower their tax bill. (See also Bermuda, Ireland, Guernsey and Panama.) With a tax rate of just 10%, Ireland is a favorite nesting spot for European asset managers. Guernsey, in the English Channel, is London's closest and most widely used offshore center. Panama, in addition to low (or no) taxes, has few reporting requirements. It's fast becoming a favorite place to shelter assets.

I doubt the pressures to close such "loopholes" will ever take hold. The financial world breathes through holes like these -- too many wealthy and powerful people depend on the tax-free oxygen they provide.

Of course, you still have to make money. As Bloomberg reports, Paulson's investors lost about $19 million last year. They wouldn't have paid any taxes anyway.

Why Greenlight Re Is A Good Way To Try This Out
Chairman Einhorn owns 17% of the stock. He's what I call an owner-operator. What trips up the online sites is that David Einhorn owns his stake through "B shares." These come with super voting rights. He owns 6.2 million shares. There are 36 million shares of A and B shares altogether.

Einhorn manages the float of Greenlight Re in his hedge fund. (Float is the premiums that GLRE collects on insurance policies, which it invests.) Unlike other insurers who invest their float in bonds, Greenlight is in stocks -- long and short.

So you get Greenlight's hedge fund plus an insurer. Check out the growth of the portfolio, GLRE's book value per share (BVPS) and the market (the S&P 500).

The average gain for the portfolio was 10% over this time, but for GLRE's book value, the average gain was 12%. Both trounce the S&P's 6%.

GLRE invests policyholders' money along with its own. But the gains it makes investing accrue only to GLRE. It doesn't share them with policyholders. It just has to make good on insurance claims. Sound familiar? This is how Warren Buffett did it with Berkshire Hathaway.

This is one of those stocks where if it goes lower, you buy more as long as the book value is there to support you. And we're in one of those moments. Rebounds are wonderful things. Thank the market for giving us a chance to own it at such a good price.

Greenlight Re is a great way to piggyback on the investing genius of David Einhorn and benefit from the tax shield of billionaires: a Cayman Islands reinsurance company.

P.S. -- Not only is Chris Mayer on the track of billionaires, he also likes to find the safest ways to earn 42% year after year. Readers of his Capital & Crisis newsletter have enjoyed just that return over the past two years. For a complete look into Capital & Crisis' recommendation list, click here.

Chris Mayer does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.