A trip to the doctor is always a gamble. But for hedge fund Millennium Partners, a standard physical exam was the key to placing huge bets on insurance-company stock portfolios.

Millennium, the $3.2 billion fund run by Wall Street impresario Israel Englander, regularly asked its workers to submit to insurance company physicals they didn't need, so that they would become eligible for variable annuity life insurance policies.

According to former employees, Millennium's traders would then pile into the insurance contracts, exploiting their mutual fund-like characteristics in a strategy of rapid-fire trades known as market timing. The technique is a legal cousin to late-trading, the forbidden stale-price arbitrage that led a Millennium trader into the arms of prosecutors last fall.

The doctor's visits were crucial to the smooth running of Millennium's market-timing operation, one employee said, allowing the fund to set up multiple accounts with an insurer and reduce the possibility of detection by the companies that sold annuities. Indeed, it is the companies that sold the policies -- not the hedge funds that traded them -- that have earned the most scorn from securities cops.

For their troubles, the ersatz patients got a bonus: dinner at a nice restaurant, according to one former employee. Some got to go to the Ryland Inn, which Zagat's once called the best restaurant in New Jersey.

"They would send someone out there and set up an annuity account, and get part of a life insurance policy," the former employee said. "It was operations people, not traders. They'd say to them, 'Go get a physical, sign the paperwork, and we'll buy you dinner.' "

Tom Daly, a Millennium spokesman, declined to comment for this story.

News of the unusual Millennium strategy comes as both state and federal prosecutors step up their inquiry into hedge funds' role in the trading scandal in the $7 trillion mutual fund industry. Authorities have recently indicated the probe's focus is turning to variable annuities, the tax-advantaged contracts that behave almost exactly like mutual funds for the vast majority of investors.

In October, former Millennium trader Steven Markovitz pleaded guilty to making illegal late trades in shares of mutual funds. TheStreet.com previously reported that Millennium in December told its investors that it was setting aside up to 10% of their assets to cover the cost of a possible settlement with regulators and New York Attorney General Eliot Spitzer.

Markovitz, a former top trader at Millennium who made in excess of $40 million over a two-year-stretch, led the small group of traders that used the employee accounts to market time variable annuities, several former Millennium employees said.

As crazy as this scheme might sound, Millennium wasn't the only hedge fund to buy variable insurance policies on its employees.

A source close to the investigation into abusive trading in the mutual fund and insurance industries said other hedge funds, including Canary Capital Partners and Samaritan Asset Management, employed a similar technique. Like Millennium, Canary and Samaritan have emerged as key players in the trading investigation. It was Spitzer's $40 million settlement with Canary and Edward Stern, Canary's managing partner, which launched the far-reaching trading investigation last fall.

According to a person close to the investigation, it was common for the employees to assign the policies' economic interest to the hedge funds, providing them with another source of cash flow if the employee died. No source indicated such a benefit was ever collected.

James Nesfield, a former consultant to Canary, said using hedge fund employees to set up variable annuity accounts was no secret in the shadowy world of market timers and late traders.

"They did it just to get front accounts," said Nesfield, who has been a source of information to investigators. "Everything was carried to the Nth degree."

At this point, sources said state and federal regulators don't think there is anything illegal in the hedge funds taking out insurance policies on their employees as a way to gain trading access. The regulators view it as an example of the absurd lengths to which hedge funds would go to gain a trading edge.

Regulators take a dimmer view, however, of the insurance companies that sold these policies to employees of Millennium and other hedge funds. A source said regulators believe the insurers knew perfectly well the intentions of hedge funds like Millennium.

In the coming weeks, regulators are likely to bring enforcement actions against insurers for allowing hedge funds to market time variable annuities, a person close to the investigation said. The cases will be similar to the more than one dozen actions regulators have filed against mutual fund companies over improper trading.

In January, Conseco ( CNO) said regulators have notified it that they intend to file civil charges against the firm for permitting hedge funds and other investors to market-timer variable annuities. Other major players in the variable annuity market that have received subpoenas from regulators include Hartford ( HIG), John Hancock ( JHF), Keyport Life Insurance, Nationwide Financial Services, and Lincoln National.

In most respects, market timing of variable annuities is no different from market timing of mutual funds. This fast-paced trading, in which investors try to take advantage of pricing inefficiencies, is legal. But many mutual fund companies and insurers tell their shareholders they try to deter market timers because the fast-paced trading created needless administrative costs that eroded the value of the fund.

Regulators have found that too many mutual funds and insurers violated that promise and willingly opened their doors to market timers, especially ones who were willing to park assets in other funds they were managing.

Market timers also used a vast array of dummy partnerships and false accounts to hide their identities, law enforcement sources said.

In the case of Millennium, two former employees said the hedge fund had dozens of "bogus" partnerships that were nothing more than shell companies that permitted the hedge fund to open hundreds of trading accounts. Some of the partnerships had names like Stonecastle, Castlemark, Gilmore & Gillespie and Wyatt & Atwood. It's believed some of the partnerships were named after employees at Millennium.

"You'd go over to Prudential and set up an annuity account, and it would get flagged" after too many trades, said a former Millennium employee. "So you'd go over and set up some partnerships with a funny name, like Jack Jones L.P., and you could trade with that, until they said, 'Aha -- it's another group that's trading too much.' "

Prudential Financial ( PRU), which has reported receiving "formal requests" from regulators about the sale of variable annuities, said mechanisms were in place to prevent the abuse.

"The regulators are looking and we are really limited in what we can say," said Laurita Warner, a spokeswoman for Prudential's annuity division. "Prudential is cooperating with regulatory inquiries and we have been conducting our own internal review into our annuity business. While our review is incomplete, the information reviewed to date leads us to believe the policies and procedures we have in place to detect and prevent disruptive market timing in Prudential annuities products have been largely effective."

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