For captives being given that deduction “is a tremendous benefit, compared to self-insurance, where losses are only deductible when paid,” he said. “The same amount will ultimately be deducted, but an insurance company [or captive] may deduct the loss several years earlier than a self-insurer.”

He said the proposed regulations apply to situations where the captive is included in the same consolidated income tax return with its insureds, its parent and/or the parent's operating subsidiaries.

Under the proposed regulations, he said, the related-party insurance would be treated as self-insurance, meaning that losses on related-party business are deducted when paid and the captive can still deduct a reserve for estimated losses on unrelated business. He noted that the IRS had taken a similar position on related-party insurance in 1977 and litigated for more than 20 years to defend that position.

“The IRS lost enough cases so that in 2001 it officially conceded that captive insurance was effective for tax purposes if done correctly,” Mr. Lavelle said, adding that in 2002 the IRS issued some safe harbors as guidelines on structuring captive insurers.

The proposed regulations, however, would overturn litigated court cases and reverse some IRS guidance on the proper structure of captives, he said.

In reaction, Scott H. Richardson, director of insurance for South Carolina, sent a letter dated Oct. 4 to Sen. Jim DeMint, R-S.C., stating that the proposed regulation would “have a detrimental effect on the U.S. commercial insurance market in general and particularly South Carolina's captive insurance community.”

According to Mr. Richardson's letter, the IRS' proposed regulations and rules would “create additional economic burdens on the commercial markets, driving many of these captive companies to offshore domiciles, out of business, or into economically unviable contracts.”

Dennis P. Harwick, president of the Captive Insurance Companies Associations, said in an interview, “It is obvious that this proposed regulation would have far-ranging impacts on U.S.-based captives and non-U.S. captives, which have elected to be taxed as U.S. corporations.

“CICA will move aggressively to coordinate an industrywide response to these proposed regulations and educate the IRS about the ramifications and unintended consequences of such a change.”

Mr. Harwick continued that CICA, in cooperation with the Vermont Captive Insurance Association, “is utilizing a blue ribbon task force chaired by Tom Jones of McDermott Will & Emery to review these proposed regulations and develop recommendations to the CICA board for an industry response.”

He added that the task force is “giving this matter its immediate attention.”

Robert H. “Skip” Myers, general counsel for the National Risk Retention Association, said if implemented the rule would undermine single-parent captives of large corporations.

He said the change would mean that “the vast majority of single-parent captives for large corporations will have to change their insurance program,” he said. “It's a huge problem for many of the big companies in the U.S. that have captive insurance programs.”

He called it “big news” that there was no forewarning the regulation would be issued. “This conflicts with recent positions of the IRS.” The ruling would not affect RRGs, he noted.