With no prior hint of its plans, the IRS published its proposals in the Federal Register on Sept. 28. Its notice said that, since issuing the regulations that are currently in place, the agency determined it would "no longer invoke the 'economic family theory' in addressing whether captive insurance transactions constituted insurance for federal income tax purposes."

Self-insureds, unlike insurers, are currently unable to deduct a discounted reserve for estimated losses and expenses, whether or not claims have been filed, explained Charles J. Lavelle, a member of the Tax and Finance Practice Group with Greenebaum Doll & McDonald PLLC in Louisville, Ky.

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--although the captive could still deduct a reserve for estimated losses on unrelated business. He noted that the IRS had taken a similar stance 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 captives.

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

"Captive insurance companies pay taxes just like commercial insurance companies, but this proposed regulation would suddenly penalize legitimate, fully regulated captive insurance companies," said CICA President Dennis Harwick.

"A change in the IRS rules of this magnitude creates uncertainty in the federal regulatory environment," added VCIA President Molly Lambert. "Businesses may continue to use the captive insurance tool, but the U.S. industry would be significantly affected if this proposed regulation were implemented."

In reaction, Scott H. Richardson, director of insurance for South Carolina, sent a letter on Oct. 4 to Sen. Jim DeMint, R-S.C., stating that the proposed regulation 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."

Robert H. "Skip" Myers, general counsel for the National Risk Retention Association, said if implemented the rule would mean "the vast majority of single-parent captives for large corporations will have to change their insurance programs," calling this "a huge problem." However, he noted, the ruling would not affect RRGs.

VCIA and CICA officials hired the firms of McDermott Will & Emery LLP, Dewey & LeBoeuf LLP, and McIntyre Law Firm, PLLC to develop a coordinated response to the proposed regulation.

The U.S. captive insurance market includes some 1,200 companies in 26 states throughout the country, according to the groups, which contend that implementation of the proposed IRS regulation would change this environment dramatically.

The coalition said its work will begin immediately, and those interested in supporting its efforts can contact VCIA or CICA.