A proposed regulation by the Internal Revenue Service that wouldreverse a longstanding tax benefit for captive insurance operationsand put them on the same footing as self-insureds has caught thecaptive industry by surprise.

The move sparked a letter of protest from a state regulator anda captive trade group said it would mobilize to fight theproposal.

The IRS published its proposals in the Federal Register on Sept.28 with no advance notice. Its notice said that, since issuing theregulations that are currently in place, the agency determined itwould “no longer invoke the 'economic family theory' in addressingwhether captive insurance transactions constituted insurance forfederal income tax purposes.”

Charles J. Lavelle, member, Tax and Finance Practice Group withGreenebaum Doll & McDonald PLLC in Louisville, Ky., explainedthat self-insureds, unlike insurers, are currently unable to deducta discounted reserve for estimated losses and expenses, whether ornot claims have been filed.

For captives being given that deduction “is a tremendousbenefit, compared to self-insurance, where losses are onlydeductible when paid,” he said. “The same amount will ultimately bededucted, but an insurance company [or captive] may deduct the lossseveral years earlier than a self-insurer.”

He said the proposed regulations apply to situations where thecaptive is included in the same consolidated income tax return withits insureds, its parent and/or the parent's operatingsubsidiaries.

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

“The IRS lost enough cases so that in 2001 it officiallyconceded that captive insurance was effective for tax purposes ifdone correctly,” Mr. Lavelle said, adding that in 2002 the IRSissued some safe harbors as guidelines on structuring captiveinsurers.

The proposed regulations, however, would overturn litigatedcourt cases and reverse some IRS guidance on the proper structureof captives, he said.

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

According to Mr. Richardson's letter, the IRS' proposedregulations and rules would “create additional economic burdens onthe commercial markets, driving many of these captive companies tooffshore domiciles, out of business, or into economically unviablecontracts.”

Dennis P. Harwick, president of the Captive Insurance CompaniesAssociations, said in an interview, “It is obvious that thisproposed regulation would have far-ranging impacts on U.S.-basedcaptives and non-U.S. captives, which have elected to be taxed asU.S. corporations.

“CICA will move aggressively to coordinate an industrywideresponse to these proposed regulations and educate the IRS aboutthe ramifications and unintended consequences of such achange.”

Mr. Harwick continued that CICA, in cooperation with the VermontCaptive Insurance Association, “is utilizing a blue ribbon taskforce chaired by Tom Jones of McDermott Will & Emery to reviewthese proposed regulations and develop recommendations to the CICAboard for an industry response.”

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

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

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

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