The two largest U.S. captive insurer associations are bandingtogether to combat a proposed change in Internal Revenue Serviceregulations they warn could drive many such facilities out ofbusiness.

The Captive Insurance Companies Association and the VermontCaptive Insurance Association have formed the Coalition forFairness to Captive Insurers. Its mission is to develop acoordinated response to an IRS rule that would "significantly alterthe landscape for captive insurers should it become final," thecoalition said.

The organizations said in a statement that convincing the IRS towithdraw its proposal is "critical" to their "missions of promotingthe strength of the captive insurance industry and the members thatthey serve."

The IRS proposal, which caught the captive industry by surprise,would reverse a longstanding tax treatment of captive insurers andput them on the same footing as self-insureds.

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

Self-insureds, unlike insurers, are currently unable to deduct adiscounted reserve for estimated losses and expenses, whether ornot claims have been filed, explained Charles J. Lavelle, a memberof the Tax and Finance Practice Group with Greenebaum Doll &McDonald PLLC in Louisville, Ky.

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--although thecaptive could still deduct a reserve for estimated losses onunrelated business. He noted that the IRS had taken a similarstance on related-party insurance in 1977 and litigated for morethan 20 years 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 captives.

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

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

"A change in the IRS rules of this magnitude creates uncertaintyin the federal regulatory environment," added VCIA President MollyLambert. "Businesses may continue to use the captive insurancetool, but the U.S. industry would be significantly affected if thisproposed regulation were implemented."

In reaction, Scott H. Richardson, director of insurance forSouth Carolina, sent a letter on Oct. 4 to Sen. Jim DeMint, R-S.C.,stating that the proposed regulation would "create additionaleconomic burdens on the commercial markets, driving many of thesecaptive companies to offshore domiciles, out of business, or intoeconomically unviable contracts."

Robert H. "Skip" Myers, general counsel for the National RiskRetention Association, said if implemented the rule would mean "thevast majority of single-parent captives for large corporations willhave to change their insurance programs," calling this "a hugeproblem." 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 todevelop a coordinated response to the proposed regulation.

The U.S. captive insurance market includes some 1,200 companiesin 26 states throughout the country, according to the groups, whichcontend that implementation of the proposed IRS regulation wouldchange this environment dramatically.

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