A key senator requested feedback last week on proposed legislation that would close a loophole providing a tax advantage to some offshore insurers, setting the stage for a showdown in Congress next year between offshore insurers and their U.S. rivals.

The discussion draft was released by Sen. Max Baucus, D-Mont., chair of the Finance Committee.

The tax advantage exists because current tax law allows the U.S.-based affiliates of offshore insurers to cede a large share of their property-casualty premiums to the reinsurance units of their parents, which are based in low-tax or no-tax jurisdictions, such as Bermuda. The U.S. subsidiary deducts the premium and the foreign parent company does not pay U.S. or local tax on the premium, while earning investment income subject to low- or no taxes.

This occurs because related-party reinsurance does not result in a transfer of risk outside the global group. “Thus, it is an efficient way of significantly reducing U.S. tax without transferring risk,” the discussion draft released by Sen. Baucus said.

The Coalition For A Domestic Insurance Industry, led by officials of the W.R. Berkley Company, issued a statement after Sen. Baucus released his draft noting that growth in related-party reinsurance written to foreign affiliates has been dramatic.

The coalition said that in 2007, $58.4 billion of U.S. premiums went to foreign insurers–with nearly 60 percent ($33.8 billion) going to affiliated foreign reinsurers. Since 1996, U.S. premiums going to affiliated foreign reinsurers have increased at a compound annual growth rate of 21.4 percent, the group argued.

“Today, the U.S. taxpayer, facing unprecedented burdens, also subsidizes the profits of foreign-controlled insurers,” the group added. “U.S.-based insurance groups pay their fair share of U.S. income tax. The Coalition believes foreign competitors should do the same.”

The issue was a subject before the Senate Finance Committee earlier this year Closing the loophole has also been a longtime goal of Rep. Richard Neal, D-Mass., a ranking member of the House Ways and Means Committee and chair of its Subcommittee on Select Revenue Measures. He has introduced legislation in numerous sessions of Congress to close the loophole.

The proposal by Sen. Baucus contains “similarities” to H.R. 6969, a bill he introduced in the House in September, the Coalition said.

Anticipating the move by Sen. Baucus, foreign insurers that are members of a group called the Coalition for Competitive Insurance Rates wrote a letter to the Senate Finance Committee and the House Ways and Means Committee in November expressing its concerns.

“We urge you to be wary of proposed revenue-raising amendments that promise the U.S. government more tax revenue but will ultimately have the effect of increasing insurance prices for U.S. policyholders,” the group said, warning that the Baucus and Neal proposals “essentially impose an isolationist tariff on international insurers conducting business in the U.S.”

If Sen. Baucus ultimately decides to introduce legislation and provide support for it within his committee, it would set up a battle between insurance giants.

Supporters of legislation that would close the loophole include AMBAC, American Financial Group, Berkshire Hathaway, Chubb, EMC Insurance Companies, The Hartford, Liberty Mutual (and its Safeco affiliate), Markel, MBIA, Scottsdale Insurance, Travelers and Zenith Insurance.

Lining up on the other side are such firms as ACE, Allianz of America, Arch Capital Group, Munich Re, XL America and Zurich, as well as the Association of Bermuda Insurers and Reinsurers.

The Risk and Insurance Management Society also opposes any change in the status quo, as do alternative risk-transfer groups including the American Risk Retention Association, Captive Insurance Companies Association, National Risk Retention Association, Self-Insurance Institute of America, and the captive insurer associations of the District of Columbia, Montana and Vermont.