GEORGE TOWN, Cayman Islands (Reuters) - A proposed tax change by the US Internal Revenue Service could drive more captive insurers offshore, providing a boost to Cayman and Bermuda and hurting Vermont and other US states that have sought to snare a piece of the action, industry officials say.

If approved, the proposal would eliminate the ability of US based captive insurers —-firms that insure their parent companies - to claim tax deductions for money set aside in reserves to pay for future claims and losses.

Instead, these deductions would only be allowed at the time the actual claims are paid out, potentially leading to millions of dollars in taxes being collected up front.

"Companies wanting to set up captives are holding off to see what happens," said Dan MacLean, president of the Insurance Managers Association of Cayman (IMAC) and managing director of Aon Insurance Managers (Cayman), part of Aon Corp.

"Right now, Cayman and Bermuda are watching from the sidelines."

Other emerging captives markets, such as Ireland, Switzerland and Luxembourg, could also benefit if the IRS proposals took effect, industry experts believe.

Captives, which insure part or all of their parents, were once considered a fringe product to traditional insurance.

But companies, especially in the United States, have found they can make significant savings on premiums by forming captives rather than through buying traditional insurance. There are now more than 4,000 captives worldwide, writing more than $20 billion in premiums, according to the captive information website captive.com.

To date, Bermuda, a mid-Atlantic British territory, leads the captive market with about 870 registered companies, followed by the Cayman Islands, a British dependency in the Caribbean, at 756.

Vermont has been the only real onshore US competitor for Bermuda and Cayman, with 562 listed captives.

In recent years, however, a number of other US states have brought in legislation to get a piece of the lucrative pie.

Mr. MacLean said he believes the states with the best chances of grabbing a significant market share include Hawaii, South Carolina, Arizona, Nevada, the District of Columbia, and New York.

"Since 9/11, there has been more of a patriotic push to keep business onshore. Beyond these states, it is unlikely that other states can effectively build the momentum needed in the industry," he said.

This trend could be threatened though by the proposed tax rule changes, industry officials said.

"There hasn't been anything as serious on the regulatory front like this for at least 10 years," said Dennis Harwick, chairman of the Coalition for Fairness to Captive Insurers, a group established by 46 industry associations, captives and US states, including Vermont.

The IRS has set a hearing for February 29 to listen to the coalition's arguments.

"I don't think the IRS understood that they are stepping on the states' toes. One of the assumptions that people at the IRS had made was that they didn't think that captives were real insurance companies," Mr. Harwick said.