The European Commission has proposed changes to State aid rules, so that the protection enjoyed by the VHI ceases by the end of next year.
In a statement, the Commission said the statute of the VHI means that it cannot go into liquidation, or be wound up and so cannot go bankrupt.
As a result, its creditworthiness is improved and it enjoys an undue financial advantage over its competitors.
Joaquin Almunia, Commission Vice President in charge of Competition Policy, said a level playing field on the Irish market for private health insurance can only exist if all operators compete on equal market terms.
He said the removal of the unlimited State guarantee to the VHI was essential.
In response to concerns regarding the distortion of competition created by State guarantee, Mr Almunia said the Government has proposed to incorporate one or several subsidiaries of the VHI as private limited companies by December 2013 at the latest.
He said the Government also ensured that whatever the final structure and sequencing, the unlimited guarantee will be gone by December 2013.
The Commission said that if no agreement is reached on the proposed measures within a month, the Commission may open a State aid investigation.
Minister for Health Dr James Reilly said the Commission's announcement represents a clear pathway by which issues can be resolved.
VHI Healthcare also welcomed the decision and said it will need extra capital to meet the Central Bank's solvency requirements under the changes.
It said: “The measure outlined by the Commission today forms part of a complex process that will allow VHI Healthcare make an application to the Central Bank in order to be authorised by 31 December 2013 as per the European Court of Justice Ruling in November 2011."