When searching for a potential captive insurance company to work with, it's important to know which kind of captive would most benefit the company. The most common type of captive, for example, is the single-parent captive, and the two main types of captive are 831(a) and 831(b). Each type is unique in regards to premium prices and the taxation of the insurance company.

831(a) captives are used by traditional insurance companies. Captives treated as insurance companies are taxed for federal income tax purposes the same as any other C-corporation, and by extension, they are subject to taxation at the corporate level on their premium and investment income. 

"A health insurance captive is a wholly owned subsidiary insurer that provides risk-mitigation services for its parent company or a group of related companies," Everlong Captive Health Insurance explained on its website. "The employer, along with other similar-sized enterprises, sign up to become participants of the plan. As member-owners of the program, the participants all agree to spread the risk, using a stop-loss insurance model. This approach is designed to keep costs down over time while also reducing volatility."

All taxable C-corporation income receives ordinary income tax treatment instead of capital gains tax treatment. Although regular captives are taxed based on their premium income, they can deduct legitimate reserves and other expenses, as well as avoid premium income taxation if they have sufficient deductions.

831(b) captives are used by small insurance companies. If these captives received less than $2.45 million of premium income each year, they are taxed solely on investment income instead of premium income.

"Over time, smaller companies saw the advantages of the captive model and adapted it to suit their needs," Everlong said. "They were able to overcome their smaller workforce by joining forces with other similarly sized employers."

For a captive to obtain its associated tax benefits, it must be considered an insurance company. According to the IRS, in order to qualify as an insurance company for a year, a corporation's business must consist of activities, for federal tax purposes, that count as "insurance" for half of a year. Something can only be considered "insurance" if it involves both risk shifting and risk distribution.

Risk shifting occurs when a party facing a potential economic loss transfers some or all of their risk's financial consequences to another party so that a loss doesn't affect the insured. With the aid of an insurance arrangement, the insurance payment offsets their loss. Risk shifting is also easier compared to risk distribution.