What is Premium Income?
Premium income can refer to the proceeds an investor derives from writing (selling) options contracts or the income an insurer derives from payments from policyholders. In both cases, premium income comes from the sale of risk protection to a buyer.
Investors can sell options for premium income through several strategies that reduce their overall exposure to selling risk protection, including using spreads, covered calls, or investing in premium income funds. options.
Key points to remember
- Premium income refers to cash receipts from the sale of risk protection.
- Insurance companies sell policies and collect premium income in exchange for guaranteeing compensation in the event of damage or danger.
- Option sellers (sellers) earn premium income by selling options contracts to buyers and become obligated to deliver the underlying asset at the long-term strike price if awarded.
Understanding premium income
Premium income is any money received by an individual or business as part of a premium payment. The term is commonly applied to options contracts or insurance policies. In both cases, the premium income compensates the beneficiary for the risk that he will have to discharge a financial obligation towards the counterparty. In the case of an options contract, this obligation will be either cash or an underlying security. An insurance company’s obligation will almost always be in cash to replace lost assets.
Options traders who write and sell options contracts sometimes refer to the payment they receive from their counterparty as a premium. This payment allows the buyer, who holds either a put or a call option following this payment, to exercise the contract at his discretion. If the option is exercised, the underwriter of the contract is said to be the assignee and must deliver the underlying asset at the exercise price.
In theory, the premium of an options contract should be equal to the sum of two dollar amounts. The first is the difference between the strike price and the spot price of the underlying asset. The second is a monetary representation of the expiration time. The opinions of traders and academics on how to gauge this time to expiration will vary. Everyone would however agree that the time value of an options contract is subject to decay over time. The value decreases as the time to expiration decreases.
An option premium is quoted per share, while option contracts cover 100 shares each. A trader who offers a premium of $3.25 for a call contract will expect premium income of $325 on a standard contract covering 100 stocks.
Insurance premium income
The second meaning of premium income comes from the insurance industry. An insurance premium is the fee paid by a policyholder to an insurance company for coverage against some form of risk. Common forms of insurance cover damage to automobiles, families who have lost a loved one, or homeowners whose property has suffered major damage.
The insurance company calculates premium income based on the level of risk it believes it is assuming relative to the claims it may have to pay. Companies will do one of two things with the premium income from any policy. He can use this income to repay losses on another policyholder’s claim or he can invest the premium income in a relatively liquid asset until he has to pay a loss. Part of this premium income is a liability. Ultimately, the insurer will have to pay it to an insured.