What Is Premium Income?
Premium income can refer to the proceeds an investor earns from writing (selling) options contracts, or the revenue an insurer earns from payments from policyholders. In either case, premium income originates from selling risk protection to a buyer.
Investors can write options for premium income through several strategies that reduce their overall exposure from selling risk protection, including using spreads, covered calls, or investing in option income funds.
- Premium income refers to cash inflows derived from selling risk protection.
- Insurance companies sell policies and receive premium income in return for guaranteeing claims benefits in the event of a harm or hazard.
- Options writers (sellers) earn premium income by selling options contracts to buyers, and become obligated to deliver the underlying asset at the strike price to the long if assigned.
Understanding Premium Income
Premium income is any money received by an individual or business as part or all of a premium payment. The term applies commonly to options contracts or insurance policies. In both cases, premium income compensates the recipient for the risk that they will have to deliver a financial obligation to the counterparty. In the case of an options contract, that obligation will either be cash or an underlying security. An insurance company's obligation will almost always be 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 entitles the buyer, who owns either a long put or call as a result of making that payment, to exercise the contract at their discretion. If the option is exercised, the writer of the contract is said to have been assigned, and must deliver the underlying asset at the strike price.
In theory, the premium of an options contract should be equal to the sum of two dollar amounts. First is the difference between the strike price and the spot price of the underlying asset. The second is a monetary representation of the time to expiration. Traders' and scholars' opinions on how to value that time until expiration will vary. All would agree, however, that the time value of an options contract is subject to time decay. The value decreases as the time to expiration decreases.
An options premium is quoted on a per-share basis, while options contracts cover 100 shares each. A trader who quotes a premium of $3.25 for a call contract will expect premium income of $325 on a standard contract covering 100 shares.
Premium Income in Insurance
The second meaning for premium income comes from the insurance industry. An insurance premium is the fee paid by a policyholder to an insurance carrier for coverage against some form of risk. Common forms of insurance cover damages to automobiles, families that have lost a loved one, or homeowners whose property has suffered significant damage.
The insurance company calculates the premium income according to the level of risk that it feels it is assuming relative to the claims it may have to pay out. The companies will do one of two things with the premium income from any policy. It can use that income to pay off losses on another policyholder's claim or it can invest the premium income in a relatively liquid asset until it needs to pay a loss. Some portion of that premium income is a liability. Eventually, the insurance carrier will have to pay it to a policyholder.