What Is a Premium?

Premium has several meanings in finance. Mostly, it refers to:

1. Generically, a security trading above its intrinsic or theoretical value is trading at a premium (in contrast to a reduction). The difference between the worth paid for a fixed-income security and the safety’s face amount at issue is known as a premium if that price is higher than par.
2. The acquisition price of an insurance policy or the regular payments required by an insurer to offer coverage for an outlined time frame.
3. The entire cost to purchase an option contract (often synonymous with its market price).

Understanding a Premium

Broadly speaking, a premium is a price paid for above and beyond some basic or intrinsic value. Relatedly, it’s the worth paid for cover from a loss, hazard, or harm (e.g., insurance or options contracts). The word “premium” is derived from the Latin praemium, where it meant “reward” or “prize.”

Kinds of Premium

Price Premium

A price that exists above some form of fundamental value is known as a premium, and such assets or objects are said to be trading at a premium. Assets may trade at a premium resulting from increased demand, limited supply, or perceptions of increased value in the long run.

A premium bond is a bond trading above its face value or in other words; it costs greater than the face amount on the bond. A bond might trade at a premium because its rate of interest is higher than current rates available in the market.

The concept of a bond price premium is said to the principle that the worth of a bond is inversely related to rates of interest; if a fixed-income security is purchased at a premium, which means then-current rates of interest are lower than the coupon rate of the bond. The investor thus pays a premium for an investment that can return an amount greater than existing rates of interest.

A risk premium involves returns on an asset which can be expected to be in excess of the risk-free rate of return. An asset’s risk premium is a type of compensation for investors. It represents payment to investors for tolerating the additional risk in a given investment over that of a risk-free asset.

Similarly, the equity risk premium refers to an excess return that investing within the stock market provides over a risk-free rate. This excess return compensates investors for taking over the relatively higher risk of equity investing. The dimensions of the premium varies and depends upon the level of risk in a specific portfolio. It also changes over time as market risk fluctuates.

Options Premium

Premiums for options are the price to purchase an option. Options give the holder (owner) the appropriate but not the duty to purchase or sell the underlying financial instrument at a specified strike price. The premium for a bond reflects changes in rates of interest or risk profile because the issuance date. The customer of an option has the appropriate but not the duty to purchase (call) or sell (put) the underlying instrument at a given strike price for a given time frame.

The premium that’s paid is its intrinsic value plus its time value; an option with an extended maturity at all times costs greater than the identical structure with a shorter maturity. The volatility of the market and the way close the strike price is to the then-current market price also affect the premium.

Sophisticated investors sometimes sell one option (also often called writing an option) and use the premium received to cover the price of shopping for the underlying instrument or another choice. Buying multiple options can either increase or reduce the chance profile of the position, depending on the way it is structured.

Insurance Premium

Premiums for insurance include the compensation the insurer receives for bearing the chance of a payout should an event occur that triggers coverage. The premium may additionally contain a sales agent’s or broker’s commissions. Probably the most common varieties of coverage are auto, health, and homeowners insurance.

Premiums are paid for a lot of varieties of insurance, including health, homeowners, and rental insurance. A typical example of an insurance premium comes from auto insurance. A vehicle owner can insure the worth of their vehicle against loss resulting from accident, theft, fire, and other potential problems. 

The owner often pays a hard and fast premium amount in exchange for the insurance company’s guarantee to cover any economic losses incurred under the scope of the agreement. Premiums are based on each the chance related to the insured and the quantity of coverage desired.

Premium FAQs

What Does Paying a Premium Mean?

To pay a premium generally means to pay above the going rate for something, due to some perceived added value or resulting from supply and demand imbalances. To pay a premium may additionally refer more narrowly to creating payments for an insurance policy or options contract.

What Is One other Word for Premium?

Synonyms for “premium” include prize, fee, dividend, or bonus. In insurance and options trading, it could be synonymous with “price.”

What Are Premium Pricing Examples?

Premium pricing is a marketing strategy that involves tactically setting the worth of a specific product higher than either a more basic version of that product or versus the competition. The aim of premium pricing is to convey higher quality or desirability than other options.