The term “premium” is utilized in nearly every aspect of the financial world, from insurance contracts to the price of bonds. However, “premium” is given quite divergent meanings depending on the context within finance of which it is represented. This paper discusses the variety of meanings for “premium”, defines them clearly, and then gets into the variety of different types of premiums that exist within the financial realm at present.
What is a Premium?
Most basically, a premium is that which is paid in excess over standard or intrinsic value for anything goods, services, or assets. In essence, an extra cost reflects either value added or something more, or something enhanced compared to what is otherwise offered at the basic level.
A premium, in the financial sense, is generally believed to refer to compensation for agreeing to bear more risk, for purchasing protection from or assurance of something, or for gaining some form of concession. It might be a recurring payment, like in the case of insurance, or a one-off, upfront payment, depending on the financial product.
Different Meanings of Premium in Finance
The term “premium” is used in several key contexts within finance, each with a specific meaning.
Insurance Premium
On the subject of insurance, a premium is money a policyholder pays to the insurer in exchange for their provision of coverage. This is done either monthly, quarterly, or annually, and in most cases regularly, to assure that the risk insured is safeguarded for providing financial protection against some risk like accidents, health hazards, or property damage.
The quantum of premium on insurance depends on several factors: the type of coverage, the risk profile of the insured, and the sum that is insured. For example, a young, healthy person would probably be in a position to get a better deal on health insurance compared to one advanced in years who has had some health conditions before. On the other hand, a homeowner might face higher home insurance premiums arising from a history of natural disasters in his or her area.
Bond Premium
A premium is said to exist in cases whereby a bond’s trading of a given face value is above the par value. This usually is a condition resulting from a situation whereby the bond’s coupon rate, which is the rate that the interest is paid at, is compared to current market interest rates. In this case, investors would be willing to pay for anything above the par value only to secure higher interest payments from holding the bond.
For example, let’s say a bond had a face value of $1,000. The rate stated on the bond is 5%, but the current market interest rate is 3%. The investor will pay $1,100 for the bond. The additional $100 that the investor paid in comparison to the face value of the bond is the premium of the bond. As time passes, and the bond comes closer to its end date, the price of the bond may fall and essentially normalize against the face value.
Option Premium
An option premium is the price an investor pays for the purchase of an options contract where the holder holds the right—and not the obligation—to buy/sell an underlying at a particular price over a specific period. The options belong to the category of the derivative assets, so their value is derived from the value or the performance of other underlying assets—commonly the stocks or the commodities.
The current price of the underlying, the strike price, the time to expiration, and the volatility are the quantities governing the premium for an options contract. As a general rule, the more potential it has to make money or the more in-the-money the option is, the larger will be the premium.
Equity Premium
The equity premium is the excess return of the stock market investment over a risk-free rate, usually proxied by government bonds. This premium compensates the investors in equities for additional risk associated with investing in instruments that, typically, are much more volatile than bonds.
The equity premium is important, not the least, due to its being the key underlying asset pricing difference in many of the models, one example being the Capital Asset Pricing Model. Based on the historical data, it so appears that comparatively, in the longer run, stocks have higher returns than bonds, but they have more associated risk. Basically, it is the reward, while investing, that the investors receive for bearing higher risk.
Risk Premium
A risk premium is an excess return over and above a risk-free rate of return that investors expect on their investments. An extra return is required by the investor to be willing to hold the risky asset rather than the risk-free asset. The size of the premium depends to any single investment, along with the respective level of risk and the investor’s risk-tolerance level.
For instance, corporate bonds in general are priced to yield more than government bonds to make up for the additional default risk of the issuing corporation. Similarly, stocks in general provide a risk premium over bonds reflecting the higher risk of equity investments.
Premium in Mergers and Acquisitions (M&A)
Premium is what a buyer is willing to pay to acquire a company over and above the current market price of the firm being acquired in mergers and acquisitions. This premium might be a result of the belief of a potential target company, in the mind of the buyer, to have strategic value, growth potential, or synergies to justify more than its current market valuation.
For example, if a company’s shares are trading at $50 each and a potential acquirer is buying them at $60 per share, then the $10 difference is the acquisition premium. Typically, this premium forms a huge part of the total costs of acquisition and as such becomes a subject of fierce negotiations between the two companies: the acquiring and the target company.
Types of Premiums
Fixed Premium
A fixed premium is a premium that does not change over the tenor or term of a financial product. For example, a large share of the available life insurance uses fixed premiums, where the amount to be paid by the policyholder does not change over time. Stability is gained by fixed premiums, which also provide predictability, and give the individual the ability to plan better while managing his or her payments and budget.
Variable Premium
A variable premium is one that varies according to changes in variables such as interest rates, the risk profile of the policyholder, or market conditions. For instance, there are some health insurance policies that have variable premiums which can rise should the policyholder’s health levels drop or should the insurer meet higher-claim situations.
Single Premium
A single premium is a one-time payment for a financial product, like an annuity or life insurance. Against this single premium, the risk bearer of insurance or a financial institution provides the agreed-upon coverage or benefit, waiving any further premiums to be paid in the future.
Level Premium
A level premium remains the same throughout the policy term, similar to a fixed premium. There is, however, a significant difference in that level premiums are very much a part of term life insurance policies, where the fixed premium is supposed to last a number of years constituting a term. On the expiration of that term, the policyholder may have to renew the policy at a higher rate.
Stepped Premium
A stepped premium is one that increases over time, typically as the policy holder ages or as the risk associated with the financial product grows. In other cases however it provides for increase in premiums either because of the aging of the policy holder or even based on changed circumstances that affect the policy holder.
Conclusion
Definition of “premium” is infused with all sorts of meaning and applications in the world of finance; they are as loaded as “premium” implicates. Whether one is paying a premium for the need of insurance, working through a premium on a bond, or thinking through an equity premium, understanding these different contexts is critical to the judgments a person would make with respect to money.
Hence, understanding how the different types of premiums in various financial instruments work will greatly help in understanding the confusing world of finance, ensuring your decision is in line with the financial purpose you’ve set for yourself. Being a businessman, investor, or an ensured person, you would be redefining the word “premium” with time, and proper understanding in such situations would really give you an edge over managing your financial affairs effectively.