# Understanding Premiums in Finance: Definitions, Types, and Examples

> **Definition**
>
> A premium represents the price paid for a good or service that is above and beyond the item's intrinsic value.

## What Is a Premium?

"Premium" has several meanings in finance. Most commonly, it refers to the difference in the intrinsic or theoretical value of a security and the higher price at which it is being traded (in contrast to a [discount](https://www.investopedia.com/terms/d/discount.asp)). Assets might be traded at a premium if market participants feel it is undervalued or if there is an increase in demand.

The term also refers to the price to buy an options contract or the recurring payments made to an insurance policy provider.

### Key Takeaways

*   Premiums in investing refer to costs exceeding a security's intrinsic value or the price of insurance and options.
*   A bond trades at a premium when its interest rate is higher than current market rates.
*   Insurance premiums are payments made to cover potential risks, such as auto or homeowners insurance.
*   Options premiums include intrinsic value and time value, influencing their overall market price.
*   Risk premiums compensate investors for taking extra risks compared to risk-free assets.

![Premium: The cost to buy an insurance policy or an option or a bond or other security that trades above its issuance price or intrinsic value.](https://www.investopedia.com/thmb/Hf8hcR4M7a4QgQcvP9JVCIOtBMo=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/premium.asp-final-eb58bf1dd485494590a33297053e5943.png)

*— Investopedia / Julie Bang*

## Different Types of Premiums in Finance

### Price Premium

A price that exists above some sort of fundamental value is referred to as a premium, and such assets or objects are said to be trading at a premium. Assets may trade at a premium due to increased demand, limited supply, or perceptions of increased value in the future.

A premium bond is a bond trading above its face value; in other words, it costs more than the face amount of the bond. A bond might trade [at a premium](https://www.investopedia.com/terms/a/at-a-premium.asp) because its interest rate is higher than the current market rate.

The concept of a [bond price premium](https://www.investopedia.com/terms/p/premiumbond.asp) is related to the principle that the price of a bond is inversely related to interest rates. If a fixed-income security is purchased at a premium, it means that the current interest rates are lower than the bond's [coupon rate](https://www.investopedia.com/terms/c/coupon-rate.asp). The investor thus pays a premium for an investment that will return an amount greater than existing interest rates.

A [risk premium](https://www.investopedia.com/terms/r/riskpremium.asp) involves returns on an asset that are expected to be in excess of the [risk-free rate of return](https://www.investopedia.com/terms/r/risk-freerate.asp). An asset's risk premium is a form of compensation for investors. It represents payment to investors for tolerating the extra risk in a given investment over that of a [risk-free asset](https://www.investopedia.com/terms/r/riskfreeasset.asp).

Similarly, the [equity risk premium](https://www.investopedia.com/terms/e/equityriskpremium.asp) refers to the excess return that investing in the [stock market](https://www.investopedia.com/terms/s/stockmarket.asp) provides over a risk-free rate. This excess [return](https://www.investopedia.com/terms/r/return.asp) compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies and depends on the [level of risk](https://www.investopedia.com/terms/r/risk-profile.asp) in a particular portfolio. It also changes over time as market risk fluctuates.

### Options Premium: Key Concepts and Implications

Options premiums are the cost to purchase an option. Options allow the holder to buy or sell the underlying instrument at a set strike price, but they are not obligated to do so. A bond's premium reflects changes in interest rates or its risk profile since it was issued. The buyer of an option has the right but not the obligation to buy (call) or sell (put) the underlying instrument at a given strike price for a given period of time.

The premium that is paid is its intrinsic value plus its [time value](https://www.investopedia.com/terms/t/timevalue.asp); an option with a longer maturity always costs more than the same structure with a shorter maturity. The [volatility](https://www.investopedia.com/terms/v/volatility.asp) of the market and how close the strike price is to the then-current market price also affect the premium.

Sophisticated investors sometimes sell one option (also known as writing an option) and use the premium received to cover the cost of buying the underlying instrument or another option. Buying multiple options can either increase or reduce the risk profile of the position, depending on how it is structured.

### Insurance Premiums: What You Need to Know

Insurance premiums are payments to cover the insurer's risk of a payout if an event covered by the policy happens. Premiums may also include sales agent or broker commissions. The most common types of coverage are auto, health, and homeowners insurance.

Many types of insurance require premiums, including health, homeowners, and rental insurance. These payments must be made regularly to keep a policy active. A common example of an [insurance premium](https://www.investopedia.com/terms/i/insurance-premium.asp) comes from [auto insurance](https://www.investopedia.com/terms/a/auto-insurance.asp). A vehicle owner can insure the value of their vehicle against loss resulting from accident, theft, fire, and other potential problems. 

Policyholders pay a fixed premium in return for the insurer's coverage of [economic losses](https://www.investopedia.com/terms/e/economicprofit.asp) incurred under the scope of the agreement. Premiums depend on the insured's risk and the desired coverage level.

## What Does Paying a Premium Mean?

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

## What Is Another Word for Premium?

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

## What Are Premium Pricing Examples?

Premium pricing is a marketing strategy that involves tactically setting the price of a particular product higher than that of either a more basic version of that product. The purpose of premium pricing is to convey higher quality or desirability than other options.

## The Bottom Line

Premium is a term commonly used in finance, particularly in the fields of investing and insurance. Investors refer to the price paid for a security's intrinsic value as a premium. Premiums may indicate an asset is under- or overvalued, so it's important to analyze its fundamentals carefully. Options traders refer to the price to purchase an option as its premium.

Insurance providers charge a monthly fee for insurance, which is referred to as a premium. Insurance premiums vary by policy coverages and amounts, so it's essential to research them and find coverage with premiums you can afford.

> **Article Sources**
>
> 1.  Financial Industry Regulatory Authority. "[Understanding Bond Yield and Return](https://www.finra.org/investors/insights/bond-yield-return)."
>     
> 2.  U.S. Securities and Exchange Commission. "[Investor Bulletin: An Introduction to Options](https://www.sec.gov/oiea/investor-alerts-bulletins/ib_introductionoptions)."
>     
> 3.  Merrill. "[Options Pricing](https://www.merrilledge.com/investment-products/options/options-pricing-valuation)."