Most people have — and will — never face a tornado striking their house. But if it did, how would one pay for all of the damage?

Insurance is a contract. In exchange for relatively small, regular payments known as premiums, an insurer will agree to pay the policyholder a sum of money for damages.

Premiums & Deductibles

The amount of money received for damages depends on both the situation at hand as well the size of premiums paid.

For instance, two owners might have the same hurricane insurance policy. But the owner of a house swept away by floods will receive more compensation than an owner of another with only minor roof damage.

When a policyholder pays more in premiums monthly, they can expect a greater amount of money received in the event of a loss. The deductible of a policy the amount of money that a policyholder has to pay before the policy takes effect.

Suppose, for example, a health insurance policyholder required a $10,000 surgery. If the deductible of the health insurance plan was $2,000, the policyholder would only have to pay $2,000 out of pocket; the other $8,000 is covered by the insurer.

Premiums themselves can vary substantially depending on a number of factors, including the amount of coverage and risk factors related to the policyholder.

Consider two drivers, Rick and Janice.

Rick owns four very expensive cars: a Bugatti, Lamborghini, Ferrari, and Porsche. He’s 19 years old, but in only three years of driving, he’s been involved in six car accidents.

Compare him to Janice, a 60-year-old woman with a perfect driving record. She only has one car to insure - a small Prius.

Who would pay more in car insurance premiums?

Rick has behavioral risk factors in his driving record - his involvement in six accidents signals he’s more likely to get in another one. He’s been driving for only 3 years, and there isn’t as much data to judge his record. In the event that he does face damages from an accident, he also drives cars that are very costly to repair. Rick’s risk profile - and premiums - are significantly higher than Janice's.

While the comparison between Rick and Janice’s auto insurance is extreme, many similar factors, like behavior and age, determine premiums across a variety of insurance types.

The price of premiums can also be influenced by a policy’s limit, the maximum amount of money that an insurer will pay for damages. The policy limit can be both cumulative or set as an amount per claim. Limits can also be applied in relation to a period of time (e.g. annually) or over the lifetime of a policy (lifetime maximum).

Most insurers will also offer longtime customers lower premiums to encourage loyalty. The lower a policyholder's premiums are in relation to the market, the more likely they are to select a plan from their existing insurer.

Compulsory Insurance

Some insurance coverage is mandatory, depending on state and federal laws. All drivers, for instance, are required to obtain auto insurance or proof of financial culpability in the event of an accident.

Some common types of mandatory insurance include:

Auto Insurance - All drivers must obtain auto insurance to protect against damages to their own vehicle, and liability for damages caused to the vehicles of others.
Worker's Compensation Insurance - Employers must obtain insurance policies in order to compensate employees in the event of illness or injury caused by working
Professional Liability Insurance - Professionals and the self-employed need to obtain insurance to protect against damages caused by their own work. Doctors, for instance, must obtain medical malpractice insurance. A painter might obtain insurance that protects them if they paint a surface the wrong color.

Other types of insurance, like health insurance, are not mandatory but strongly suggested. Some states levy tax penalties on uninsured filers.

Extended Warranties

Some manufacturers, or third-party stores, allow consumers to purchase extended warranties for products or appliances. Such warranties are like insurance policies. In exchange for a fee upfront, losses from a product resulting from damage or malfunctions are covered. Unlike insurance policies, however, warranties can cover damage expected from wear and tear, like a car engine that needs replacing after a large amount of mileage.

For instance, an iPhone owner might purchase a repair warranty that offers a free replacement for any damage - including broken screens or a water-logged interior, that may occur for a specific period of ownership or warranty term.

Many manufacturers offer limited warranties that cover malfunctions to products for a short time after purchase.

Insurance Brokers

Insurance brokers represent a consumer in a search for insurance. Given a client's needs, insurance brokers can recommend insurance coverage, craft policies with agencies, and negotiate on behalf of the consumer.

Insurance brokers typically charge fees on the policy selected by a client, usually under 10% of premiums. All insurance brokers must obtain state-level certifications to practice.