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How Car Insurance Works

How Car Insurance Works
Matthew Collister
Updated September 14, 2021
5 Min Read

Most drivers, sooner or later, will be involved in a car accident. The fact is that there are more than 6 million accidents in the United States each year, according to the National Highway Traffic Safety Administration. And while most are fortunately very minor, some accidents can involve injuries and financial loss. For this reason, nearly every US state requires drivers to have at least a minimal amount of car insurance.

What is car insurance?

One of the most widely sold types of insurance, car insurance is designed to do four things:

  • Protect you financially from any legal obligations you have to others if you cause an accident while driving.
  • Help you pay medical bills for any injuries you receive if in an accident.
  • Protect you financially if you’re in an accident caused by a person who does not have insurance.
  • Protect your investment in your car.

How car insurance works

When you buy car insurance, you pay what’s known as a premium to a car insurance company. That premium gets you a policy that can include several coverages. Each coverage provides insurance for a specific situation — more about that in a bit.

Then, if you’re in an accident, you file a claim with your insurance company. Depending on the accident’s details and the coverages on your policy, the insurance company will pay for any property damage or injuries you cause. It may also help you cover the cost to repair your car, and help pay your medical bills.

Your insurance company typically won’t pay for repairs due to normal wear and tear of your car, or costs related to its upkeep. You may also need special coverage if you use your vehicle for business, drive for a ride-sharing service, or drive a company car.

Details of what your insurance company will and won’t pay for is contained in your policy’s contract, which is provided to you at the time of purchase. You’ll also receive a policy summary called a declarations page, and an ID card that proves you have insurance.

Car insurance policies typically have a 12-month term. At the end of this term, you’ll need to either renew your policy, or get a new policy from another insurance company. If you move and register your car in another state, you’ll need to get a new policy in that state.

Parts of a car insurance policy

A standard car insurance policy has two legally required coverages. These ensure you’ll be financially responsible for any injuries or damage you may cause.

  • Bodily injury (BI) liability — If you’re responsible for an accident that injures other drivers, their passengers, or any pedestrians, your BI liability ensures your insurance company will pay their medical bills.
  • Property damage (PD) liability — If you’re responsible for an accident that damages other peoples’ cars and/or property, your PD liability ensures your insurance company will pay the costs for repair or replacement.

Both BI and PD are subject to a limit. This is a dollar amount representing the maximum the insurance company will pay. So, if your BI limit is $100,000, that’s the most the company will pay toward the injured person’s medical bills. You’re responsible for any amount beyond that limit!

You choose these limits when you buy the policy. Choosing higher limits means you have more coverage, but you can also expect to pay more in premium. BI and PD also apply to every driver who’s covered your policy.

Beyond BI and PD, many policies feature these common coverages:

  • Collision — If you’re responsible for an accident involving another vehicle, and your own vehicle is damaged, collision ensures your insurance company will help pay for your repair or replacement costs.
  • Comprehensive — If your vehicle is damaged or destroyed by something other than a collision with another car (for example: a flood, a falling tree, or a collision with a deer), comprehensive ensures your insurance company will help pay for the repair or replacement costs.

If you buy collision and/or comprehensive coverage, your insurance company will also require you to also choose a deductible. This is your share of the cost to repair or replace your vehicle. For example: say your car insurance policy has a $500 collision deductible. You damage your car, file an insurance claim, and get a repair estimate for $3,000. The insurance company will pay $2,500 toward the repairs; you’re responsible for $500. Lower deductibles cost more in premium, but provide greater financial protection.

Collision and comprehensive coverage are optional in all 50 states, but may be required by your bank if you have a loan or lease for your car. These coverages are also specific to each car that’s covered by the policy. So if you have two cars, it’s possible to choose these coverages for one, but not the other.

  • Uninsured Motorist (UM) — If you’re involved in an accident, another driver is at fault, and that driver has no insurance, UM ensures your insurance company will help pay for your own medical and car repair costs.
  • Medical Payments (MedPay) and Personal Injury Protection (PIP) — If you’re involved in a car accident, no matter who’s responsible, these coverages ensure your insurance company will help pay you and your passengers for costs related to treatment of injuries.

Note that UM, MedPay, and PIP are all subject to limits that you choose when you buy the policy. UM and PIP are required coverages in several states. MedPay is optional.

How is premium calculated … and how to save money

The amount of money you pay for car insurance depends on multiple factors, and every company has a different way of evaluating those factors to calculate your premium. Generally, however, they all look at the following:

  • Your driving record, including violations and accidents
  • Where you live, as some areas of the country have higher rates of vandalism, theft, and accidents
  • How much you drive
  • Your age and gender, as mature drivers and women tend to have fewer accidents
  • The cost of your car, along with its likelihood of theft, safety features, and engine size
  • How you manage your credit — Insurance companies discovered long ago that there’s a connection between a person’s responsible use of credit and their likelihood of filing an insurance claim. A good credit history can thus help you pay less for your car insurance.
  • The choices you make when you buy a policy, such as the limits and deductibles you choose, and the optional coverages you select

Most of the major car insurance companies also offer a wide variety of discounts. Buying multiple policies from the same company (for example: for both your car and home) can often earn you a significant discount. Paying for your policy in full rather than in installments can earn you a discount as well, as can maintaining a clean driving record.

Another great way to save money is by shopping around. Because each insurer calculates premiums differently, you may find that you can save hundreds of dollars by comparison shopping.

Buying car insurance: Your next steps

At one time, almost all car insurance was sold through agents. Today, however, some of the major insurance companies give you the option of buying directly by phone or on their website.

Buying directly gives you the benefit of convenience. As websites are available 24/7, you can buy any time you like. These companies have invested significantly in making their online sales experience go quickly, so you can have a policy in just minutes.

But buying from an agent does have its own advantages. All agents are licensed by their state, and are trained to provide personalized service and advice on what coverages to buy. An independent agent — one not directly affiliated with a specific insurance company — can shop around between multiple insurers to help you get the best value. An agent can also assist if you have to file a claim, or just have questions about your policy. Best of all, an agent provides this level of service at no cost to you.

Protect one of your most valuable investments

Your car is probably one of your most valuable investments, and something you rely on to commute, shuttle the kids around town, run errands, and have fun. Car insurance protects that investment, while protecting you from a serious financial loss should you be involved in an accident.

If you drive, you should have car insurance. It’s as simple as that.

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