How Does Car Insurance Work and Why Is It Important?

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Written by J.J. Starr Edited by Nick Versaw Reviewed by Amanda Clear

Updated February 26, 2024

The average bodily injury car insurance claim was for more than $24,000 in 2022, according to the Insurance Information Institute (Triple-I), and the average property damage claim was for another $5,000. And those figures don’t even account for potential repair costs for your vehicle if you cause an accident.

These amounts highlight just how important it is to purchase car insurance. After all, auto insurance coverage shields you from devastating financial losses if you cause an accident or if someone without coverage hits you. Plus, it’s legally required to drive on public roads (in most states).

We’ll go over all the need-to-know components of a car insurance policy throughout this article. By the end, you’ll have a clearer understanding of what’s covered, how it influences cost, and whether you need it.

Auto Insurance: The Basics

Car insurance is complex, so it’s important to understand how it works before you purchase a policy. After all, if you know how car insurance works and what it covers, you’re more likely to purchase the right coverage and avoid paying for things you don’t need.

You’ll also reduce the chances of headaches and confusion when the unexpected happens. With that in mind, let’s go over the various components of your auto insurance policy and what each one means.

Premiums: What you pay to have coverage

A car insurance premium is the amount of money you pay to your insurance company — usually on a monthly, semi-annual, or annual basis — in exchange for coverage. In other words, your car insurance bill.

Premiums are how insurance companies ensure they can pay claims. They’re also how insurers make money.

Let’s take a look at the types of things your premium covers.

What does car insurance cover?

Auto insurance covers a range of “losses” — things like replacing your vehicle after it’s stolen or other paying for people’s injuries and repairs if you cause a collision. Different types of coverage pay for different types of losses, and you must purchase the proper coverage to get adequate protection.

Your policy will outline coverages, limits, and rules within your policy documents. Be sure to review your documents carefully.

We’ll go over the most common coverage options and rules a little later in this article.

But first, let’s take a look at some of the most common car insurance premiums.

How much does car insurance cost?

The average American pays $129 per month for car insurance, according to Compare.com data. Car insurance companies use a variety of factors to determine your rate, including age, location, driving record, and vehicle. So you may pay more or much less than average, depending on your unique situation.

The table below highlights how average costs change based on some of those factors.

Overall, rates can vary widely depending on your unique situation. In fact, the difference between the lowest and highest average premiums on this list is more than $300 per month.

State-minimum policies are cheaper than full coverage, and teen drivers pay much higher rates than older drivers. Single drivers pay a little bit more than married ones. And drivers with a clean record see markedly lower premiums than those with tickets, accidents, or DUIs.

Claims: What the insurance company pays for repairs

A car insurance claim is a formal request to an insurance company to cover the cost of an incident, such as a car accident. The amount you pay for your premium goes into a big pool that the insurance company uses to pay for claims.

Your car insurance rate is largely based on how likely you are to file a claim. Insurers use your driver profile — which includes things like your age, location, driving record, and more — to determine how risky you are to insure. The more likely an insurance company thinks you are to file a claim, the higher your premium.

Let’s take a look at common scenarios where you’d file a claim with your insurance company.

When should you file a claim?

If you hurt someone else or damage their property, you should file a claim to cover their damages. But if you only cause damage to your own property, file a claim when the cost of repairs or damages exceeds your deductible.

Filing a claim increases your rates, so it’s up to you to decide if the claim is worth it.

How do you file a claim?

To file a claim, contact your insurance company and provide details of the incident (date, location, and parties involved). Most insurers allow you to file claims over the phone, online, or with a mobile app.

You’ll need to fill out a claims form and submit supporting documentation, such as photos or police reports, to get the process started.

Deductibles: What you (sometimes) pay after an accident

Deductibles are the final piece of the car insurance puzzle that can influence your costs. They represent the amount you pay out of pocket when you file a claim.

These deductibles are in place to lessen the chance you file a claim since you have a financial stake in the claim alongside your insurance company. The deductible amount you choose affects the cost of your premiums. Lower deductibles lead to higher premiums because your insurer takes on more risk (in the form of a higher possible payout). Higher deductibles bring down the cost of your policy.

Deductibles typically apply to the following coverages:

• Comprehensive coverage
• Collision coverage
• Uninsured motorist coverage (in some states)
• Personal injury protection (PIP)

What deductibles should you choose?

Deductible options vary by insurance company, but most range between $250 and $2,000. Some insurers let you set higher deductibles, but this is rare. The most common deductible for collision and comprehensive coverage is $500 per occurrence.

If you want a cheaper policy and are willing to take on more financial risk, choose a higher deductible. But be sure you have enough money to cover your deductible amount in case of a claim.

On the other hand, if you want to minimize the amount you’ll pay to file a claim, choose a lower deductible amount.

Some companies even offer “vanishing” or “diminishing” deductibles that can lower your deductible amount every year you’re claim-free, but this typically costs extra.

Types of Car Insurance Coverage

You have many types of car insurance coverage to choose from when you purchase a policy — and every insurer will offer its own unique mix of options. With so many variables, it’s important to understand what these options are so you can decide whether you need them.

Let’s take a closer look at some of the most common coverage types.

Liability coverage

Liability coverage is fundamental auto insurance coverage that protects you financially if you cause an accident. It consists of two parts: bodily injury (BI) and property damage (PD).

Bodily injury liability protection covers medical expenses, lost wages, and legal fees for injured parties, including passengers in other vehicles and pedestrians. Coverage limits are per person and per accident.

Property damage liability protection covers the cost of repairing or replacing other people’s damaged property, such as vehicles, fences, or buildings. Coverage limits are per accident.

Both components help shield you from potentially devastating financial liabilities due to accidents you cause. That’s why it’s mandatory in nearly every state.

Collision coverage

Collision coverage is an optional component of auto insurance that covers damage to your vehicle resulting from collisions with other vehicles or objects, regardless of who’s at fault. It’s required for leased or financed vehicles as part of the loan or lease agreement.

This coverage pays for repairs or replacement of your car, minus your deductible. While the other driver’s liability coverage typically pays if they’re at fault, collision coverage ensures your vehicle is repaired even if you cause the accident.

Comprehensive coverage

Comprehensive coverage protects your vehicle against non-collision events, such as theft, vandalism, fire, animal damage, and weather damage. Some natural disasters are automatically covered depending on the insurer, but you may need an additional “rider” to cover flooding, for example (check with your insurance company to be sure).

Like collision coverage, comprehensive is required for vehicles under a loan or lease agreement. Examples of covered damage include broken windows, hail damage, vehicle theft, and damage from falling objects.

Uninsured/underinsured motorist coverage

Uninsured/underinsured motorist protection covers you if an uninsured or underinsured driver hits you or you end up the victim of a hit-and-run. Uninsured motorist coverage pays for damages if you get hit by someone without insurance or are the victim of a hit-and-run. Underinsured motorist protection covers the difference between the at-fault driver’s coverage limits and the total cost of you and your passengers’ medical expenses that result from the accident the other driver caused.

Coverage limits typically mirror your liability coverage limits. Your state may require both uninsured and underinsured motorist coverage.

Personal injury protection (PIP)

PIP covers injury-related costs for you and your passengers, like medical bills and lost wages, no matter who’s at fault for the accident.

This coverage is usually required in “no-fault” states. In these states, you cover your own medical costs in most cases, no matter how the accident occurs or who causes it. The intention of this system is to limit the number of lawsuits and lighten the load on the state’s judicial system.

Medical payments coverage (MedPay)

MedPay covers medical costs from a car accident, including doctor’s visits, X-rays, surgery, hospital stays, and more. It can also extend beyond your vehicle and cover you when you’re a pedestrian or a passenger in someone else’s car.

MedPay is usually optional but often a great idea if your insurer offers it.

Other coverage types

Depending on the insurer, you’ll have access to additional coverage options. Here are some of the most popular:

• Accident forgiveness: Prevents rate increases after your first at-fault accident.
• Full glass: Covers repair or replacement of damaged vehicle windows or windshield.
• Gap insurance: Covers the difference between loan/lease balance and your car’s value if it’s totaled.
• New car replacement: Pays for the value of a new car if yours is totaled within the initial ownership period.
• Pet injury protection: Covers vet bills if your pet is injured in a car accident.
• Rental car reimbursement: Pays for a rental vehicle while your car is being repaired during a covered claim.
• Rideshare insurance: Covers drivers who work with services like Uber or Lyft.
• Roadside assistance: Helps with common car issues, like towing or flat tires.

How to Determine How Much Coverage You Need

You have lots of things to consider when deciding your coverage options and limits, especially if it’s your first time purchasing car insurance. Here’s some general guidance to help you decide what you need to get adequately protected.

State laws and requirements

Every state has its own rules regarding minimum coverage. Even states that border each other can have radically different requirements. For example, the three states below — Maine, New Hampshire, and Vermont — are all neighbors, but each state’s requirements are vastly different.

But don’t worry: an insurance company won’t sell you a policy that doesn’t at least meet state minimums. And you can always opt to increase your coverage limits (which is usually inexpensive to do).

Lender requirements

Lenders and lessors require comprehensive and collision coverage in most cases. They may also require gap or uninsured and underinsured motorist protection.

Let’s take a closer look at each.

• Collision coverage pays for vehicle damage in the event of an at-fault collision.
• Comprehensive coverage pays for damages from animals, fire, weather, vandalism and theft.
• Gap coverage pays the difference between your car loan balance and your car’s worth if it’s totaled.
• Uninsured and underinsured motorist protection covers damages when the at-fault driver doesn’t carry enough or any insurance.

Your vehicle

The maximum payout for collision and comprehensive coverage is your car’s actual cash value (ACV), minus your deductible (unless you have a less common “agreed value” policy). If you own your car outright and it’s worth less than $5,000, you might consider dropping these coverages if you can afford to replace your less-expensive vehicle. With a $1,000 deductible, the maximum payout is $4,000, which may not be worth the additional insurance cost — $1,092 per year, on average, according to Triple-I.

You may find it more useful to save that money for future repairs or to buy your next vehicle.

Your budget

How much you can reasonably afford for car insurance may affect your coverage options and limits. Some vehicles are more expensive to insure, and higher-value vehicles might need higher coverage limits. You’ll also need to have emergency savings to cover the cost of your deductibles.

Our advice: downsize your vehicle instead of downsizing your insurance coverage. It’s better to be fully protected against financial loss than vulnerable to expensive lawsuits.

How to Save on Car Insurance

The good news is that you can save money on car insurance in lots of ways. Here are some of our favorites.

• Use discounts: Car insurance discounts can save anywhere from 2% to 40% off your monthly premium. The most valuable include the safe driver, bundling, and telematics discounts. Stack them to get an even lower rate.
• Raise deductibles: Most policies default to $500 deductibles. Raising the deductible to $1,000 or more will decrease your monthly payment.
• Remove unnecessary coverage: Gap, collision, and comprehensive coverage become less important as your car gets older. For example, if you owe less than your car is worth, you don’t need gap coverage.
• Compare quotes often: Comparing quotes is the best way to tell if you’re getting the best deal. Compare rates at least every six months to ensure you never miss a chance to save.

Car Insurance FAQs

With so many moving parts, car insurance is bound to leave you with questions. Here are the answers to the ones most often asked about how car insurance works.

How does insurance work in the USA?

Car insurance in the U.S. operates through risk pooling. You pay a premium in exchange for coverage against specified risks. When a covered incident occurs, you file a claim, which the insurer investigates and compensates you for accordingly. Premiums vary based on many factors, like driver demographics, vehicle, coverage options, and state laws.

How does insurance work when you get hit?

When another driver hits you, you typically file a claim with their insurer, providing details of the incident. So be sure to get the other driver’s insurance information if you’re ever in an accident. The insurance company assesses the damages, determines fault, and compensates you accordingly.

How do car insurance deductibles work?

A deductible is the amount you agree to pay out of pocket before your insurance kicks in. If your deductible is $500 and the repair cost is $2,000, you pay $500, and your insurer covers the remaining $1,500. Higher deductibles have lower premiums, as the insurer takes on less risk.

How do auto insurance down payments work?

Auto insurance down payments are initial payments made when purchasing a policy. They typically cover a portion of the six-month or annual premium, with the remainder spread out over monthly installments. Down payments vary depending on the insurer’s policies and the cost of premiums. But you can typically get a big discount if you pay your semi-annual or annual premium in full when you purchase your policy.

Methodology

Data scientists at Compare.com analyzed more than 50 million real-time auto insurance rates from more than 75 partner insurance providers in order to compile the quotes and statistics seen in this article. Compare.com’s auto insurance data includes coverage analysis and details on drivers’ vehicles, driving records, insurance histories, and demographic information.

All the quotes listed in this article have been gathered from a combination of real Compare.com quotes and external insurance rate data gathered in collaboration with Quadrant Information Services. Compare.com uses these observations to provide drivers with insight into how auto insurance companies determine their premiums.

Sources

1. Insurance Information Institute, “Facts + Statistics: Auto insurance,” Accessed February 12, 2024.

J.J. Starr Insurance Writer

J.J. Starr is an insurance writer for Compare.com who specializes in auto insurance and personal finance. She has a passion for helping people save money by explaining complex topics like car insurance in a way that is simple and easy to understand. Prior to writing for Compare.com, J.J was a registered banker and life insurance consultant. She holds a master's degree in writing from New York University and a bachelor's degree from Stephens College.