How does car insurance work?
Fact-checked with HomeInsurance.com
Buying your first car is an exciting rite of passage. Buying your first car insurance policy? Not so much. Still, navigating the process of purchasing auto coverage is a must before you can even drive your new wheels home. But how does car insurance work and why is it so important? As it turns out, an auto insurance policy protects not just your vehicle but all your finances – and in almost every state, it’s illegal to drive without it. Here’s everything you need to know about how auto insurance works.
How car insurance works
Even if you take every precaution to be a safe driver, there’s always risk associated with getting behind the wheel of the car. Not only can accidents cause injuries that put your safety at risk, they also lead to costly damages. Since most people can’t afford to simply replace their totaled vehicle out of pocket or pay for another driver’s emergency medical bills, they share risk with other drivers by purchasing an auto insurance policy.
How car insurance works is that every vehicle owner contributes a monthly fee in exchange for a certain amount of coverage. When one driver gets into an accident, the fees paid by everyone else are put towards their expenses. Ideally, you’ll never be in an accident and won’t need to use your policy. But in the event that something does happen, you’ll have peace of mind knowing the out-of-pocket costs won’t ruin your financial future.
Parts of your car insurance policy and how they work
Before you purchase a policy, you should know how car insurance works in its various components. These are all factors you’ll need to choose when you sign up for coverage.
When you sign up for car insurance, the insurance company will quote you a monthly rate – also known as a premium – that you’ll be expected to pay in exchange for continued coverage. Car insurance premiums are determined by the amount of coverage you purchase and certain risk factors that include your geographic location, the type of car you drive and your personal information.
In the event that you get into an accident or need to make a claim, your insurance policy won’t typically cover the full cost. Before the insurance company covers any damages, you’ll need to pay a deductible, which is a flat rate determined when you purchase your policy.
For example, if the repair bill following an accident is $5,000 and you have a $500 deductible, you’ll need to pay the first $500. The insurance company will pick up the remaining $4,500.
Car insurance doesn’t automatically cover every type of incident related to your vehicle. Policies consist of different types of coverage, which pay for specific damages like bodily injury and property damage. Some types of coverage are required by law while others are optional. If you choose not to purchase a certain type of coverage, you won’t be insured against those damages and will have to pay out of pocket in the event of an accident.
Each type of auto insurance coverage is only valid up to a certain limit, or a dollar amount that you choose when you purchase your policy. In the event that a claim goes over your limit, you’ll be on the hook for the excess amount.
Types of auto insurance
Car insurance policies are made up of several different types of coverage. Most states require drivers to carry certain types of auto insurance, although laws vary by location. Check with the Insurance Information Institute to see which types of insurance are mandatory in your state.
Liability coverage is the most common type of auto insurance that covers expenses for which you are liable or at fault. But just how does liability car insurance work? Generally, there are two types of liability coverage: bodily injury and property damage. If you’re responsible for an accident, bodily injury liability will pay for the other driver’s medical expenses. Property damage liability will cover the repairs to their vehicle and any other property you may have damaged along the way, such as a fence or building.
Since liability insurance won’t cover damages to your own car, many drivers choose to purchase collision insurance. This type of policy pays for repairs to your vehicle in an accident you cause.
Not all auto damages are caused by collisions. If your vehicle is damaged by a natural disaster, hitting an animal, vandalism or theft, the cost of fixing it will only be covered if you have comprehensive insurance.
Personal injury protection
Personal injury protection or PIP insurance is required in some states. It covers the medical expenses of you and any passengers in your vehicle in the event of an accident, regardless of who is at fault.
While most state laws require all licensed drivers to carry insurance coverage, the unfortunate reality is that not all do. Uninsured/underinsured motorist insurance pays for your medical and property damage expenses if you’re in an accident caused by an uninsured driver. It will also pick up the bill if the driver at fault has a policy, but their limit is too low to cover the full amount.
What factors affect your premium?
Every auto insurance company uses their own method to decide how much to charge drivers for insurance. However, most generally look at the same set of variables. According to the Insurance Information Institute, these factors are most likely to affect your auto insurance premium:
- Your policy, including the type of coverage, limit and deductible.
- Your personal information, such as your age, gender and marital status.
- Your location, since some geographic areas have higher rates of theft and accidents.
- Your vehicle, including the make, model, year and any custom equipment.
- Your commute, namely the number of miles you drive to work or school every day.
- Your credit, as credit scores are generally correlated with responsibility as a driver.
Determining how much coverage you need
Every state sets minimum amounts of coverage that drivers are required to carry by law. A common rookie error among new drivers is assuming that the state minimum is sufficient. Unfortunately, this isn’t quite how auto insurance works. If you cause an accident that causes more in damages than your policy limit, you’ll be held responsible for the rest. Legally, your personal assets could eventually be seized to cover the difference.
Here’s an example. Let’s say you’re a New York driver carrying the state minimum of $10,000 in property damage coverage. One night, you hit a patch of ice and skid out of control, crashing into the side of someone’s home. The total damages are $25,000, far in excess of your policy’s $10,000 limit. The homeowner sues you and wins a judgment against your personal assets for the remaining amount. This means you’ll have to come up with the remaining $15,000 out of pocket; if you can’t, the homeowner may be entitled to put a lien on your property or even garnish your wages.
At the end of the day, you should at least carry enough auto insurance coverage to protect your net worth, or the total value of your personal assets minus your debts. This includes the equity you have in your home, your vehicle and any investments or cash savings.
Tips for first-time car insurance buyers
Is it time to buy your first auto insurance policy? Now that you know how car insurance works, you’ll be better prepared to purchase the right plan. Here are a few tips to help get the best coverage and rate:
- Get insurance quotes before purchasing a new vehicle. Some cars are much more expensive to insure than others.
- If you finance your vehicle, ask your lender for their minimum insurance requirements, which differ from state requirements.
- Unless you’re driving an older car with an extremely low replacement value, you should probably purchase collision and comprehensive insurance.
- Consider a higher policy limit if you own property or have high-value financial assets.
- Shop around for rates. You might be surprised at the vastly different quotes you get for the same amount of coverage.
- Your car insurance policy consists of a monthly premium, deductible, coverage type, and policy limit.
- The most common types of car insurance are liability, collision, comprehensive, personal injury protection and uninsured/underinsured motorist.
- Car insurance rates are affected by your policy details, personal information, location, type of vehicle, daily commute and credit score.
Getting car insurance for the first time can be intimidating, especially when you’re uncertain as to how auto insurance works and what type of coverage you need. However, once you’ve picked out a policy, you’ll be able to drive worry-free knowing that you’re covered against the most common dangers on the road.