How Does Car Insurance Work?

What does auto insurance cover?

Woman sits in driver's seat of a car while pulling a seatbelt across her chest
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If you’re a first-time driver or considering a new car insurance company, you may be wondering, “How does car insurance work?” Auto insurance can be confusing. But once you understand the basics, it becomes easier to understand.

Auto insurance is legally required in most states. It also covers unexpected losses and helps avoid out-of-pocket expenses. Getting the most out of your car insurance is easy when you understand how car insurance works, what coverage is and isn’t available, and what to expect.

Pros of Car Insurance
  • Ensures you’re legally driving a car

  • Protects your savings and assets by covering unexpected expenses related to legal, medical, and property claims

  • Can include “extras” for emergencies, including rental reimbursement and towing assistance

  • Protects a significant asset (your car) from loss or serious damage

Cons of Car Insurance
  • Expensive if you have limited driving experience

  • Only carrying the state minimum required by law could lead to serious financial consequences if you’re at fault in an expensive accident

  • Making claims can cause your annual costs to increase

  • Comparing insurance offers, document language, and limitations can be confusing

Do I Need Car Insurance?

You don’t need auto insurance to hold a driver’s license in most states, but the car, truck, RV, or motorcycle you’re driving must be insured. The insurance covers the vehicle and, usually, whoever is authorized to drive the vehicle. 

Driving without required car insurance can have severe legal and financial consequences, such as license loss, jail, accident damages, or car impoundment. Your car insurance costs will be higher as a result. 

More than six million police-reported car crashes are reported annually in the U.S., including personal injury and property damage. Safe driving can help avoid accidents, but you’re never in full control of on-the-road circumstances. Accidents are sometimes unavoidable, as are damages or injury.

Some or all of your auto coverage may extend to any car you might rent, in most cases. Check with your insurance company to find out how your car insurance works with a rental. 

How Does Car Insurance Work?

First, you’ll get an estimate (or quote) for the insurance price (the premium), with several different options based on the maximum protection amounts (coverage). Coverage is based on your state requirements. For example, in some states, the insurance company is required to offer you uninsured motorist coverage. 

You select the protection (coverage) you want and pay the premium of your insurance contract (policy) in monthly, semi-annual, or annual payments.

If you have an accident or want to make a compensation claim, you exchange insurance information with the other driver and contact the police to come to the scene or ask them how to file a report.

With the right coverage, the insurance company takes care of negotiating and paying costs. In some cases, you'll be responsible for a small amount, known as the deductible—the amount you’ve agreed in advance to pay if you make a claim.

When you file a claim, your car insurance premium could go up on the next renewal, because insurance companies take your driving record into account when calculating your premiums. One factor is how many years you’ve had a claims-free history.

In states with “no-fault” insurance laws, each party’s own insurance company covers injury claims, no matter who is “at fault” in the accident. States initiated no-fault laws to reduce lawsuits seeking compensation. No-fault insurance states have different minimum insurance type and amount requirements. 

What Does Car Insurance Cover?

At a minimum, car insurance policies cover your liability (or responsibility for an accident) for bodily injury to others and property damage you cause. Some insurance coverage is mandatory, while other types are optional.  

Only purchasing the minimum in liability insurance could leave you responsible for thousands (or hundreds of thousands) of dollars in damages. The insurance industry and consumer groups recommend a minimum of $100,000 per person and $300,000 per accident in liability insurance.

Here are some common types of coverage:

Bodily injury liability coverage Pays for bodily injuries and other claims if you’re at fault in an accident; may include hospitalization, doctor’s visits, and legal bills. It does not reimburse you for your injuries but covers the other party you injured.
Property liability coverage Protects you from claims from damages you’ve caused to others’ personal property, such as cars, walls, fences, and other objects. It does not cover damage to your vehicle if you’ve been in an accident.
Personal injury protection (PIP) Commonly required in no-fault insurance states, PIP covers injury and economic expenses and losses for you, household relatives, car occupants, and pedestrians.
Medical payments coverage Covers injuries due to a car accident, whether you are at fault or not, for yourself, your family members, or your passengers.
Uninsured and underinsured motorist Covers claims when the driver who hits you is uninsured or underinsured, or if you’re the victim of a hit and run.
Comprehensive coverage Covers damage, other than a collision with another car or object. Some of the risks covered include contact with an animal, fire, theft, vandalism, explosion, earthquake, windstorm, hail, water, flood, riot, and often, glass breakage.
Collision coverage Covers the damage to your car if in a collision with another vehicle or object.
Guaranteed auto protection (GAP)  If you owe more on your leased or heavily financed car than it’s worth at the time of a claim, GAP coverage pays the difference. Also known as lease/loan payoff.

Optional, more customized insurance coverage can include:

Roadside assistance Can cover towing costs, jump-starts, and help with flat tires, among other issues. Coverage varies depending on the insurer, and also known as emergency road service.
Auto glass insurance Glass may be included in comprehensive insurance coverage, but some insurance companies also offer full glass coverage or low- or no-deductible glass coverage.
Rental reimbursement Pays for a rental car while your vehicle is undrivable or being repaired due to a covered claim. Also known as rental reimbursement and transportation expense coverage.
Custom equipment Covers high-value car equipment, such as a stereo or custom wheels.
Mechanical breakdown Covers car repairs for new and leased vehicles, as an alternative to the dealer’s extended warranty.
Rideshare insurance Prevents gaps in coverage when a personal vehicle provides rideshare or delivery services.

How Car Insurance Is Priced

Car insurance is priced based on your personal information, driving experience, and specific details about your car. The insurance company calculates a base insurance rate and then applies discounts, credits, or surcharges depending on your circumstances. The insurance company calculates your premium for a set term, such as six months or one year. 

To determine how much to charge you, insurance companies could use some or all of these factors:

  • Your age, address, driving history, marital status, and insurability or credit score 
  • All the car’s drivers and their driving histories 
  • Accidents, tickets, or violations
  • Car use (commuting, travel, business)
  • Car type (make, model, and year)
  • Value of the car and any car modifications
  • Anti-theft devices
  • The total coverage amount 
  • Your deductible 

A higher deductible lowers the price of your premium. For example, your collision and comprehensive premiums may be cut by 40% or more by increasing your deductible to $1,000, with some insurance companies.

Car Insurance Discounts

Each car insurance company offers discounts. One car insurance may provide a lower rate based on how you use your car, while another may not. Quotes from different insurance companies will give you the best price for your unique situation.

Examples of car insurance discounts:

  • Payment discounts (including paying the premium in full, paperless statements, autopay)
  • Plan renewal or loyalty discounts
  • Good student discounts
  • Defensive driver course or safe drive discounts 
  • Discounts for bundling more than one car, or multiple policies (home, renters) 
  • Discounts for keeping your car in storage
  • Discounts for anti-theft devices
  • New car discounts
  • App-based or usage-based insurance discounts
  • Military, union, or other job-related discounts

If your situation changes during the year and you’re now eligible for a potential discount, call your agent to see if they can apply it. For example, now you’re a good student with straight A’s—and you weren’t before. 

How to Get Car Insurance

First, you’ll get a quote (or estimate) by providing an insurance company, independent agent, or broker with the necessary information about your car, including the make, model, and year, and your personal information. You can usually get several auto insurance quotes in a few minutes, and in most cases, get a policy issued right away or on the same day. Most insurance company websites can provide an online quote. 

Before buying a new or used car, check with various insurance agents to get quotes. Some used vehicles are almost uninsurable due to expensive parts, or the likelihood of theft. 

The insurance price is locked in for a set time period (term). When the policy renews, the price may change again if there have been changes. If you choose to change insurance companies partially through the period for a lower rate elsewhere, you may receive a refund and face penalties. 

Bottom Line/Key Takeaways

  • Car insurance is a requirement for driving a car in the U.S. 
  • There are a variety of insurance options 
  • Requirements for car insurance vary by state
  • The cost of car insurance varies by insurer, so shop around for the best price
  • Higher deductibles can save you 40% or more on car insurance

Article Sources

  1. NHTSA. "National Statistics." Accessed Sept. 17, 2020.

  2. Insurance Information Institute. "Five Insurance Mistakes to Avoid... and Still Save Money." Accessed Sept. 17, 2020.