Rachael Brennan has been working in the insurance industry since 2006 when she began working as a licensed insurance representative for 21st Century Insurance, during which time she earned her Property and Casualty license in all 50 states. After several years she expanded her insurance expertise, earning her license in Health and AD&D insurance as well. She has worked for small health insuran...

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Chris Harrigan has an economic degree from Limestone College and an MBA from Clemson University. He previously managed auto insurance claims for Enterprise Rent-A-Car. Currently, he is using his business and insurance expertise to provide insurance data analysis and visualizations to enhance the user experience.

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Reviewed by Chris Harrigan
Former Auto Insurance Claims Manager Chris Harrigan

UPDATED: Oct 14, 2020

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Key takeaways...

  • Insurance companies take the risk and spread it out between policyholders
  • Companies invest premiums in addition to paying expenses and claims with the funds
  • They protect profit levels by carefully determining premiums and minimizing risks through policy limits

When you understand how car insurance works, you can make more informed decisions about your policy and choose the right coverage levels.

When you start looking at prices and rates, remember the basics of car insurance so that you can find the right plan for your unique needs. Enter your zip code in our FREE tool above!

The Shared Risk

Auto insurance is essentially a group of people who agree to share risks in order to protect their own assets. According to the Insurance Institute of Michigan, or the IIM, the idea has actually been around for centuries.

It started with the sailing ships of past eras. If one ship sank, each person lost a small percentage rather than risking complete financial ruin.

When you sign up for a policy, you’re essentially agreeing to a binding legal contract that spells out what will be covered and what types of situations will not be covered.

It’s important to read the fine print so that you’ll know when to file a claim and when you’ll have to cover damages on your own.

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Where the Premiums Go

The IIM encourages people to consider where the premiums go. All of the funds collected is not simply put in an account to cover different accidents or events.

In fact, there are actually three ways that the insurance company will use your premiums.

  • Money is pooled to cover claims
  • Expenses are covered, including payroll and overhead
  • Funds are pooled and invested to help keep the costs for policyholders down

Setting the Rates

One of the most challenging aspects of underwriting insurance is determining what amount each person will pay. The premium is based on several factors, including driver experience, type of car insured, age, and location.

If you want to save on your insurance premiums, then you should focus on maintaining a clean driving record and choosing cars with good safety ratings.

Before you buy a car, you may want to call your insurance provider to see how your rates might change based on the specific vehicle you’re looking at.

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The Necessary Coverage

Even if you’re an excellent driver, you still need car insurance. Remember that while you can control your own actions, you cannot control other drivers. Insurance protects you in the event that someone runs a light or is driving aggressively.

States require drivers to carry a certain amount of liability coverage to protect other people on the road. Liability coverage includes three components:

  • Bodily injury liability for injuries to other people as the result of your own negligence
  • Property damage liability to have the other vehicles repaired
  • Uninsured motorist coverage in case another driver does not have the necessary insurance

However, this isn’t all the coverage you would need. You’ll also require protection for your own vehicle in the event that you sustain damage in an accident. There are two different levels of protection available for your own ride, including:

  • Collision coverage for damages resulting from an accident
  • Comprehensive coverage for damages resulting from other events like falling objects, storms, or vandals

As you add coverages to your plan, your premium amount will rise. You can easily lower your bill by dropping these protections, but that may not be the most cost-effective choice.

Lienholders of financed cars usually demand that the vehicles carry comprehensive and collision.

You’ll also appreciate that peace of mind that comes with knowing you’re covered in case of an emergency. If you’re worried about the rise in premiums, then take a closer look at your deductible.

If you can set aside $500 or $1,000 for a higher deductible, then you can shop around for a much more attractive premium.

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Choosing A Company Based on Stability

It is possible for insurance companies to go out of business, so it’s wise to look for a company with a solid financial rating and a strong background.

Unlike other companies that go out of business and their customers just have to find a new supplier, there are special guidelines in place for the insurance industry.

Each state has a Department of Insurance that monitors the strength of companies headquartered in their region. If they believe that a company is at risk of failure, the department or State Commissioner will step in to intervene.

In the event that a company cannot be saved, then the state will oversee a liquidation process.

Once it becomes clear that a company will cease operations, the current policyholders will either be covered through an insurance guaranty association or the association will have the policy transferred to a stable company.

Claims will continue to be covered through the liquidation process or by other insurers who are providing services in the state.

It’s impossible to know the future, and even the most stable companies can fall on hard times. However, the Better Business Bureau encourages people to look at a company’s financial rating with agencies like:

  • Moody’s
  • Standards and Poor’s
  • A.M. Best

You can also check with the state to ensure that a company is properly licensed to do business in that area.

Maintaining Profit Levels

Insurance companies are ultimately in the business of making money, so that means that they need to minimize their own risks. They accomplish this through policy limits. These limits are outlined in your policy, and they clearly state the maximum amount that will be paid for each type of occurrence.

If you have a personal property limit of $10,000, then the insurance company will only pay out up to that $10,000, even if the damage caused is actually closer to $40,000.

There are also limits per person and per occurrence that can be applied. This type of distinction is used to clarify how much money might be paid to any one person in an accident or towards damages on any one vehicle.

Before choosing your policy limits, you should take a look at your personal assets. You want to be sure that your assets will be shielded in the event that you cause an accident. You may pay a little more for the coverage, but you’ll have the protection that you need.

When you’re in the market for a new insurance plan, take the time to compare different companies. They all work in basically the same manner, but some have a better financial rating than others.

In addition to finding rates you can afford, you also want to look for a company that’s experienced and has an excellent customer service record. Compare car insurance rates now by using our FREE tool below!