How Does Auto Insurance Work? Everything You Need To Know

Auto Insurance – Millions of licensed drivers share the roads, yet many of those with car insurance may need to comprehend what their policies encompass fully. Reading through insurance policies can be tedious, but we are here to assist.

We won’t delve into the intricacies of a complete policy here; instead, we will focus on the fundamental aspects of car insurance that every policyholder should grasp, with a better understanding of how each component of your auto insurance functions, you’ll be better equipped to make informed decisions when purchasing coverage, ensuring your vehicle’s protection and guarding against liability risks.

A Brief Overview Of Auto Insurance

At its core, insurance is the transfer of risk. In the context of auto insurance, it involves shifting risk from an individual to a group of insured individuals, wherein this insured group comprises policyholders of individual insurance companies.

While all group members pay premiums, not all will experience losses simultaneously.
On a personal level, it is impossible to predict when or if we will encounter a loss and its associated cost.

However, when we insure through a collective group, statistical probability enables us to determine the amount each insured person should contribute to cover the collective risk of the group.

When a member of the insured group incurs a loss, the premiums paid by all members collectively cover their claims.

Nevertheless, our coverage extends only to the specific coverages we have chosen within the policy.

For instance, if you lack collision coverage for your vehicle, your policy won’t assist you in covering repair costs when you are at fault.

According to a recent AAA study, the average annual cost of auto insurance for a new vehicle was estimated at $1,342.

While the specific coverage you select will influence your actual premiums, this figure is useful for understanding how premiums contribute to claims.

This average cost for car insurance, including full coverage for a 2021 model, applies to drivers under 65 residing in suburban areas who have never been involved in an accident.

Auto Insurance Coverage Types

Lenders typically mandate physical damage coverage, but individual state auto insurance requirements primarily emphasize liability coverage.

Coverage types can be categorized as follows, though state-specific requirements and available coverages may vary:

Physical Damage Coverage

Physical damage coverage encompasses comprehensive insurance and collision insurance. In 2020, comprehensive claims averaged $1,995, while collision claims averaged $3,588, according to the Insurance Information Institute (III) data.


This coverage handles damage resulting from a collision with another vehicle or a stationary object, including damage from rollovers.


Also known as “other-than-collision coverage,” comprehensive insurance covers damage arising from incidents other than collisions.

It includes vandalism, broken glass, theft, damage from falling or flying objects, fires, floods, and similar occurrences. Comprehensive insurance also covers damage caused by animals.

Although the law does not mandate physical damage coverage, lenders and leasing companies often require it for auto loans and leases.

In such cases, a portion of the vehicle still belongs to the lender, and physical damage coverage safeguards the lender’s financial interest in the vehicle and the policyholder’s financial losses due to damage.

“Full-coverage auto insurance” typically refers to coverage for physical damage in addition to mandatory coverage such as auto liability and medical insurance.

Liability Insurance

Auto liability insurance is a legally mandated coverage in most states, and drivers must carry it. It pertains to our financial responsibilities toward others and comes into play when we are at fault in an accident.

For example, suppose you accidentally rear-end the vehicle in front of you at a stoplight. In that case, you are likely to be deemed at fault for the accident, making you liable for any injuries or damage suffered by the other vehicle’s occupants.

According to the most recent statistics from the National Highway Traffic Safety Administration, nearly two million car-related accidents result in injuries each year.

Bodily injury liability claims average over $20,000, and property damage claims average nearly $5,000, as reported by the III.

Auto liability insurance covers two specific perils:

  • Bodily Injury Liability: This coverage pertains to injuries inflicted upon others due to your actions.
  • Property Damage Liability: Property damage liability covers damage to others’ property, including other vehicles, street signs, guardrails, traffic lights, and buildings.

While each state establishes its requirements for liability insurance, it is generally advisable to opt for coverage limits that exceed the state’s minimum mandates.

The minimum requirements in some states may need to provide more financial protection, as they may not align with the actual costs that can accrue, especially in cases of severe accidents where claims can substantially exceed minimum limits.

For instance, the minimum liability requirements in New Jersey and some other states are as follows:

  • Liability for Bodily Injury (per person): $15,000
  • Liability for Bodily Injury (per occurrence): $30,000
  • Liability for Property Damage (per occurrence): $5,000

It’s worth noting that New Jersey’s required bodily injury liability coverage per person falls below the average claim amount of over $20,000.

Furthermore, average claim amounts are just that—averages. Some claims can far surpass these figures.

As such, your state’s minimum liability coverage limits may not suffice for comprehensive financial protection. Fortunately, higher liability coverage limits are readily available.

Medical Coverage

State laws dictate automobile insurance requirements, and while most aspects of a car insurance policy remain consistent across states, variations often emerge concerning medical coverage.

Some states necessitate medical insurance for you and your passengers, while others do not. State-specific disparities in medical coverage options may encompass Personal Injury Protection (PIP) and Medical Payments (Med Pay) coverage.

These options come into play when you or your passengers incur medical expenses following a car accident.

Med Pay is the simplest of the two, covering your medical costs up to the coverage limit you choose if you are at fault in an accident.

If you are not at fault, the other driver’s liability insurance should cover your medical bills.

Conversely, PIP covers medical expenses regardless of fault and includes additional expenses directly linked to an auto accident, such as lost wages.

Add-Ons And Riders

Most auto insurance policies offer additional options or add-ons, some of which may be called riders or endorsements. While some are billed separately from your insurance policy, they are included in your premium.

Common add-ons for car insurance encompass:

Rental Reimbursement

This coverage assists with the cost of renting a replacement vehicle if you have a covered claim.

Ridesharing Endorsement

Designed for those who drive for ride-hailing companies like Uber or Lyft, this endorsement bridges coverage gaps when logged into the app but still needs a passenger.

Gap Insurance

This coverage may cover the difference between the insured value of your vehicle and the amount owed to the lender in the event of a total loss.

Roadside Assistance

Various insurers provide services such as towing, jump starts, roadside repairs, and fuel delivery.

Car Insurance Coverage Limits

Two types of coverage rely on market value rather than specified coverage limits within your auto insurance policy.

These coverages protect up to the limits defined by your vehicle’s value for collision and comprehensive coverage.

Physical Damage Coverage Limits

Over time, the coverage limit for your vehicle decreases in tandem with its depreciating value. Consequently, the insurer covers the loss—the depreciated value—rather than the cost of replacing your vehicle.

Liability Coverage Limits

While your state may impose minimum liability limits, you can opt for higher limits or augment your coverage with an umbrella policy.

In the event of a liability judgment, the availability of sufficient funds to cover your losses or damages may not be considered.

As such, the money you owe after a car accident can impact your savings or future earnings.

Car Insurance Deductibles

Like many other forms of insurance, auto insurance employs deductibles to maintain lower premiums for all policyholders.

As the name implies, the deductible amount is subtracted from your claim settlement.

However, not all types of coverage employ deductibles; for instance, liability coverage does not.

It is advisable to select an affordable deductible for collision and comprehensive insurance. Medical coverage may also involve a deductible.

Car Insurance Exclusions

Auto insurance policies do not cover everything; they typically include an exclusions section. While exclusions can vary from insurer to insurer, they generally adhere to a common pattern.

Business Use

Personal insurance policies do not cover risks associated with business activities. If you employ your vehicle for business purposes, discussing your coverage requirements with a reputable agent is essential. You can often add a rider for coverage tailored to your specific usage.


Claims arising from race-related activities are not covered by auto insurance.

Illegal Acts

Auto insurance policies do not cover claims stemming from illegal activities. While this may be a minor consideration, it’s worth noting that auto insurance does not cover individuals fleeing from the scene of a bank robbery, as depicted in movies.

Mechanical System Damage or Failure

Auto insurance policies do not cover wear and tear and mechanical failures. In such cases, consider establishing a savings account to cover expenses associated with your vehicle’s ageing.

How Your Auto Insurance Protects You

Despite the frustration that often accompanies the payment of auto insurance premiums, your policy can shield you in subtle yet significant ways.

By safeguarding against unpredictable liabilities, comprehensive coverage protects your vehicle and financial security.

Engaging in an annual conversation with a reputable insurance agent to evaluate your coverage is advisable. Your insurance needs may evolve, necessitating adjustments to your policy.

Furthermore, take advantage of opportunities to compare insurance rates periodically. While car insurance companies use similar factors to determine rates, the weighting of these factors can vary among insurers.

Consequently, even if you haven’t filed a claim recently, auto insurance may seem costly; however, not having appropriate coverage can prove far more expensive.

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