How Auto Insurance Companies Work

A driver, known to an auto insurance company as a policyholder, makes a monthly payment, or premium, to the company. If a driver gets into an accident that requires extensive repairs, he reports this to his insurance company, which then issues a claim payment to the driver, after the driver pays a deductible. How this works: Say a driver pays a monthly premium of $80 on a policy with a $5,000 deductible. That person then gets into an accident, which results in $6,000 in damages to the vehicle. The driver would have to pay the first $5,000 out-of-pocket to repair the vehicle; the auto insurance would then cover the remaining $1,000 balance. Conversely, a higher premium would lead to a lower, more desirable deductible, because the driver has put more cash to the insurance company upfront.

The cost of a policy differs among drivers. Factors such as credit history and driving record help an insurer determine how much of a risk the driver may be. This helps make sure that the money coming into the insurance company from the driver is going to be proportional to the possibility of money going out later, based on the frequency and severity of the claims of similar drivers in the past. If a driver with three accidents signs up for a $30,000 comprehensive plan (more on that below), a driver with a perfect driving record and credit would actually pay a lower premium for the same policy.

Auto insurance companies provide a variety of coverage, with each option adding to the premium cost. Collision coverage covers for damage to the insured driver's car in the event of a collision with another car, even if the driver is at fault. (If the driver isn't at fault, the driver's auto insurance company will try to get the cost of repairs paid for by the other driver's insurance company.) Property damage liability covers damages to other property, such as to a building. Personal injury protection coverage pays medical bills if the driver and passengers are injured in an accident. This is different from bodily injury liability, which provides assistance in the event that another driver or passenger in another car is injured in an accident caused by the policyholder. Finally, comprehensive coverage does not mean that a policy covers "everything." It's a clause that insures the car even when it isn't being driven -- a garage fire that destroys the vehicle, for example.

It might seem that after deductibles were paid out, insurance companies end up footing the bill a lot of the time. So how do they make money? Read on to see how insurance companies profit even with charging moderate fees and making large repair payouts.

In most consumer activities, the customer exchanges money for a product or quickly performed service. Auto insurance is different: The customer pays a fee to the insurance company, and the insurance company maybe provides a service or financial assistance at some point (although if the service is never rendered, both the consumer and the company would probably be pleased).

Auto insurance companies make money through a combination of managed risk and the strategic use of money. Insurers associate together large swaths of their policyholders into "groups" via the risk-assessment criteria discussed earlier -- type of car, driving record, and so on. Out of each group, it's likely that a very small percentage of these policyholders will endure a car accident severe enough to file a claim during the coverage period.

But say that one policyholder in the group does get into an accident that results in a $50,000 payout by the insurance company. Then, imagine that that policyholder has been a client of the insurance company at that point for five years, and has paid a monthly premium of $100. That person has then brought in $6,000 to the insurance company. That would be a direct loss of $44,000 to the insurance company -- except it wouldn't be. That's because managed risk spreads the short-term financial burden out over the rest of the group, the remaining members of which, in this scenario, haven't received any payouts that cost the insurance company money.

Further, insurance companies are essentially financial institutions: They take in money and dole out money, just like a bank does. (Many insurance companies are even branches of large banking conglomerates.) Also, like a bank, they invest the money of its customers and policyholders in interest-earning investments. While the shared risk approach allows for large sums of cash on hand for claims payouts, investments are a long-term financial strategy, to make sure that the insurance company will have cash on hand for payouts years down the line.

Finally, and most directly noticeable to the policyholder, insurance companies' auto insurance policies limit payouts. Limits of liability are set to match the premium rate paid. For example, if the driver pays a $50 monthly premium, he may have a $10,000 liability cap; if he pays $200 a month, the insurer may enable a $50,000 liability cap. This means that the auto insurance company won't pay for damages or medical bills beyond a specific amount that the driver agrees upon.

Next: how to file a claim with an auto insurance company.

Thankfully, the vast majority of drivers will never suffer an accident severe enough to file a claim for reimbursement from their auto insurance company. But when a car accident does occur, and the damage is moderate to severe or expensive, a policyholder should take the right steps to file a claim.

At the scene of the accident, file a police report and collect witness statements. This will provide an official, legal record of events, which is important for the insurance company calculating the claim, and if the driver at fault is sued at a later date. And, of course, seek medical attention if necessary. Next, drivers should exchange personal and auto insurance information. Remember that it's important to carry an auto insurance company policy card in the vehicle for just this purpose. The driver should then contact his insurance company as soon as possible, even right from the scene. The company will walk the frazzled driver through the process and collect the necessary information -- policy number, accident details, other driver details, and so on. The driver should do this even if he's not at fault in the accident, but one should always let the other driver know, if applicable, that a claim is being pursued.

Traditionally, the next step is that an adjuster from the insurance company will meet with the driver to assess damage to the vehicle (and perhaps the driver) and estimate how much it will cost to repair the vehicle or replace it, if it was totaled. (Companies pay out "actual cash value," or ACV, which is what the car would have sold for at auction, pre-accident. This usually happens if the repairs total 80 percent or more of the car's ACV.) The adjuster will then decide on the amount due and report that to the auto insurance company, which then cuts a check, minus the policy's collision deductible.

However, the driver may never see an adjuster. Some insurance companies employ a network of affiliate mechanics and auto repair shops. All have agreed to standard costs of repair. This means that instead of an adjuster, the auto insurance company will recommend a shop. The driver then goes to that shop, which will send a repair/replace estimate to the driver's insurance company, which then goes through the process of cutting a check minus the deductible.

Two notes: Drivers may use any auto body shop they wish, by law, not just the ones recommended and affiliated with their auto insurance company. Secondly, it's illegal in some places for insurance companies to cancel a policy after an accident, but the driver should be prepared for coverage rates to rise. The driver's risk and financial burden just went up -- and auto insurance is a business, after all.

For lots more information on the insurance industry, see the links on the next page.