Nearly 230 million licensed drivers travel American roadways throughout the U.S., but most of the ones with car insurance probably don’t understand their coverage. The truth is that insurance policies make for dull reading, but we can help.

Instead of rolling out a whole policy, we’ll focus on the basics you should know about car insurance. With a better understanding of how each element of your car insurance works, you can make a well-educated  buying decision, protecting your vehicle while also safeguarding against liability risks.

This article will cover:

At its simplest level, insurance is the transfer of risk. In the case of auto insurance, we’re transferring risk away from ourselves as individuals to an insured group. The policyholders for an individual insurance company are the insured group.

We all pay premiums, but we won’t all have a loss simultaneously.

At an individual level, it’s impossible to predict if or when we’ll have a loss. We also don’t know how much it will cost. However, when insuring through a larger group, we can put probability and statistics to work to determine how much each insured person should pay to cover the collective risk for the group.

The premiums we pay cover the claims for those within the insured group when they have a loss.

If or when we have a loss ourselves, the premiums paid by the insured group cover our losses —but only for coverage types we’ve purchased with the policy. For example, if you don’t have collision coverage for your car, your policy can’t help pay for repairs to your car when you are at fault.

A recent study from AAA estimated the average cost for insuring a new car at $1,342 per year. Your actual premiums will vary based on many factors including the coverages you select, but this figure offers a helpful way to understand how premiums pay for claims.

AAA’s average car insurance cost includes full coverage for a 2021 model vehicle. The $1,342 average cost represents an average for drivers under age 65 who live in the suburbs and have a clean accident history.

The Insurance Information Institute (III) reports the following average loss amounts for 2020:

Although $1,342 can seem like a lot to pay for car insurance (on average), the number pales in comparison to the average bodily injury liability claim at over $20,000. It’s also worth noting that many accidents resulting in injuries can be much costlier.

The many policyholders paying $1,342 each year make it possible to cover the claim for over $20,000 in this example.

That $1,342 average premium is also well below the average loss for property damage liability, collision damage, or comprehensive claims.

Lenders usually require physical damage coverage, but individual states focus car insurance requirements on liability coverage.

Requirements and available coverages can also vary by state, but coverage types fall into the categories below.

Both collision and comprehensive insurance fall under physical damage coverage. Collision claims averaged $3,588, while comprehensive claims averaged $1,995 in 2020, according to III data.

Physical damage coverage is not required by law. However, lenders and leasing companies typically require physical damage coverage as an auto loan or lease condition.

From a lender’s perspective, at least part of the car still belongs to them. Physical damage coverage protects the lender’s financial interest in the vehicle but also protects the policyholder from financial losses due to damage.

Full-coverage auto insurance refers to physical damage coverage combined with required coverages, such as auto liability or medical insurance.

Most states require drivers to carry auto insurance, and auto liability insurance is one type of coverage required by law. Liability refers to our financial responsibility to others.

For example, let’s say you accidentally hit the car in front of you at a stoplight. In most situations, you’d be found at fault in that accident, likely causing you to become liable for damage to the other vehicle or injuries caused to the occupants of the other vehicle.

Recent statistics from the National Highway Traffic Safety Administration show nearly two million auto-related accidents per year that result in injuries. The III reports an average claim amount of over $20,000 for bodily injury liability claims and nearly $5,000 for property damage claims.

The numbers can add up quickly, especially for injuries, which is why most states require drivers to carry coverage.

Auto liability insurance covers two specific risks:

Although bodily injury liability is largely self-explanatory, property damage liability isn’t always well understood. Property damage liability pays for damage to the property of others. This can include other cars as well as street signs, guard rails, traffic lamps, or even buildings.

Liability insurance requirements vary by state, but it’s often best to choose a coverage limit above the minimum state requirements.

For example, in New Jersey and a few other states, the minimum requirements are as follow:

New Jersey’s required bodily injury liability coverage per person is lower than the average claim amount of over $20,000, according to III data. The other factor to bear in mind is that the III figures are average claim amounts. Some claims reach totals much higher than average.

State minimum coverage limits may not be enough to protect you financially. Fortunately, you can choose higher liability coverage limits.

Car insurance is governed at the state level. While most elements of an auto policy are similar from one state to the next, each state sets its own requirements. Medical coverage is the area in which states tend to differ from their neighbors.

Some states require medical coverage for you and your passengers; others do not.

Medical coverage options also vary by state, with some states offering personal injury protection (PIP) and others offering medical payments (med pay) coverage.

These options provide a way to pay for medical needs for you or your passengers if injured in a car accident.

Of the two, med pay is the simpler structure and pays for medical expenses if you are at fault in an accident, up to the coverage limit you choose. If you are not at fault, the other driver’s liability insurance should cover your medical expenses.

By comparison, PIP pays for medical expenses regardless of who is at fault in an accident. PIP also extends coverage options to include additional costs such as lost wages and other expenses directly caused by an auto-related injury.

Percentages vary wildly by state, with Mississippi having the highest percentage of uninsured drivers (29.4 percent in 2019) and New Jersey having the lowest (3.9 percent). Overall, the Insurance Research Council says that about 1 in 8 drivers is uninsured.

A higher number of drivers likely don’t have enough coverage. These drivers are referred to as underinsured motorists. The tricky part of the calculation is that we often don’t realize we are underinsured until faced with a loss that exceeds our coverage limits.

Uninsured and underinsured motorist protection, required in some states, offers a way for your own insurance policy to provide coverage if an uninsured or underinsured driver causes a loss they can’t cover.

Where required, you may need to carry the same coverage limits you choose for your liability coverage. In effect, UM and UIM provide protection for you, even though the coverage is triggered by the liability of other drivers (and their inability to cover that liability through an insurance policy).

Most car insurance policies also offer add-ons or options. You’ll often see some of these referred to as riders or endorsements. However, some might actually be separate products that are billed with your premium but are not part of an insurance policy.

Here are some of the most common car insurance add-ons:

Your car insurance policy provides protection up to the coverage limits you’ve chosen, but two types of coverage are determined by market value instead. On a standard auto insurance policy, both collision and comprehensive insurance use your vehicle’s value as a coverage limit.

Like many other types of insurance, car insurance uses deductibles to keep premiums more affordable for everyone. As the name suggests, the deductible is “deducted” from your claim settlement. However, not all coverage types use deductibles. For example, liability coverage does not use a deductible.

Choose a deductible you can afford to pay for collision and comprehensive insurance. Medical coverage may also use a deductible.

Car insurance policies don’t cover everything. Your policy also has a section that details coverage exclusions. These exclusions can vary by insurer but usually follow a similar pattern.

We all grumble when the car insurance bill arrives, but your policy can protect you in ways that aren’t always obvious. With full coverage, you can protect both your car and your finances by insuring against impossible-to-predict liabilities.

It’s wise to review your coverage about once per year with a trusted agent. Life changes and your coverage might need to change as well.

Take the opportunity to occasionally compare rates, as well. Although car insurance companies use similar factors to determine rates, each company might weigh these factors differently.

Car insurance can seem expensive, especially if you haven’t had a claim recently. But not having coverage that’s well matched to your needs can be much costlier.