Car insurance costs leave many people wondering if the whole thing is just a scam to make money out of us. But is it?
Why is car insurance a legal requirement?
As in many countries around the world, if you want to drive a vehicle on a public road then the law states you must have insurance, with Third Party insurance being the minimum level of required cover.
Driving a car without insurance is illegal and can get you 6 points on your license and a police fine of £300. Worse, if the case ends up in court, you could be disqualified and the fine amount is unlimited. In certain cases the police have powers to seize the vehicle and even destroy it!
The reason car insurance is a legal requirement is to financially protect you, other road users, pedestrians and property in the event of an accident.
Severe car accidents can result in life changing injuries. Such injuries may require expensive rehabilitation, on-going medical bills or even a lifetime of care where the accident has caused disability and/or brain injuries.
The costs associated for such injuries can run into millions of pounds. The vast majority of us cannot afford to be sued for such amounts, it would leave us financially broken and more importantly, the victim left without compensation to pay for care. Therefore, it’s in all our interests that everybody who drives on a pubic road has car insurance.
Do car insurance companies take advantage of us?
The next question is whether car insurance companies take advantage of this necessary legal requirement and overcharge customers?
Believe it or not, making money in car insurance is a very difficult business. Many firms operate on thin margins where a small change in the frequency of claims, an increase in claims costs such as repair work or in increase in internal expenses such as salaries, computer systems and marketing, can make the difference between an acceptable profit or a huge loss.
At this point it’s important to make the difference between an actual insurance company and an insurance broker.
A broker is essentially selling insurance company products for commission. The broker is not taking on any of the risk exposure. An insurance broker may take 10% or 15% of any policy sold.
For example, if you buy a car insurance policy through a broker for £500 (the current average cost), then the broker could be keeping £50 to £75 of that in commission, with the rest being sent to the insurance company taking on the risk.
With this is mind, the insurance company has already forked out in paying the broker their commission. Now they have to hope that the policyholder does not make a claim.
According to the ABI (Association of British Insurers), the average cost of a claim is around £3,000 and the average personal injury cost around £11,000. The average claims frequency is around 10% i.e. on average, 10 out of every 100 people make a claim.
The car insurance business model
With all that in mind, let’s use these basic numbers in seeing how much profit, or loss, a car insurance company can make.
Let’s assume they sell 100 policies at an average of £500 = £50,000
The broker takes about 10% i.e. £5,000 which leaves £45,000.
Other internal expenses (staff, systems etc.) are around 20% i.e. approx. £9k
That leaves around £36,000.
Claims frequency of 10% = 10 claims x £3,000 (avg. claims cost) = £30,000.
That leaves around £6,000.
On top of that, insurance companies also pay what is called re-insurance. Essentially this is an insurance policy they take out for themselves against the possibility of exceptionally high individual claims such as lifetime care and compensation claims that can run into tens of millions. A re-insurance policy usually pays for the portion of a claim above a certain limit.
For this example we haven't even included any potentially expensive personally injury claims which could wipe out any profit altogether.
This leaves the final amount at or near zero.
So, you can see a difference in costs anywhere along this chain can make or break the profitability of an insurance company.
This is why insurance companies either try and avoid taking on high risks such as young drivers or compensate for it by increasing the price on these policies.
So, is car insurance a scam?
No, car insurance is not a scam. Car insurance is there to protect you and others in the event of an accident. The price of car insurance is determined by the individual risk profile, the potential costs incurred by the insurance company for any claim and the requirement of the business to try and make a profit and avoid a loss.
Making money from car insurance is hard. This is not to say that some companies don’t operate what might be called sharp practice in terms of their marketing for example or even their renewal prices. However, the industry is highly regulated and companies are extremely careful not to breach the law.
The car insurance market is a highly competitive one and unlike the old days where you had to physically visit a high street branch to buy a policy, you can now instantly compare hundreds of policies and quotes online to find the cheapest.
Loyalty rarely pays these days and switching your provider year to year can prove very cost effective and save you a lot of money.