A few years back, I got a tidy little lesson in exactly what collision coverage is. We'd had a car damaged in an accident, damaged pretty badly. So, it wasn't a surprise when the insurance company called and said they were going to total the car. Fortunately, we checked over the paperwork they sent.

It turned out that the appraiser had made an error--he thought the car was two years older than it actually was. Not only did that make a difference in how big of a check we had coming, it actually changed their decision: the book value of a car two years newer was high enough that it was cheaper to fix the car, and that's what they did. We've been driving it ever since--something like ten years now.

That's what collision insurance is: a promise to pay a very specific amount of money, and the ceiling for that amount is the book value of your car, minus the deductible. (The amount of the premium is based on the assumption that your car is an average car of its type. If it is somehow better-than-average, the time to make that case is before your car is in an accident.) Every year it's a promise to pay less money (as your car depreciates). And, of course, its value drops to zero if you don't pay the premium.

The insurance company is out to make a profit, of course, and (aside from the interest they earn between when the premiums are paid in and the claims are paid out) there are only two ways to make a profit in the insurance business:

1. they can charge premiums that are more than their customers losses
2. they can pay out claims that are less than their customers losses

In the real world, of course, they do a little of both, but a combination of competition, regulation, and lawsuits means there are some limits. By and large, premiums are just a bit more than "fair" and payments on claims just a bit less. But that's the point: anytime you pay for more insurance than you need, you're handing the insurance company a bit of extra profit.

After the insurance company paid to fix our car, I took a hard look at what they might have paid if the car had been damaged just a little more, then dropped the collision coverage and started banking the difference that made in the premium. By now we've saved much more than the car is worth. And that'll always be true. Over time, what you pay in premiums will always be greater than you'll get back in claims. The only way you'll come close is to have claims that are either large or numerous--and in either of those cases, you can be sure that the insurance company will raise your premiums enough to put you right back where they want you.

The rule is, take the risks you can bear, and insure the ones you can't. Look up the book value of your car: that, minus the deductible, is the most the insurance company will pay. If you had to cough up that much money, would it break your finances? If not, then drop collision altogether. Otherwise, you need at least some collision coverage. (Of course, if your car isn't paid off, the bank will insist that you insure it. Another good reason to pay it off as quickly as possible--you not only get out from under the car payment, you can get out from under the collision premium as well.)

How much coverage do you need? Probably not enough to make you whole again--that would amount to carrying a zero deductible. Instead, you want the highest deductible you can safely afford. Think about what your options would actually be, if your car got totaled. Could you get by without replacing that car? Could you get by with a cheaper car? Figure out the rock-bottom you could make do with, and set your deductible appropriately.

Ask your insurance company or agent how much your premium will go down. Even in the first year you're not actually facing that "rock-bottom" scenario, because you've got the saved premium on top of that. Punch that amount into a financial calculator and see how quickly the saved premium, plus interest, adds up to the book value of your car. After a very few years, you'll be able to raise the deductible again. Very soon after that, you won't need collision coverage at all.

Take the risks you can bear and insure the rest. That's the rule.

And, as a bonus: if you self-insure, you don't have to worry about getting cheated and you won't have to hire an attorney to sue yourself for trying to low-ball you on the estimate.