Car insurance costs are set to be studied by the Competition Commission after the Office of Fair Trading (OFT) said the market was "dysfunctional".
The OFT says artificially high car hire and repair charges add £225m a year to drivers' premiums and it wants the commission to investigate the sector.
It says some insurers connive with garages and suppliers of courtesy cars to let them charge inflated prices.
The OFT's announcement was welcomed by the Association of British Insurers.
John Fingleton, chief executive of the OFT, warned there was no "quick fix" for the problem, which is why he wanted the Competition Commission to launch a full inquiry.
"Competition in this market does not appear to work well for drivers."
Nick Starling of the Association of British Insurers (ABI) agreed, pointing out that drivers were bearing the cost.
"For too long insurers and people paying premiums have faced inflated rates for credit hire cars and excessive hire periods, which have led to higher premiums," he said.
"There is no control of costs which have run away, and some people have taken advantage of the system," Mr Starling added.
The OFT explained that when a claim is made, the insurer of the "at-fault" driver will have to pay for repairs and temporary car hire for the other driver in the accident.
But these costs are inflated by the insurer of the "not-at-fault" driver arranging artificially expensive car hire deals and repairs.
The insurers do this in return for a lucrative fee from the car hire firm or garage involved.
This made replacement car hire on average £560 more expensive each time, and made each repair on average £155 more expensive as well, the OFT said.
The cost is borne by the insurer of the "at-fault" driver, but is eventually passed on in the form of higher premiums.
"Insurers of the not-at-fault driver and others, such as brokers, credit hire organisations and repairers, can take advantage of this lack of control as an opportunity to generate revenues through rebates and referral fees and so inflate the costs of insurers of at-fault drivers," the OFT explained.
"This is an inefficient way for the sector to operate, raising the total costs for providing private motor insurance which drivers end up paying."
The OFT's decision to refer the car insurance market to the Competition Commission is a provisional one. It will announce its final decision in October 2012.
Which? executive director, Richard Lloyd, said change was needed: "Consumers have been hit time and again with significant increases in costs for their car insurance without seeing increased benefits to their policy.
"We would also welcome an investigation by the Competition Commission to put an end to bad practices and give consumers get a better deal on their car insurance."
The OFT started looking at the cost of repairs and the supply of temporary replacement vehicles in September.
This followed the exposure last year of the covert system of referral fees, under which insurers, in effect, stoke up claims against themselves and thus drive up premiums.
They do this by selling details of their own policy holders' accidents to solicitors, who then encourage those drivers to sue for damages such as whiplash injury.
The Credit Hire Organisation (CHO), which represents car hirers, said the excessive costs identified by the OFT in its latest report were just 2% of the car insurance industry's total spending of £13bn a year.
"The original decision of the OFT to investigate the private motor insurance market came after insurer claims that motor insurance premiums had risen by almost 40% to compensate for the increased costs of personal injury claims (whiplash) and other costs including those of credit hire," said Martin Andrews of the CHO.
"The Transport Select Committee subsequently identified that these claims were unfounded and the rise in premiums was in fact closer to 12% and was caused by the increase in whiplash claims more than any other factor," he added.
Earlier this year, the government said it would take action to cut down on spurious whiplash insurance claims.
The Transport Committee had urged the government to change the law so that such claims could only be paid if there was objective evidence of both an injury and of its having a significant effect on the claimant's life.
These claims alone are thought to cost the insurers £2bn a year and their rapid growth in the UK has made the country the "whiplash capital" of Europe.