Drivers are paying £225m extra a year for car insurance because insurers are inflating costs for repairs and hire vehicles, the Office of Fair Trading said as it announced its intention to refer the market to the Competition Commission.

Motor insurance premiums rose by 12% between 2009 and 2010, and by a further 9% in the first three quarters of 2011, according to the OFT.

It has now concluded that a large part of that increase is down to insurers inflating the costs of providing replacement vehicles to not-at-fault drivers following an accident. In some cases the cost of these is more than £1,000 above the going rate.

"Competition in this market does not appear to work well for drivers," said John Fingleton, chief executive of the OFT. "We believe the focus that insurers have on gaining the competitive edge through raising their rivals' costs means that drivers pay more than they need to for their motor insurance policies.

"Because insurers are distracted from competing primarily on the quality and value of service provided to insured drivers, incentives for greater efficiency may be reduced."

The announcement follows a three-month period of evidence collection by the OFT after a previous investigation concluded drivers were being overcharged.

Among the evidence provided it discovered that, following an accident, insurers of not-at-fault drivers are adding on average £560 to the cost of a replacement car over a typical hire period.

At the same time they are also paying referral fees of up to £400 to credit hire organisations, the businesses that provide replacement vehicles to drivers involved in accidents. They may also receive a typical £155 in referral fees from repairers, paint suppliers and parts suppliers, with that money clawed back through higher repair charges.

The OFT also found that credit hire agreements tend to run for longer periods than direct hire arrangements, in some cases because the credit hire companies are deliberately delaying repairs.

All these costs are passed on to the insurance company of the at-fault driver, with the end result being an increase in car insurance premiums across the board for drivers.

"There does not appear to be an appropriate, quick fix to these problems," Fingleton said. "We have provisionally decided that a more in-depth investigation by the Competition Commission, which has a range of additional tools at its disposal, may be necessary."

The Association of British Insurers said it welcomed the OFT's announcement. "For too long insurers have faced inflated rates for credit hire cars and excessive hire periods which have led to higher insurance premiums for customers," Nick Starling, ABI's director of general insurance, said. "Regulation of all players in the market to tackle excessive costs is needed."

The Credit Hire Organisation, which represents the credit hire industry, dismissed the OFT's findings saying the rise in insurance premiums was primarily down to a dramatic increase in the number of claims for whiplash.

Director general Martin Andrews said: "The provisional findings from the OFT conclude that the costs of any market dysfunctionality in the UK private motor insurance market place are £225m, representing less than 2% of the insurers' total annual spend of approximately £13bn. Quite clearly, then, the costs of any market dysfunctionality are not the reason for the recent rise in the cost of premiums."

The OFT will announce its final decision in October 2012, and any investigation by the Competition Commission is likely to take a further two years.