An estra £10 per year is being added to every policy by the "dysfunctional" motor insurance market, a trading watchdog has said.

The Office of Fair Trading (OFT) is concerned that insurers are focusing too much on pushing up rivals' costs and it wants to see firms concentrate on the quality and value of the service they provide to customers.

The industry has come under fire for soaring motor insurance premiums, which rose by 12% between 2009 and 2010 and a further 9% in the first three quarters of 2011, at a time when consumers have already been squeezed by high living costs, including rocketing petrol prices.

The OFT estimates the problems it has uncovered cost private motor insurers £225 million last year and mean consumers could be paying an extra £10 per private motor insurance policy.

One of the problems is falsely high charges being levied by car hire companies, who in turn pay large referral fees to insurance companies.

Drivers who are not at fault are legally entitled to be put back in the position they were before the accident happened, which could include receiving a replacement vehicle.

The OFT found that insurers of the driver at fault have "little control" over how repairs and vehicle replacement services are carried out. Insurers of the drivers who are not at fault take advantage of this to generate cash through referral fees and rebates.

These extra expenses ramp up the costs for other insurers, which end up being passed on to drivers as their premiums go up.

The OFT has pinpointed several practices which could be inflating the cost of replacement vehicles, including insurers of not at-fault drivers referring them to credit hire organisations which tend to charge higher daily rates, in exchange for referral fees of up to £400.

The watchdog also highlighted practices which could be increasing repair costs to not-at-fault drivers' cars, including agreements between insurers and repairers to charge higher labour rates.

The watchdog will reach a final decision on whether the matter should go before the Competition Commission by October.