We often make decisions based on expectations about the future, but the future is never as expected. It can be better or worse, but almost never as we expect it. A sound financial plan addresses such unexpected events, particularly when they can be a serious setback to achieving our goals. Planning for setbacks is part of what financial planners call risk management, and liability insurance is part of it.
A simple rule of thumb is to have enough liability insurance policy equal to your net worth. Your net worth is simply the sum of everything you own minus everything you owe, like your mortgage and other debt, if any. The net worth gives you a measure of your accumulated assets, and it makes sense that it would be something you want to protect. But the simple rule of thumb does not work all the time. What if you face a liability claim greater than your net worth? For example, what if someone with a net worth of $1MM is found liable for $2MM of damages? And at the other extreme, does someone with a $100 million or more net worth even need liability protection?
In general, how much liability insurance to consider depends on the potential loss relative to one’s net worth (rather than simply net worth), the likelihood of experiencing large net worth losses, and how averse to risk the individual is.
Personal liability and insurance
Before getting to the numbers, it’s worth discussing some basics of personal liability. Personal liability is a legal obligation to pay someone as a result of negligent acts for which you may be found liable, including property damages or personal injury caused while driving, injury of others at your residence, damages resulting from homeownership, etc. Here are just some examples of risks that you may be exposed to:
- You are at fault in a serious car accident;
- Someone gets injured in your home or yard;
- Someone drowns in your swimming pool;
- Someone gets hurt in your rental property, or is hurt by tenants’ dog at your rental property;
- Someone gets hurt in a boating accident and you own the boat;
- You are sued for slander or libel in for making a statement;
- You’re on a board of directors of a charity and are sued for a board-related issue;
- Incidents that happen outside the US.
Liability insurance protects you against the costs that can result in a liability case, including legal costs, injuries, and property damages, up to the policy limit. Auto and home insurance provide coverage for personal liability while driving, and as a result from home ownership. For some, choosing appropriate levels of auto and home coverage might be enough.
For many people, however, the limits placed by these policies may not be high enough or general enough to cover the liability that they may be subject to. In this case, increased protection through an umbrella policy can be purchased.
An umbrella policy provides additional liability protection by providing broader coverage and excess coverage in addition to your home and auto liability coverage. Umbrella coverage is sold in million dollar increments ($1MM, $2MM, $3MM etc.) and to qualify for an umbrella policy the insurance company may require you to purchase certain underlying liability coverage first (home or auto). Umbrella policies cover the policyholder and their family but, like all liability policies, do not cover losses or injuries due to intentional acts.
Use your risk exposure as a starting point
The first step in deciding the level of protection you may need is to identify the risks you may be exposed to. Situations that expose you to greater risks include serving on a charitable board, owning a swimming pool, owning rental properties, having dogs, horses, or other large animals, managing a family trust, hosting large parties, or employing household staff. Review the examples above and think about what risks you may be facing that are not on the list. The more risks apply to your situation, the greater the potential liability exposure. So the first step is to catalog the risks that may apply to you.
Next, get a sense of the magnitude of the risks. A good place to start is by reviewing some of the top settlements in personal injury litigation from the website TopVerdict. In 2021, only the top 50 US personal injury settlements were above $3.5MM and only the top 35 are above $5MM. Top settlements related to motor vehicle accidents are somewhat lower, with the top 50 above $1,750. As you review these, keep in mind that the top 50 cases represent a small fraction of the many thousands personal injury cases that are filed each year. Average settlements tend to be much lower, but the average may not be a good indicator when considering insurance.
When to buy more than net worth
With an idea about potential risk magnitudes, the next step is to compare the potential losses to your net worth. If potential claims are similar to net worth, then a policy of approximately that amount may work. But if they are higher, a greater level of protection may be warranted. For example, someone with a $1MM net worth potentially facing a $3MM claim (maybe because multiple situations in the list above apply) will want to insure more than net worth, particularly if you live in a state where future earnings could be garnished. How much more depends on your risk tolerance, how likely you think certain outcomes might be for you. Umbrella policies are relatively inexpensive, in part because your standard auto or home liability protection would be used first. They are sold with coverage in million dollar increments, and successive millions tend to cost less than the first, so it may be worth rounding up.
When to buy less than your net worth
Some of your net worth assets may be protected in full or in part in the event of a lawsuit. Protected assets include your 401k or similar plan, your IRA, your Social Security, and the equity in your home. You can think of protected assets as a minimum amount of assets you can count on in case of an adverse claim. Since these can be a significant portion of your net worth, it’s important to consider their impact on your financial plan. For example, someone with a net worth of $4MM, $2MM of which are protected, may only need a $2MM policy. In general, the higher the value of the protected assets relative to your net worth, the lower the needed coverage, and vice versa.
After you consider protected assets, you may also consider your risk capacity. At high levels of net worth, particularly if a large fraction is protected, it may make sense to leave a portion of assets unprotected. A household with a $7MM net worth and $2MM of protected assets may be comfortable with a $3MM policy if they are more than fully funded for their goals. Even at lower levels of net worth it may be OK to leave some unprotected assets. Someone with a $2.5MM net worth, $1MM of which is protected, may be comfortable with a $1MM policy.
Economics of insurance and loss aversion
If insurance companies set their premiums assuming zero profits, risk averse individuals would normally fully insure against potential losses. This can mean a coverage that is greater than your net worth. However, insurance companies mark prices up to be profitable, and in this case it may be optimal to partially insure against potential losses, in which case the optimal coverage could be below the level of your net worth.
When deciding about insurance, however, there is a psychological factor at play. Your current level of net worth constitutes what behavioral economists call a reference point. A decrease in wealth from this reference point is twice as powerful psychologically than an increase in wealth of the same magnitude. That is, most people think it’s better not to lose a $100 you already have than to find a $100. This psychological factor is called loss aversion. Insurance companies are aware of loss aversion and know that if they get you to focus on potential losses, you will buy greater coverage. That’s why they typically include loss statistics in their advertisements. Viewing the net worth as a reference point is where the rule of thumb of insuring net worth comes from.
How can we balance these economic and behavioral factors? It is important to put any potential loss, like the one due to a liability claim, into perspective. Instead of focusing on the potential loss, start by prioritizing financial goals, and think about the level of wealth you need to achieve these goals. Then think about your protected assets as a minimum level of wealth you can count on in a worst case scenario. The difference between these two numbers is a good starting point in deciding the level of wealth you need to protect. For wealthier individuals, this amount is likely less than net worth, but can also be greater than net worth at lower net worth levels.
Finally, since we are discussing economics, it is important to realize that you can affect the probability of large claims to some extent. Are you thinking of building a pool, or letting your teenager drive a motorboat? Consider the liability implications of these choices. You may decide you don’t need the additional liability that comes with that decision.
Putting it together
Insurance works best for low probability events that can have catastrophic consequences. So it makes sense to insure against potentially high liability claims. How much to insure depends on your situation and the level of exposure to potential claims. The best way to start is to identify the risks you may be exposed to, and get a sense of potential liability. While some of these events have very low probability, they can have a catastrophic effect on your financial plan. Then consider how much of your net worth is protected in a liability claim, and the additional wealth needed to achieve your financial goals. This is the level of wealth you need to protect from potential claims. After these considerations, do you need more coverage than your net worth? Or is a lower level appropriate?
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. He is also a lecturer of finance and economics at Texas State University. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
