A few weeks ago, I met with an accounting professional. We were discussing business and talking about additional ways we add value for our clients. I mentioned that we had recommended umbrella policies to every one of our planning clients over the past year because none of them had an umbrella policy. He was shocked to learn that so few of our clients carried umbrella insurance, but a lack of umbrella coverage is far from abnormal. A Consumer Reports study in 2013 found that only 10% of homeowners carried umbrella. While many people incorrectly believe that umbrella policies are only for the wealthy, even the wealthy lack adequate coverage. In a 2012 study, ACE Private Risk Services found that for people with $5 million or more in assets, about 20% don’t have an umbrella policy at all, and about 25% carry less than $5 million in coverage. The need for umbrella coverage is widespread, if not ubiquitous. In fact, in studying for the CERTIFIED FINANCIAL PLANNER™ exam, the instructor of my review class told us to always select “recommend umbrella coverage for the client” if a question on the exam offered it as one of the answers.

Homeowners’ insurance policies and auto policies provide liability protection. This coverage is available for incidents like auto accidents, injuries on the insured’s property, or dog bites, to name a few. The problem is that the limits for liability coverage on home and auto policies are quite low. Most homeowners’ policies top out at $500k of coverage. This is where umbrella kicks in. Adding an umbrella policy provides another layer of protection. After home or auto limits are exhausted, the umbrella policy pays the excess amounts, up to the policy limit. If a judgement or settlement is reached against the defendant for an amount that exceeds the liability limits of the homeowners’ (or auto, whichever applies) plus the umbrella, the defendant would need to liquidate assets and/or have their wages garnished.

Umbrella insurance provides coverage or excess coverage for wide variety of perils. Here are some of the most common:

• Harm caused to others by your dog (dog bites represent about 33% of all liability claims according to the Insurance Journal)
• Defense costs if you are sued
• Auto accidents
• Injury to another person on your property
• Pain and suffering in the event you are found to be at fault in an accident
• False arrest
• Slander
• Libel
• Defamation

It is important to remember that there are several exclusions to umbrella. Here are some of the things personal umbrella does not cover:

• Intentional or criminal acts
• Damage to your own property
• Your own injuries
• Claims arising from the operation of a business (business umbrella policies must be purchased separately)

It is important to note that umbrella policies require underlying policies to be purchased meaning you’ll need home and auto policies before the umbrella policy will be underwritten. You’ll also want to make sure you’re carrying enough liability coverage on the home and auto policies to avoid a gap in coverage. For example, if your umbrella policy requires $500,000 in underlying homeowner’s liability coverage, but you only have $300,000, a $1 million liability claim would result in you being on the hook for $200,000. In this example, the homeowner’s policy would pay the first $300,000 (minus any applicable deductibles) and the umbrella policy would pay the amount from $500,000 to $1 million. You would be responsible for the gap from $300,000 to $500,000. Simply carrying $500,000 in homeowner’s liability would have eliminated this gap.

Many people underestimate the need for liability coverage. While the odds of making a liability claim are low, the level of damages needing to be paid can be very high. In fact, the ACE Private Risk Services report showed 13% of all personal injury liability awards and settlements were over $1 million. With most homeowners and auto policies offering a maximum of $500,000 in liability coverage, this is a huge deficit for most people to cover.

The good news is that umbrella policies are quite cheap. $1 million in umbrella coverage can typically be purchased for around $200-300 per year, with an additional $1 million costing roughly $75 per year. The reason these policies are so cheap is two-fold. First- umbrella policies only pay after the limit of the underlying insurance (the home or auto) is exhausted. This is why umbrella is also known as excess liability. Second- while the potential costs can be very high, the probability of needing coverage to use this coverage is quite low. Unfortunately, the fact that umbrella coverage is so inexpensive is one of the major reasons why umbrella policies are underutilized. Many people do not understand why they need umbrella and insurance agents often do not actively sell umbrella coverage to their clients because the commissions are small on these low margin policies.

It is not uncommon for people to struggle to find the right amount of umbrella coverage to carry. The truth is- there is no right answer. While the rule of thumb is to carry coverage at equal to your net worth, there is nothing preventing a judgement against you in excess of this amount. It is not unheard of for legal judgements or settlements to be reached in excess of the liability limits on an individual’s insurance (necessitating asset liquidation) or in excess of an individual’s net worth (necessitating both asset liquidation and wage garnishment). Both of these scenario’s can be financially devastating. Likewise, there is a very good probability the policy owner will never need to use the coverage, in which case they would like to avoid overpayment. In the end, the answer to this question must come partially from an assessment of one’s own risk- “What is the probability I’ll use my liability coverage?” and partially from a qualitative assessment of one’s own tolerance for risk- “How much coverage do I need to sleep at night?”

Just as each person has a different tolerance for risk, the probability of facing a liability judgement or settlement can vary tremendously by person. Some people drive 30,000 miles every year, while others don’t own a car. Some people have a dog, pool, and trampoline at their house, requiring higher levels of liability protection, while others live in an apartment. Knowing the potential risk factors that increase your chances of needing coverage is an important step in determining the level of coverage you need.

Umbrella insurance is inexpensive, fairly easy to understand, and needed by almost everyone. However, determining your level of risk exposure, risk tolerance, and net worth can be difficult. We recommend seeking the advice of a fee-only CERTIFIED FINANCIAL PLANNER™ for an unbiased opinion if you need help determining a level of coverage that works for you.