In part 1 of this post I talked about the advantages and disadvantages to using a LLC for asset protection. In part 2 I’ll analyze umbrella policies, then provide recommendations.
An umbrella policy is an additional layer of protection on top of your existing insurance policies. It provides protection against a wide variety of perils across all of your assets.
Advantages of an umbrella policy
Provides protection beyond your rental properties
An umbrella policy doesn’t just augment your existing homeowner’s insurance policy – an umbrella policy provides protection in just about every area of your life. It provides protection beyond your personal residence and auto policies. It provides insurance against incidents that happen away from home (your dog bites somebody in a park). It provides protection against libel and slander. It protects you against a variety of threats to your finances that aren’t protected through other mechanisms. It even protects you against civil lawsuits for false arrest (I’m trying to imagine how this was a common enough occurrence that needed to be added to standard umbrella policies).
In short, an umbrella policy provides a very comprehensive layer of protection against threats you might not have any protection from today.
An umbrella policy is cheap
For all the additional protection that umbrella policies provide, they are surprisingly cheap. I was able to get a $1M umbrella policy for $250/year. As mentioned above, this provides additional protection not just for my 8 rental properties, but it provides protection in case of personal liability, liability for auto accidents, and others. For accounting purposes, not all of the $250 policy is for protection on my rental properties. I’d probably allocate $125 of the total cost towards protection on the rental properties and the other $125 towards the personal protection provided by the umbrella policy.
And not only is the actual policy cheap, but adding additional insurance is inexpensive and can be done at any time. I assumed that if the cost of $1M of protection is $250/year then $2M should be $500. I was wrong.
As a general rule, insurance is priced like this: cost of insurance = likelihood of a loss * cost of loss
Higher liabilities are exponentially less likely to occur. Only 13% of personal injury and liability judgements are for $1M or more. Even in case of death it’s unlikely that a judgement would be into the seven figures, and even if it is, it’s much more likely to be around $1M than $2M. This means that additional umbrella coverage is surprisingly inexpensive. I was quoted $100 year for an additional $1M in coverage (a total of $350/year for $2M in coverage). Coverage of $10M is available for around $1,000/year.
Umbrella policies are simple
I have one umbrella policy that covers my both personal and business (rental properties) liability. There is one check to write each year and one company to deal with. It’s the Platonic ideal of simplicity. I didn’t even need to meet with an adjuster – everything was handled over the phone.
One policy will cover all of my current rental properties plus any new properties I purchase. If I purchase additional properties I just have to notify my insurance company so they can add the new address to the list of covered properties, but there is no additional charge.
An umbrella policy covers all of your properties, regardless of location
A LLC is specific to the state it’s formed in. If you have a LLC formed in California and you want it to operate in Texas you’ll need to file paperwork (and pay fees) to register the LLC in Texas. If you’re going to file paperwork to allow your California LLC to operate in Texas you might as well just create a new LLC in Texas and have a bit more protection.
An umbrella policy will cover all of your rental properties throughout the US, regardless of what state they are in.
Disadvantages of an umbrella policy
You’ll need to increase your underlying policy amounts
Most umbrella policies require the underlying insurance policies to have relatively high liability limits. In my case I had to increase my homeowner’s insurance for the rental properties to $500k of liability insurance. My auto policy already provided sufficient coverage ($300k) but if your policy is lower than this you’ll need to increase your coverages.
Increasing my underlying insurance to the required minimum only cost about $10 per property per year. This is cheap, but obviously your additional cost (if any) will depend on your existing policy amounts. This is an additional cost that you’ll need to factor into your analysis.
As with any other insurance policy, umbrella policies have a deductible. And as with any other insurance, lower deductibles result in higher premiums and higher deductibles result in lower premiums.
My $1M policy has a $10k deductible. This means that if I am sued AND I am found liable AND the resulting liability exceeds my underlying policy (if any), then I am responsible for the first $10k of additional liability and my insurance company will pay the next $1M. I am then responsible for everything beyond that.
$10k is obviously a large deductible. I specifically chose a large deductible because it allowed me to purchase larger amounts of insurance for the same dollars. I see the umbrella policy as catastrophic insurance. I’m willing to take on $10k in liability if it means I can purchase an additional $500k in umbrella coverage.
You become a bigger target
As I mentioned in part 1 of this blog, the personal injury lawyers typically work on a contingency basis. They only take cases that they think they can win AND that have a potential payout large enough to compensate them for the risk of working on a contingency basis. Even if the lawyer has an open and shut, slam dunk case against you, they aren’t going to pursue a case if you’re broke. If you have a $1M umbrella policy you suddenly become an interesting target.
You’re going to get pissed when the insurance company settles
The reality is that only a small number of lawsuits actually go to trial. Lawsuits are expensive and risky. Even if you have all the facts on your side there’s still the possibility that you’ll lose. As a result, insurance companies tend to settle, even when the plaintiff has a ridiculously weak case. You have no input into this. Remember how I told you that the great thing about insurance is that the insurance company provides your legal defense? Well, the downside of that is that you don’t have any say in how the defense is handled. It’s likely that if you’re sued your insurance company will settle just to make the lawsuit go away. From a moral perspective this is going to piss you off. Somebody is going to sue you for a totally bogus reason and get paid tens of thousands of dollars.
Comparing LLCs and Umbrella Policies
Let’s run through a few scenarios to compare the protection provided by a LLC vs an umbrella policy. For all of these scenarios we’ll assume the following:
- Homeowner’s policy with $500,000 of liability coverage
- One of the following
- An umbrella policy with an additional $1,000,000 of coverage and a $10k deductible, or
- A LLC for each property where you are the sole owner.
You own 5 properties, all in California (where I live). You have a LLC for each of the 5 properties. There are no accidents and nobody tries to sue you.
- LLC – $4,000 (5 properties * $800/year/property for a LLC)
- Umbrella policy – $250 for a $1M umbrella policy with a $10k deductible
It’s pretty obvious than in a typical year you’ll pay a LOT more for a LLC than for an umbrella policy. This might make sense if a LLC offers significantly better protection, but as we’ll see below, that’s usually not the case.
A tenant trips on a loose piece of carpet in the living room, falls, and breaks his arm. Total medical bills are $20,000. He’d previously notified you of the loose carpet but you hadn’t had a chance to fix it yet.
Your tenant sues you and your insurance company settles for $50,000.
LLC – no effect, as the coverage is provided by your rental dwelling insurance
Umbrella policy – no effect, as the coverage is provided by your rental dwelling insurance
Total financial loss
- LLC – $0
- Umbrella policy – $0
You own an apartment building. Current equity in the apartment building is $300,000. One of your tenants has a party on the deck of his unit. The deck collapses, causing serious injury to 5 people. The most serious injury results in a broken leg, broken foot, and nerve damage in the victim’s knee. You are sued for $1.65M. Your rental dwelling insurance covers the first $500k of liability
LLC – your LLC is responsible for the remaining $1.15M of liability. This exceeds the value of the assets ($300,000) in the LLC. The plaintiffs take the $300,000 in equity in the LLC and the remaining $850,000 of the judgement is uncollectible.
Umbrella policy – you pay the $10k deductible. Your insurance pays the next $1M. You pay the remaining $140,000. Your total out-of-pocket liability is $150,000.
Total financial loss
- LLC – $300,000
- Umbrella policy – $150,000
You are clearly better off with the umbrella policy, as your loss is $150,000 vs $300,000. In addition, I would argue that the umbrella policy results in a better social outcome, as the plaintiffs receive money for medical payments, pain and suffering, loss of income, etc. With a LLC they only receive $800,00, which might not cover their losses.
(This scenario was taken from a real-life event at UC Santa Barbara in 2013)
Same facts as scenario 2, except that your equity in the apartment building is $2M.
LLC – your LLC is responsible for the remaining $1.15M of liability. The value of the assets in the LLC is $2M. You’ll likely need to sell the property to pay the $1.15M judgement.
Umbrella policy – you pay the deductible ($10k). Your insurance pays the next $1M. You pay the remaining $140,000. Your total out-of-pocket liability is $150,000.
Total financial loss
- LLC – $1,150,000
- Umbrella policy – $150,000
Again you’re significantly better off with an umbrella policy
You own 17 properties worth an average of $2M each, putting your total net worth at $34M. Each property is in its own LLC.
One of the properties is a dilapidated warehouse that’s used as an artists’ collective. This includes unpermitted residences and improvements. The lease owner occasionally holds unpermitted events, such as concerts, to help pay the rent. During one of these events a fire breaks out. Due to numerous fire code violations, the general state of disrepair of the property, and illegal improvements, the fire rips through the building, killing 36 people.
The families of the victims sue you and the lease owner for $25M judgement.
LLC – The $25M judgement exceeds the value of the $2M warehouse in the LLC. You’ll lose the warehouse and any insurance money paid to the LLC as a result of the fire. More importantly, you’ll likely be charged with criminal negligence. The $32M in other property outside of this LLC are safe, which will help support your family while you spend the next 20 years in jail.
Umbrella policy – you’re screwed. You’ll lose the $25M judgement plus spend the next 20 years in jail.
Total financial loss
- LLC – $2,000,000 (value of the property in the LLC holding the warehouse that burnt down)
- Umbrella policy – $25,000,000 (resulting in personal bankruptcy)
In this case you are significantly better off financially with the protection of the LLC.
(This scenario was loosely based off of the recent “Ghost Ship” warehouse fire in Oakland, CA)
In addition to owning rental properties you have a personal finance blog. You write an article refuting an article on another blog and, as part of the rebuttal, say that the other blogger seems uninformed about the topic. The other blogger sues you for libel. The legal fees are $50k and you’re victorious in court.
LLC – No protection. You will need to pay for legal costs even though you win.
Umbrella policy – your umbrella policy covers legal costs to defend you. The deductible does not apply because you win the lawsuit and have no liability.
Total financial loss
- LLC – $50,000
- Umbrella policy – $0
The vast majority of individual investors are better off with an umbrella policy. The most likely scenario is that you’ll have no issues and no claims. In that case an umbrella policy is significantly cheaper than a LLC (see Scenario 1).
If you have lots of small properties (individual rental houses, for example) then the LLC fees will eat into your profits if you have a separate LLC per property. If you have multiple properties per LLC then you’re losing much of the protection of having a LLC in the first place.
If you have a small number of large or valuable properties (Scenario 4) then a LLC doesn’t help much because most of your net worth is probably already tied up in the property. Losing the property in a judgement will effectively wipe you out financially anyway.
The only scenario where having a LLC makes sense is if you have lots of expensive properties (Scenario 5). Putting each property in a LLC prevents a single large liability from wiping out your entire net worth.
Some people will advocate for a “belt and suspenders” approach of having both a LLC and a high amount of liability insurance. However, the cost of having both will significantly decrease the profitability of your properties, at which point you have to ask why you’re bothering to invest in real estate in the first place.