An umbrella policy vs. LLC for asset protection – part 2

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.

Umbrella policy

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.

Deductibles

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.

Scenario 1

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.

Total cost

  • 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.

Scenario 2

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

Scenario 3

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)

Scenario 4

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

Scenario 5

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)

Scenario 6

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

Conclusion

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.

29 thoughts on “An umbrella policy vs. LLC for asset protection – part 2

  1. Really informative summary. I appreciated the excellent comparison between LLCs and Umbrella Insurance. I have a 3 mill Umbrella Policy with American National for $540 per year. I agree with you that the Umbrella Policies are great value. You can easily increase them as your exposed net worth grows.

  2. Could you double check the numbers on Scenario 4 Umbrella Policy. It seems 2 million judgment minus 10k deductible minus 1 million in coverage should leave you with a bill of 990k or a total of 1 million down making the LLC the better option.

    Great article, really appreciate learning this as I’m hoping to make a property purchase in the next couple of years.

    1. In scenario 4 the amount of the judgement ($1.65M) is the same as in scenario 3. The difference is that your equity in the property is $2M in scenario 4 vs. $200k in scenario 3.

      The math for the umbrella policy in scenario 4 is the same as in scenario 3.

  3. I have had a much different experience with liability insurance. I own a couple of dozen rentals outside California and one in California, along with my personal residence. In the State Farm universe, I have to have two umbrella policies, one in California and one in Arizona. Each policy is on top of the rental insurance policies and the California policy sits on top of the homeowner’s policy as well. I had to raise the liability limits on the auto policies to conform with the California umbrella policy.

    The cost for $5MM of coverage on each policy is not cheap. State Farm will not write over $5MM policies themselves. They have to go through commercial underwriting and are much more expensive. I would like to get a $10MM policy but not at the multi thousand dollar price estimated by State Farm.

    LLC’s in California are expensive. In many cases, the corporate veil is easily pierced, especially when you are involved with managing the properties yourself in any capacity. I am not convinced they are worth the cost in my specific situation.

    1. I had the same issue with State Farm insurance limit. I went with another insurer. There are a number of choices, but I went with ACE (a division of Chubb). I have a $10 million umbrella policy that costs about $1400 a year.

      1. They key is to shop around. Just because one insurance company can’t meet your needs doesn’t mean that nobody can.

        By the way, my insurance policy is a commercial policy. I was told that’s what I needed for the number of properties that would be covered.

  4. My million dollar policy cost about $450. Two go to two million wasn’t close to double that, of which I’m probably going to do on the next renewal.

    1. I might do the same. I know the general recommendation for an umbrella policy is to have enough protection to cover your net worth, but that seems excessive. I think the better way to decide how much coverage to carry is to determine how much liability you’re likely to incur and purchase that much coverage.

  5. In state of Virginia, personal umbrella policy will cover only up to 4 rental properties. If you have more than four rental properties, you are required to have commercial umbrella for the rental properties and personal umbrella policy for personal liability (so you are having two umbrella policies). Is there company that offers an umbrella policy that covers both the personal and commercial excess liability?

    1. A commercial umbrella policy provides both personal and commercial excess liability. Our commercial policy covers us for up to 10 named properties. I had to go to a commercial policy for the exact reason you stated – a personal policy would only cover up to 4 properties.

  6. Very informative article. I have 7 properties. struggled with finding a insurance company that would cover all 7. What is the insurance company you use?

  7. The prices you mention for your State Farm umbrella policy is amazing. I’ll need to check them out. Trying to get a quote from Allstate who insures my personal and rentals for 1million is $750 and the 2million was approx. $1321. Seems a large difference.

    1. I get the feeling that there are a number of insurance companies who don’t really want to write umbrella policies, so they make the cost high enough to dissuade people from actually purchasing the policies they offer. Definitely shop around – I saw big differences in policies from various companies.

  8. Absolutely best article I have read this year regarding this topic! Every where they are pushing llc and I have been an advocate for unbrella from day one! This puts into words and examples what Ive been saying! Thank you, Thank You!

    1. I wrote this article for exactly the reason you mentioned – everybody in real estate seems to automatically just recommend an LLC. And while an LLC isn’t necessarily a bad choice, it’s certainly not always the best choice. My goal was to do a deep dive analysis and determine if/when an LLC would be superior to an umbrella policy, and if/when an umbrella policy would be better.

      Thanks for the kind words. This is exactly why I decided to start blogging in the first place – to help people!

  9. Hi,

    This was probably the most informative article I have found on the subject due to the examples. I have been struggling to figure out which approach to take in a sense over the past year while I have rounded out my rental portfolio. Now that it is complete and before I have to pay the yearly fee to Florida for the rentals I would like to figure out my long term strategy as what I was doing was “start-up strategy”. If you don’t, mind, I will give you my scenario and see what you might suggest.

    I have 33 rentals in Florida. It costs me $150 per year to renew the LLCs for each. So that is $4950 a year I am paying and it is how I have them currently setup.

    In addition, I carry 1M in liability insurance on each at $108 per year each. So that is $3,564 per year I am paying.

    Thus this $8,500 a year for LLC and 1M liability protection. I want to evaluate if there is a better way to protect myself and my assets.

    I think you have to take other things into consideration. Each property for argument’s sake is worth $100K. So each being in their own LLC limits what could be taken from that LLC to a certain extent ($1M in insurance and $100K asset) absent piercing the LLC.

    My net worth is probably $6M. So I do have a worry of the veil being pierced because I don’t get to something quick enough, I fix something that causes an issue or one of my handymen cause and issue.

    So on a personal level, I do have a 2M umbrella policy which I think is costing me about $800 a year. I am going to check into it, but I don’t think it covers the rentals. Many of the insurance companies I have spoke with don’t want to touch this many rentals with a 10 foot pole. I will check with State Farm as I can’t recall if I checked with them as I made about a dozen calls previously.

    I am being offered a commercial umbrella policy that will cover all my rentals with the following:
    $1,000,000: $858
    $2,000,000: $1,464
    $3,000,000: $2,070
    $4,000,000: $2,676
    $5,000,000: $3,282

    Now one of your statements that this can eat up your profits quickly…well, I rather sleep well at night and have a couple grand less a year than lose it all. If I make an extra few grand a year by saving on insurance or LLCs….well, it will not change my lifestyle one bit. That said, I don’t want to throw money away either as it could go to help someone. So there is a balance.

    One last note, I have toyed with the idea of maybe having 6 LLCs to sort of limit liability fees and upping the umbrella. But I would really welcome another person’s perspective as all the insurance agents are scared to provide any guidance and I don’t know anyone else in this same boat or who really understands it.
    Thanks
    BB

    1. Thanks for the kind words.

      First, only you can decide what level of protection you’re comfortable with. There is always a tradeoff between cost and protection. And, no matter how much money you spend, there will always be some risk. Neither an LLC or umbrella policy will protect you against going to jail for criminal negligence, etc.

      Second, you’re almost certainly correct that your personal umbrella policy does not cover your rentals. If you have 33 rentals then your rentals will almost certainly be considered a business (regardless of the actual legal entity through which you hold the rentals), and a personal umbrella policy doesn’t cover liability incurred in a business.

      Third, the amount of liability protection that’s appropriate depends in part on the properties. Are these 33 properties single family residences (SFRs), duplexes, or 50 unit apartment buildings? My guess is that they are SFRs, as you have a $6M net worth and 33 properties, so even if all of your net worth was from your rentals (which I’m sure is NOT the case), that would be $181k of equity per property.

      Fourth, It’s generally more economical to have a single high limit liability policy then lots of little policies. I think it’s also safer – having 33 policies of $1M is less safe than a single $5M policy, as the 33 policies still only provide up to $1M of protection for each house, whereas the single $5M policy provides $5M of coverage for ALL your properties. Some people will say the 33 policies is preferable because it’s possible that if you’re hit with a claim your insurer will cancel your policy, but the reality is that insurers share information, and if you’re hit with a lawsuit all of your policies for other properties will be reevaluated by your insurer.

      Finally, I absolutely agree that you should select the balance of cost and coverage that will let you sleep at night. The intent of this article is to give you the information to make that choice for yourself. However, given the limited information you’ve provided, I would think that a single $5M policy is going to provide more protection than the 33 $1M policies you currently have, and it will likely do so at approximately the same cost.

      As for the protection that LLCs provide – well, let’s just say I’m skeptical that the average individual real estate investor is going to enjoy much protection from one.

  10. I am writing to say thank you for putting together this article. I have been parsing information for a week and talking to lawyers and accountants who were not nearly as helpful as this article. The more I dug into the challenges of setting up LLCs, problems with the banks holding the mortgages, etc. the more inclined I was towards the well-insured route instead and this information did the trick. Thanks again!

  11. I made the decision a long time ago to use an umbrella policy instead of LLCs, but lately I was considering revisiting LLCs. I am glad you reminded me that I should probably stay the course.

    And in Part I of this series I laughed about your reference to study of doctors who are jerks. I had a torts professor in law school who cited the same study and it’s one of the few things I remember from a law school lecture. I actually included the same analogy in a blog post I wrote a few months ago about dealing with tenant issues, ha ha.

    Anyway, great stuff, I’m subscribing.

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