Do you need umbrella insurance?

You probably already buy a variety of insurance policies to protect your assets and your loved ones. But beyond the standard auto, homeowners or life insurance policies, you may have overlooked an important and affordable type of insurance: umbrella insurance. That's largely because the financial protection it provides comes into play only under certain—but often vital—circumstances.

What is umbrella liability coverage?

Sometimes known as excess liability or personal liability insurance, umbrella insurance doesn't stand alone. Instead, it supplements other liability policies most people already have in place, such as auto, homeowners, or renters insurance. It's designed to kick in when the liability coverage on those policies has been exhausted.

"The main purpose of an umbrella policy is to protect you and your assets from the financial fallout of certain unforeseen events," explains Matthew Kenigsberg, CFA, CFP®, of Fidelity Managed Solutions Client Investment Analytics.

"Generally, if you get into an automobile accident or someone has a mishap involving your property, you may be held responsible for damages or injuries. Umbrella policies are intended to cover any resulting liability that exceeds the amount covered by your other standard insurance policies," adds Kenigsberg.

In some cases, depending on the provider, umbrella policies can also be written to provide a broader form of coverage, which can cover types of damages not covered by the underlying policies, such as libel or slander, and can help to pay for the costs associated with legal fees.

Why is umbrella insurance important?

To best answer that question, consider the assets you own, and the role they play in fostering your financial security. When thinking about assets, there are obvious items that come to mind: your car, house, investment accounts, and checking and savings accounts. But more broadly, even your estimated stream of future income can be viewed as an asset. In fact, it may even prove to be the most valuable asset of all.

In the event that you become the target of a lawsuit for a substantial sum of money, but don't have enough insurance to cover the damages that may arise, the expenses would have to come out of pocket. This could create significant financial hardship. An umbrella policy can forestall the prospect of financial ruin due to an unintentional misstep or an unforeseeable accident.

You may also wish to consider increasing the liability limits on your auto or homeowners insurance policies. This strategy may suffice for some common mishaps, but may not protect against all potential expenses. For example, a car accident could result in court proceedings, or an idle remark made on social media could lead to a lawsuit for slander. Unfortunately, the possibilities are endless.

Umbrella insurance picks up where other liability policies leave off, both in terms of dollar limitations and scope of coverage. Put simply, it provides extra (or "excess") liability coverage and is effectively insurance of last resort, but coverage will not take effect until after other sources of coverage have been used fully.

What does umbrella insurance cover?

Although the definition of coverage that is provided under an umbrella policy, at first glance, seems somewhat nebulous, it can be boiled down to 3 broad categories:

1. Bodily injury liability covers the cost of injuries to another person, and may include the cost of medical bills and liability claims that are the result of injuries to:
   •     Other people, due to a car accident where the policyholder is at fault
   •     Other people, by a pet owned by the policyholder
   •     Guests in the policyholder's home, due to a fall or some other accident
2. Property damage liability covers the cost of damage or loss to another person's tangible property, and may include the costs associated with:
   •     Damage to vehicles and other property, resulting from a car accident for which the policyholder is found at fault
   •     Claims incurred in connection with damage caused to the property of others
   •     Accidental damage caused to school property by a child
3. Other personal liability covers other actions a policyholder could be sued for, such as:
   •     Slander (an injurious spoken statement)
   •     Libel (an injurious written statement)
   •     False arrest, detention, or imprisonment
   •     Malicious prosecution
   •     Mental anguish or shock

Weighing the costs and potential benefits

The price of obtaining $1 million of personal liability coverage from an umbrella policy can be relatively low, generally costing between $300 to $500 per year. And for every additional $1 million of financial protection, the incremental premium cost tends to gradually diminish.

From the insurer's perspective, the lower premium payments charged to purchase umbrella liability coverage reflect the fact that no payments are made until after the coverage limits of all other applicable policies have been exhausted. Bottom line: The probability of any claims being filed against an umbrella policy is relatively small, which results in a lower premium for the consumer.

Tip: Keep in mind that the cost of obtaining umbrella liability insurance can often be reduced even further: In most states, discounts are available if more than one policy is purchased from the same firm. This can make umbrella insurance less expensive if it is purchased from the same insurance company that covers your car, home, or boat.

Umbrella insurance providers will expect an applicant to have in place previously purchased auto, homeowners, or renters insurance before issuing such a policy. Most insurers will require an applicant to have a minimum of $250,000 of liability insurance on an auto insurance policy and about $300,000 of liability on a homeowners insurance policy before selling a $1 million umbrella insurance.

A potential pitfall in the world of insurance is a gap in coverage that can arise due to different expiration dates between your regular coverage (auto, home) and your umbrella policy coverage. The next time you change insurance agents, be aware that it is possible that coverage limits could be changed, say from $250,000 to $100,000 on an auto policy, potentially causing a gap in coverage with your umbrella policy.

Tip: One way to reduce the risk of any possible gap in coverage would be to have one insurance agency underwrite your underlying auto, homeowners and umbrella policies together, giving them the same expiration dates.

How much coverage do you need?

In assessing the level of coverage that may be appropriate, the following factors should be considered:

1. The total value of all assets to be protected. All other things equal, the higher the asset value, the higher the amount of umbrella policy coverage that may be appropriate.
2. The perceived scope of the risks that are faced. This requires a thorough, objective analysis of:
   •     Risks arising from being a homeowner or a renter
   •     The risk of causing an accident—one potential factor may include the length and nature of a commute to work
   •     Any potentially dangerous activities one undertakes that could put others at risk
3. The potential loss of future income. As mentioned earlier, future potential income could be considered an asset, or a source of wealth, in its own right. Liability lawsuits can stake a claim on both assets and future potential income.

Umbrella coverage should generally cover the value of the taxable assets owned, as well as that of any homes beyond the primary residence. (Again, however, one's actual need could be higher or lower.) Assets held in employer-sponsored retirement accounts (e.g., 401(k) or 403(b) accounts) are generally protected from exposure to civil liability under the provisions of the Employee Retirement Income Security Act of 1974 (ERISA). The same protection generally also applies to up to $1 million worth of assets held in individual retirement accounts (IRAs). So, in assessing your needs for umbrella coverage, in general only nonqualified assets, along with assets in excess of $1 million in IRAs, need to be considered.

With respect to your primary residence, it's possible that at least part of this component of your net wealth need not be included when determining an appropriate level of umbrella coverage. This depends on the degree of protection under the homestead exemption^* for a given state of residence (intended to prevent the forced sale of a home to meet the demands of creditors).

For example, if you live in a state where the homestead exemption threshold is $1 million, and the value of your equity in the home is lower than $1 million, there is typically no need for umbrella liability protection on your home equity. Note, however, that for the homestead exemption to apply, a homeowner generally must record a Homestead Declaration with the local registry of deeds.

Annuities and irrevocable trusts

Annuities and irrevocable trusts may also be used as a supplement to or even a replacement for umbrella insurance to provide protection from creditors in some cases. But the protection available depends on the specifics of the trust or annuity in question, and also varies from state to state. And of course, irrevocable trusts and annuities come with significant costs and other disadvantages that may outweigh the benefits of any protection from creditors that they may provide. So consult with a financial advisor or a qualified attorney before making decisions regarding strategies for asset protection, whether these strategies involve umbrella policies, trusts, annuities, or some combination of these.

Directors and officers policies

If you or your spouse serves on a board of directors for a company, partnership, condo association, or even a nonprofit organization, Directors and Officers (D&O) insurance can protect you from liabilities that may arise in connection with your service as a director. Some organizations carry their own D&O insurance, but many do not.

Errors and omissions policies

Errors and Omissions (E&O), also referred to as professional liability insurance or malpractice insurance, is often used by self-employed individuals such as architects, accountants, consultants, dentists, and physicians to protect them from liability that may arise from their professional activities. The specifics vary greatly from profession to profession and state to state, so if you are a self-employed professional you may wish to consult with an attorney to better understand the risk that you might be exposed to along with the possible remedies available through insurance that may help mitigate risk.

Tip: In some cases, D&O or E&O coverage may be offered as options or they may be included in the standard cost of an umbrella insurance policy. Check with your insurance provider for pricing details.

Plan ahead

"You've worked hard to accumulate assets, and no matter your net worth, you could be subject to a lawsuit," says Kenigsberg. "So it makes sense to consider options such as umbrella insurance to help protect your assets as well as your future income."