Auto Liability Insurance: Protecting Your Net Worth

It is recommended that you have liability insurance equal to the value of your net worth. Your net worth is the sum of everything you own minus everything you owe, such as your mortgage and other debts. However, this rule of thumb does not always apply. If you have a high net worth, you may not need as much liability protection. If you have a low net worth, you may need more protection in case of a large claim. Liability insurance protects you against the costs that can result from a liability case, including legal costs, injuries, and property damage, up to the policy limit. Auto insurance policies provide coverage for personal liabilities while driving. However, the limits placed by these policies may not be high enough or general enough to cover all liabilities, so some people may opt for an umbrella policy, which provides additional liability protection.

Liability insurance and net worth

Liability insurance is a crucial aspect of financial planning, protecting you from unexpected events that could derail your goals. While some people may consider their auto insurance sufficient, it is essential to evaluate your net worth and potential risks to determine if you need additional coverage.

Understanding Net Worth

Net worth is the sum of your assets, such as your home, vehicles, savings, and investments, minus your debts, like mortgages and other loans. This gives you a measure of your accumulated wealth, which you would want to safeguard. A simple rule of thumb is to have liability insurance coverage equal to your net worth.

However, this rule doesn't always apply. If you face a liability claim that exceeds your net worth, you may need additional protection. For instance, someone with a net worth of $1 million could be liable for $2 million in damages.

Assessing Potential Risks

When deciding on the level of liability insurance, consider the potential loss relative to your net worth, the likelihood of significant losses, and your risk tolerance. Identify risks you may encounter, such as serving on a charitable board, owning a pool, or having pets. Then, assess the magnitude of these risks by reviewing top settlements in personal injury litigation.

When to Buy More or Less Than Your Net Worth

Compare the potential losses to your net worth. If the claims are similar to or exceed your net worth, consider a policy that matches or exceeds that amount. Certain assets, like your 401k, IRA, Social Security, and home equity, may be protected in a lawsuit, so factor this into your decision.

Additionally, consider your risk capacity. If a large portion of your net worth is protected, you may opt to leave a portion of your assets unprotected, especially if you are well-funded for your goals. For example, an individual with a $7 million net worth and $2 million in protected assets may be comfortable with a $3 million policy.

Economics and Psychology of Insurance

Insurance companies set premiums assuming zero profits, and in an ideal world, risk-averse individuals would fully insure against potential losses. However, insurance companies mark up prices for profit, so it may be optimal to partially insure against potential losses, resulting in coverage below your net worth.

Psychologically, people tend to be more averse to losses than attracted to gains. Insurance companies leverage this loss aversion by highlighting potential losses in their advertisements, encouraging you to focus on the worst-case scenario.

Balancing Economics and Behavioural Factors

To make an informed decision, it is crucial to prioritise your financial goals and consider your protected assets as a baseline in a worst-case scenario. The difference between these two numbers is a good starting point for determining the level of wealth you need to protect.

Additionally, remember that you can influence the probability of large claims by being mindful of certain choices, such as installing a pool or allowing a teenager to drive a motorboat.

In conclusion, while liability insurance is essential, the amount of coverage you need depends on various factors, including your net worth, potential risks, and economic and behavioural considerations. It is a complex decision that requires careful evaluation of your unique circumstances.

Insurance and risk aversion

Insurance is a classic illustration of the difference between risk aversion and risk neutrality. Risk-averse individuals will always choose to insure valuable assets, as the potential loss of the asset would be so large that most people would rather pay small amounts as a premium for certainty than risk the loss. On the other hand, insurance companies are risk-neutral and earn profits from the fact that the value of the premiums they receive is greater than or equal to the expected value of the loss.

The decision to purchase insurance depends on the price of insurance, or the premium. The premium is the amount paid for $1 worth of insurance, so for $x of insurance, the premium paid is $rx. For insurance to be actuarially fair, the insurance company should have zero expected profits. In other words, the premium paid should be equal to the expected loss.

Risk-averse individuals will always hedge the risk completely at a cost that equals the expected loss, which is the actuarially fair premium. However, they may also be willing to pay more than the actuarially fair premium to get rid of the risk. This additional amount is called the risk premium.

When deciding on the level of auto liability insurance to purchase, it is recommended to have liability insurance equal to the value of your net worth. Your net worth is the sum of everything you own minus everything you owe, such as debt and mortgages. However, this rule of thumb does not always work. The amount of liability insurance you need depends on the potential loss relative to your net worth, the likelihood of experiencing large net worth losses, and how averse you are to risk.

If you are risk-averse, you would want to choose a level of insurance that maximises your expected utility. In the case of actuarially fair insurance, you would choose to fully insure your car. However, if the premium is greater than the probability of an accident, you would under-insure. The amount you under-insure would depend on how much greater the premium is than the probability.

It is important to note that certain assets are protected in full or in part in the event of a lawsuit, such as your 401k, IRA, Social Security, and equity in your home. These protected assets can be considered a minimum amount of assets you can count on in case of an adverse claim. Therefore, the higher the value of protected assets relative to your net worth, the lower the needed coverage.

Umbrella policies

The amount of coverage provided by an umbrella policy depends on the specific policy and can range from $1 million to $10 million or more. The cost of an umbrella policy will depend on factors such as the amount of coverage, your location, the number and types of vehicles you own, and whether you own multiple houses.

To qualify for an umbrella policy, insurance companies may require you to purchase certain underlying liability coverage, such as a minimum level of auto or homeowners insurance. Umbrella policies are typically very affordable and can provide peace of mind by offering additional protection against potential lawsuits or accidents.

When considering an umbrella policy, it is important to assess your risk exposure and determine the potential losses relative to your net worth. If the potential claims are higher than your net worth, you may want to consider a policy that provides coverage beyond your net worth. On the other hand, if you have protected assets, such as a 401k or IRA, you may need less coverage than your net worth.

State-required liability coverage

Bodily injury liability coverage helps pay for bodily injury for which you are legally liable. This means that your actions caused injury to another person, and you were found legally responsible for those injuries. It covers defence and court costs if you are sued, as well as medical bills, pain and suffering, and lost wages up to your coverage limits.

Property damage liability coverage helps pay for damage done to another person's or company's property, as well as the loss of use of that property. This means that your actions caused damage to property, and you were found legally responsible for those damages. It covers the removal of a damaged tree, repairs to a building wall you crashed through, and defence and court costs if you are sued.

The minimum amount of liability coverage required varies by state. For example, Arizona's liability coverage requirements are 50/30/10, meaning drivers need $50,000 in bodily injury liability coverage per person, $30,000 in bodily injury liability coverage per accident, and $10,000 in property damage liability coverage overall. Other states may have different requirements, so it is important to check the specific requirements for your state.

While state-required liability coverage is the legal minimum, it is generally recommended that drivers carry more than the minimum coverage. If you cause an accident that exceeds your coverage limits, you could be personally liable for all of the costs that exceed your policy's limits. This could result in consequences such as garnished wages, liens against your assets, and court fees. Therefore, it is important to consider your potential risks and choose a coverage amount that provides adequate protection.

Insurance and retirement accounts

When it comes to auto liability insurance, the general rule of thumb is to have coverage equal to the value of your net worth. Net worth is calculated by adding up everything you own, then subtracting everything you owe, such as mortgages and other debts. This gives you a sense of your accumulated assets, which you would want to protect in the event of an accident.

However, this rule doesn't always apply. The amount of liability insurance you need depends on the potential loss relative to your net worth, the likelihood of a large net worth loss, and your risk aversion.

For example, if you have a net worth of $1 million but are found liable for $2 million in damages, your $1 million policy won't be sufficient. In such cases, you may need to purchase additional protection through an umbrella policy, which provides broader coverage and excess coverage beyond your home and auto liability coverage.

On the other hand, some of your net worth assets may be protected in the event of a lawsuit. These protected assets include your 401(k), IRA, Social Security, and home equity. If a significant portion of your net worth is protected, you may not need as much liability insurance.

Additionally, at high levels of net worth, particularly if a large portion is protected, you may choose to leave a portion of your assets unprotected, especially if you are fully funded for your financial goals.

Retirement Accounts

Now, let's talk about retirement accounts. There are several options available for retirement savings, each with its own advantages and disadvantages. Here are some of the most common types of retirement plans:

• Defined Contribution Plans: These include 401(k)s, 403(b)s, and 457(b) plans. You can contribute pre-tax wages, which grow tax-free until retirement. Withdrawals before retirement age may result in additional taxes and penalties.
• Traditional Pensions: These are employer-funded and provide a fixed monthly benefit upon retirement. However, they are becoming less common.
• Guaranteed Income Annuities (GIAs): These are purchased by individuals to create their own pensions. You can buy them on an after-tax basis or within an IRA, with different tax implications for each option.
• Federal Thrift Savings Plan (TSP): This is similar to a 401(k) but is available to government workers and offers very low investment fees.
• Cash-Balance Plans: These are a type of defined benefit plan that defines the benefit in terms of a stated account balance. They provide more certainty about the benefit amount compared to traditional pensions.
• Cash-Value Life Insurance Plans: These plans provide a death benefit while building cash value, which can support retirement needs. Withdrawals of premiums paid are typically tax-free.
• Nonqualified Deferred Compensation Plans (NQDC): These are typically offered to top executives and provide tax-deferred savings opportunities.

In addition to these dedicated retirement plans, you can also use Health Savings Accounts (HSAs) and 529 education savings plans to supplement your retirement savings.

When deciding how much liability insurance you need, consider your net worth, the risks you are exposed to, and the potential magnitude of claims. Then, weigh that against the level of wealth you need to protect to achieve your financial goals. This will help you determine if you need more or less coverage than your net worth.

Frequently asked questions