By Derek Kartchner | Gila Insurance
Recently, I heard a claims story – one of the worst kinds. This was not my client, but it was a friend. He and his wife own a business, and the wife had gone to the shop to run some sort of errand. While leaving, she pulled out onto the road and hit a car she had failed to see. The good news is that while injuries did occur, everyone is okay. The bad news is that there is now a multi-million-dollar lawsuit at play. That is generally abnormal, although it is becoming more common. Why a multi-million-dollar lawsuit?
Well, I don’t want to degenerate the legal profession, but I think it’s because they can.
These clients had a successful business. The wife was conducting company business when this occurred, and so the lawyer in question is handling this as a business lawsuit (which does tend to have higher payouts).
So, why do I tell this story? Because of the fallout.
Gila Insurance Group specializes in working with investors, but we also provide our local community standard insurance services like auto, home, and business insurance. This claim has caused an explosion of questions about liability, and something I feel the AZREIA community should hear. Here are a couple of thoughts about liability:
- Talk to your lawyer. AZREIA has a couple of good ones. As a member of the risk management community, I can tell you about claims, but my job is to ensure things as they are, the best I can, with you in the driver’s seat. Telling you how to set up LLCs, Trusts, etc. is a game for legal professionals. Legal vehicles like Trusts and LLCs should be a part of your risk management plan!
- How much liability is enough? Excellent question. The answer is $1 more than that for which you will be sued. How much will that be? I don’t know, but my friend’s business is not likely worth $2 million. A good rule of thumb is to add up your assets and AT LEAST carry that much (although that is a rule of thumb and is not really how settlements work). If you get sued, lose, and have a judgment against you, there is no cap on the judgment of your insurance limit or any limitation on taking your assets.
I like to think of it in terms of a football analogy. In this game, you have all your assets. Your home, rental properties, cash, stocks, bonds, and all other assets are put into the end zone. If sued, your liability acts as a defense against the person suing you, getting into the end zone, and taking your assets! Therefore, if you have no liability coverage, it is like putting up no defense! The judgment against you could force you to mortgage rental properties, pay out cash, sell stocks, etc. so you can meet that judgment. Having liability insurance doesn’t stop the other team from making it to the end zone. What it does is make the judgment higher before you would be required to liquidate assets.
So, can a team score from the 20-yard line? Of course! What about from their 1-yard line? Again, of course but the further away you are, the harder it is. The liability limit you have makes it more or less likely that a judgment requires you to liquidate assets.
In this make-believe scenario, maybe a $300K liability limit puts the plaintiff at the 20-yard line, a 500K limit at the 30-yard line, an umbrella of $1 million at the 50-yard line, and so on (please don’t look at the probability of a team scoring from these, points on the field it’s just an example). In short, more liability coverage means your assets are better protected!
- LLC or Umbrella? – THESE ARE NOT MUTUALLY EXCLUSIVE! Again, talk to your lawyer, but you will probably need both. An umbrella policy increases the amount of liability coverage that you have, and an LLC separates assets from other assets. For example, If you owned two rental properties, and each was under different LLCs, and you set them up and managed them properly, a lawsuit affecting one property will not affect the second one, essentially keeping it out of the end zone. It’s not the asset of that LLC. However, just because you have fewer assets in the end zone, doesn’t mean you shouldn’t have an Umbrella as well! You should protect the assets in that LLC.
- I don’t know how much my friend is worth, honestly. But $2 million seems like a lot. He is getting sued because there is a perception he has assets. You as a real estate investor are perceived to have assets. Act like it when protecting yourself. You might be cash-flowing $100 a month or even have negative cash flow, but to your tenant, you have more than one home – you are wealthy. Protect yourself as such.
Liability claims can be nasty, no doubt about it. How do you protect yourself? Meet with a lawyer and put together a plan. Work with your lawyer and your insurance agent to make sure you feel comfortable with the amount of liability coverage you have. Finally, don’t assume that a one-size-fits-all solution like an LLC or Umbrella exists. A legit risk management plan will have a comprehensive and multi-pronged approach to ensure that your Real Estate Investment business is properly protected.