What is Umbrella Insurance and Do I Need It?

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Homeowners insurance, car insurance, health insurance, life and disability insurance … if you already have all these policies in place as part of a strategic protection plan for yourself and your assets, you might find it hard to believe that there could possibly be yet another type of insurance that you need.

But the reality is, the more complex your financial situation gets — and the more your net worth grows — the more pressing it becomes to consider umbrella insurance on top of your current policies.

Here's why (and when) you should think about an umbrella insurance policy, and what you need to know before applying for coverage.

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What is umbrella insurance?

Umbrella insurance (also known as excess liability insurance) is a type of coverage designed to cover potential gaps left by other insurance policies you may already have in place.

If you needed to pay for expenses relating to claims that exceeded the coverage provided by existing insurance, umbrella insurance could help cover those costs.

A good way to think about umbrella insurance is as an extra layer of protection in order to help you avoid financial hardship should a major accident or unexpected event happen. It's like a fail-safe to completely protect your personal savings and assets.

What umbrella insurance covers and how it works

If you're sued for damages that exceed the liability limits of your car insurance, homeowners insurance or other coverages, an umbrella policy would step in to help you pay what you owe.

While this might sound like something that would never happen, it's more common than you might think. We can take a look at a real-life example to see how an umbrella insurance policy works to protect you in the case of an unforeseen circumstance.

You might have heard of Georgia's infamous 2014 Snowmageddon event, where forecasts that called for unusually significant snowfall midweek were largely ignored. When snow began to fall fast and thick around lunchtime, there was a mass exodus of folks trying to commute home from work and school.

Combine Atlanta's existing traffic and congestion problems with untreated roads, bad winter weather and residents with no experience navigating such conditions, and it quickly turned chaotic on the roads.

Now, imagine you were one of those drivers that day. As you tried to get home, your car spun out of control on a snowy hill. You totaled the car next to you — and even worse, several people were badly injured.

The totaled car cost $80,000 to replace. The treatment of injuries costs a combined $800,000. In this situation, you'd be responsible for $880,000 in damages … and you carry $300,000 in liability coverage through your car insurance.

The remaining $580,000 would have to come out of your pocket. That's a major hit — and a good reason to think carefully about purchasing umbrella coverage, which in this case would have stepped in and paid what your car insurance did not cover.

How much umbrella insurance costs

Coverage limits on umbrella policies typically start at $1 million, and in most cases, go as high as $5 million. Basic policies at the lower end of that coverage range can cost $150 to $300 per year.

Keep in mind that your umbrella insurance may only cover a claim if you maintain the minimum coverage amounts required by your other insurance companies (for things like home and auto).

If the umbrella insurance provider feels you are not maintaining appropriate levels of insurance on your other policies, they may not extend a policy offer to you.

This rule protects the insurance carrier from individuals who are trying to carry minimum state liability coverages (to drive down their auto and home policy premiums) and supplement those coverages with the extremely low cost of an umbrella policy.

Who needs umbrella insurance coverage, and how much is enough?

Umbrella insurance is an optional insurance policy, not required by most state laws. Even so, there are specific reasons you might want to seriously consider obtaining umbrella coverage:

1. You have significant savings or assets to safeguard.

Protecting your assets is just as important as growing them, especially when umbrella insurance costs relatively little to carry.

2. Visitors could injure themselves on property you own.

Do you own, rent or borrow things that can lead to injury? If you have a pool, tree house, ATV, trampoline or dog, you could be liable for major expenses if somebody gets hurt on your property.

3. You're responsible for others — and thus at risk of being sued.

If you're a landlord, a kids' sports coach or someone who serves on the board of a nonprofit, your responsibilities might put you in a vulnerable position. Umbrella coverage can help offset any major expenses you might incur through this work.

4. You walk on the wild side or travel abroad.

Do you participate in sports where you can easily injure others, such as skiing, surfing, hunting or — my personal favorite — mixed martial arts? If you were to accidentally cause someone else injury and they sued, umbrella insurance would likely cover you.

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Your policy can also protect against liability claims against you while traveling outside of the United States.

5. You're kind of a big deal.

If you need to protect yourself from defamation lawsuits, like libel and slander, consider umbrella coverage. Those proceedings can get costly quickly.

Once you know you need a policy, determining the right amount is fairly simple: Subtract your respective liability coverage limit from all assets at risk, including home equity, personal property, investments and savings.

A negative result indicates a gap in coverage, which umbrella insurance can help fill. And finding funds to pay for the policy can be simple, too.

Consider increasing the annual deductibles on your auto and home policies from $500 and $1,000 to something more in line with the $1,500 to $2,500 range (ensure you have adequate cash reserves).

This change should help reduce the cost of monthly premiums and give you the cash flow savings needed to afford this new policy without any additional outlay.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Malik S. Lee, CFP®, CAP®, APMA®, is a financial expert with nearly two decades of experience and is the managing principal and founder of Felton & Peel Wealth Management, a full-service, comprehensive wealth management firm servicing clients nationwide with offices in both Atlanta and New York. Malik graduated with a degree in finance from Morehouse College and is a CERTIFIED FINANCIAL PLANNER™, Chartered Advisor in Philanthropy® and an Accredited Portfolio Management Advisor℠.