What is Umbrella Insurance and How Does It Work?

If you have a homeowners, renters, or auto insurance policy you already have liability coverage on each of those policies. Purchasing an umbrella policy can help you cover liability damages that you are responsible for beyond the limits of your home, renters, or auto policies.

Let's look at a practical example to demonstrate how an umbrella policy works. Say that you accidentally run a stop sign and crash into another driver. As a result of this accident, the other driver incurred damages and injuries that amounted to $140,000

You would be responsible to reimburse the other driver $140,000 for their losses that you caused. If you had $100,000 worth of liability coverage on your auto policy, you would be on the hook to pay the other driver $40,000.

If you have an umbrella policy, it would be able to take care of that $40,000 bill. Umbrella policies exist for this reason - to protect you if you are liable above the limits of your other insurance policies. If you did not have an umbrella policy in the example above, the other driver could sue you.

If you could not pay the $40,000 and did not have an umbrella policy, the other driver could try to get compensation from any assets you own. They could potentially come after your home, your personal property, your bank account and more to get compensated for their loss.

Umbrella insurance can protect both yourself and the members of your household from a variety of claims or lawsuits when you are at fault. Most umbrella policies will cover the following.

1) Bodily injury to others

2) Damaging another person's property

3) Legal costs to defend yourself in covered lawsuits

4) Lawsuits such as defamation, libel, slander and invasion of privacy

5) False arrest, detention or imprisonment

6) Malicious prosecution

1) Your dog bites someone - If you had a guest over to your home and your dog bit them, your homeowners or renters liability coverage would be able to help cover their medical expenses and protect your from lawsuits. However, if the cost of their injuries or other losses exceeded the liability coverage of your homeowner's policy, your umbrella policy could cover the difference.

2) You crash your car into someone's property - If you crash your car into another person's property including homes, fences, business offices and more, your car insurance liability coverage would cover those expenses. But if the expenses exceed your car insurance liability coverage, your umbrella policy would kick in.

3) You or a member of your household accidentally injure someone - Say your son hit a golf ball and accidentally hit another individual in the head causing extensive injury. You would first be covered under your homeowner's insurance and then your umbrella policy if necessary.

4) You are sued for libel - If you make a libelous social media post and find yourself in a lawsuit, your umbrella policy can help protect you. It will typically pay to cover legal costs such as the cost of hiring an attorney to represent you.

Umbrella coverage will protect you in many incidents, but it is also good to be aware of when your umbrella policy will not protect you. Umbrella insurance will not cover your own injuries or damage to your own property. Umbrella insurance will also not cover the following.

1) Business losses - You need to have a separate business umbrella policy to get protection from losses that happen from a business if you own one.

2) Criminal acts committed by you or a member of your household

3) Intentional acts of injury by you

4) Damage due to nuclear radiation, war or terrorism

Umbrella insurance is not a legal state or federal requirement, but it may still be a good idea to have one depending upon who you are. If you look at financial products as a whole, some financial products are designed to help move you forward, where as other financial products as designed to prevent you from moving backwards.

In this regard, an umbrella policy is going to prevent you from moving backwards financially if you find yourself liable for damaging property or causing injury to another. So, back to the original question - do you need umbrella insurance?

The short answer is that it depends, but owning an umbrella policy is typically a good idea if have significant assets. For example, let's say that you have built up a hefty retirement nest egg of $500,000 through a Roth IRA.

Let's also assume that you have a car insurance policy with liability coverage amounting to $100,000. If you were to cause an accident that resulted in $250,000 worth of damages and injuries, you would be on the hook for that.

Your car insurance would cover up to $100,000 of the $250,000 worth of damage that you caused. If you did not have an umbrella policy, the individual that you caused injury or property damage to could sue you for  $150,000 or more for the loss that you caused that they were not able to get compensation for.

Depending upon your state laws, the individual that is suing you could potentially come after the funds in your Roth IRA for compensation. If you lose your lawsuit, you could end up losing hundreds of thousands of dollars in your Roth IRA which would derail your financial future.

Even if you do not have assets, your wages can be garnished depending upon the circumstances. A portion of your paycheck could end up going to the individual that you caused losses to until they are repaid. Outside of pure financial reasons, some insurer's will also recommend an umbrella policy if you or a member of your household increase your risk of liability or participate in an activity that does.

For example, if your 16 year old son just got his driver's license there is a higher likelihood he could cause an accident and expose you to liability risks. Other common items that can increase your chances of liability might include pet ownership, having an RV or boat, lots of driving, having a pool or trampoline at your house, and more.

With all that being said, having an umbrella policy is by no means a necessity, but it is usually a good idea if you have any assets. Umbrella policies are relatively cheap and can quite literally save your financial future if you find yourself in a situation in which you might be sued due to excessive liability damage you caused.

On the flipside, if you have assets and decide to forego an umbrella policy, it is important that you have strong liability coverage on your underlying auto and homeowner's policies to lower the risk that you would ever need to use an umbrella policy should you find yourself liable for damages or injuries you caused.

Almost all insurers start by offering umbrella policies with $1 million worth of coverage and will go up by $1 million increments. At the very least, it is a good idea to have enough umbrella coverage to protect the value of what you own.

Try to estimate everything you own that is of value. This might include real estate, investment accounts, personal property, bank accounts, vehicles, boats, jewelry and other valuables. It is important to note that your 401k is typically not subject to most lawsuits under federal law.

IRAs might be subject to lawsuits but may have protection under state law depending upon your state. When totaling the value of what you own, you do not necessarily have to include the value of a 401k or IRA, but it can still be a good idea. If you need help with this it is a good idea to speak with an attorney or insurance agent to see if you should have additional umbrella coverage for a 401k or IRA.

After calculating the value of what you own, you can estimate how much umbrella coverage you need. If you add everything up and find that your valuables total $750,000 you would need the minimum coverage of $1 million. If your valuables total $1.75 million you would need $2 million worth of coverage.

For the coverage you get, umbrella insurance is quite affordable. You will likely pay between $200 to $400 per year, or $16.67 to $33.33 per month for $1 million worth of coverage. The following factors can impact what you will pay for coverage.

1) Your location - Insurance rates will vary depending upon where you live. This is a factor that is out of your control. You might live in a state in which umbrella policies are cheaper or you might live in a state in which umbrella policies are more expensive.

2) Your credit history - If you have a poor credit score, you might pay more for coverage. Insurance companies have found that individuals that have lower credit scores are more likely to make claims which means the insurer charges them more for coverage.

3) How many vehicles you own - If you only have a single vehicle in your household, you will pay a lower rate than someone who has lots of vehicles in their households. More vehicles mean more opportunities for accidents that could result in liability claims.

4) Driving record of your household - If your household has a less than stellar track record, you will likely pay more for coverage. The more accidents, speeding tickets and traffic violations your household has makes your household a greater risk for the insurer to cover.

5) Teenagers in your household - Teenagers are going to be more prone to accidents than other drivers in your household. This increases the risk that a liability claim could arise in which you would need to use your umbrella policies which means you will pay more for coverage.

6) Coverage amount - The more coverage you buy, the more you will pay. An umbrella policy with $1 million worth of coverage is going to be cheaper than an umbrella policy with $5 million worth of coverage.

In order to purchase an umbrella policy from an insurer, you are usually required to have your auto and home or renters insurance with that insurer. For this reason, it is often easier to buy an umbrella policy from your current insurer, but you can shop for quotes at other insurers for all policies if you are wanting to switch.  

1) Meet the minimum auto and home liability requirements - All insurers require you to have certain underlying liability coverage limits on your existing home/renters and auto policies. Insurers do this to decrease the risk that you would have to use your umbrella policy.

Here is how it works. Let's say that you currently have $100k/$300k of bodily injury coverage and $50,000 of property damage coverage on your auto policy. You also have $100,00 worth of liability coverage on your home or renters policy.

Before your insurer will let you purchase an umbrella policy, you might have to upgrade your auto coverage to have $250k/$500k of bodily injury coverage and $100,000 of property damage coverage. You might also have to upgrade your home/renters liability coverage to $300,000.

The exact requirements vary by insurer so make sure to reach out to them to see if your current coverage meets the requirements or if you would have to buy more. If you don't have enough coverage, you will need to buy more to meet the requirements of your insurer before purchasing an umbrella policy.

If you have to buy more coverage, you can typically ask your insurer to provide you with a quote that would detail how much the increased liability coverage on your auto and home or renters policy would cost you before purchasing more coverage.

2) Understand how much coverage you need - Before you get a quote from your insurer, it is important to be aware of how much coverage you need. As previously stated, you can add up all the things you own that are of value to get an estimate. Your insurance agent can also advise you on how much coverage is necessary for you.

3) Ask your current insurer for a quote - Once you know how much coverage you need, simply ask for a quote. Your insurer may confirm current information or gather additional information to generate a quote.

4) Submit your premium to bind coverage - If you like the quote that you are provided and are confident that it provides you enough coverage simply fill out any necessary paperwork and submit your first premium payment to bind the coverage.

The bottom line is that umbrella insurance protects you if you are liable for expenses that exceed your underlying liability coverage on other insurance policies as a result of you injuring another person or causing damage to their property.. It is usually a good idea to obtain an umbrella policy if you own significant assets or have members of your household that increase your risk of liability.

If you opt for an umbrella policy, make sure to take an inventory of everything you own that is of value and get enough coverage to protect those items. Obtaining an umbrella policy is fairly easy and can be done quickly through your current insurer.