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My auto insurance recommends taking out a policy with a liability limit of at least my net worth. This doesn't seem intuitive to me in that the less money you have, the more a big bill is going to hurt (and the more likely you are to go bankrupt).

To use an example, imagine there are two people: Alice with a net worth of $200K and Bob with $30K. By this advice Alice might take a policy with a liability limit of $250K and Bob with $50K. Now imagine they both got into similar accidents where they were sued for $100K. Alice would be fine (except for a higher insurance bill). Bob would loose his savings, and still be short $20K (and possibly bankrupt).

I'm not aware of one's personal liability in an accident being in any way limited by personal assets, so why would someone with a lower net worth want less insurance? The only reasoning I can come up with is that they would save a little more with a lower premium.

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    FWIW this is handled differently in the UK, and is not a marketing issue. The UK Road Traffic Acts make it compulsory for all car insurance to handle unlimited third party claims for death or bodily injury, plus third party property damage up to £1.2 million. (Subject to responsibility for the claim, of course). If somebody owns property worth more than £1.2m and does not have their own insurance policy to cover accidental damage to it, then more fool them.
    – alephzero
    Sep 13 at 15:27
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    @alephzero If such a person's vast wealth is sufficiently spread out, they may be better off functioning as their own insurance policy rather than paying someone else to provide insurance.
    – Brilliand
    Sep 13 at 18:50
36

I'm not aware of one's personal liability in an accident being in any way limited by personal assets

But in effect it is, because of bankruptcy (debts well beyond your assets can be wiped out). The guideline you asked about can be understood from two key points:

  1. Bankruptcy is not the end of the world. It is inconvenient and stressful, but sets a limit on how bad things can get financially; you can still survive. Given this, the lower your income and net worth, the less you can rationally afford to spend on liability insurance versus other pressing needs.

  2. There is no "typical" judgment amount. You've framed the question on a $100k judgment, but they can easily range over several orders of magnitude at least, say from <$10k for minor injury or property damage to >$10M for death or lifelong care of multiple people (rare, but not extremely rare). This resembles a scale-invariant or Benford's law distribution.

If your net worth is $X, you are primarily concerned about protecting yourself from judgments of the same order of magnitude $X. This is because a judgment much smaller than $X don't affect you much, while a judgment much larger than $X is probably going to bankrupt you anyway. The "scale invariance" idea leads to purchasing (and being able to afford) liability coverage with a limit of order $X.

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  • 5
    Ok great. So I was initially thinking "If your net worth is $1M then you are protecting your net worth with $1M of coverage." But you are saying that's not really true. A $2M judgement would take out $1M in a claim against your policy and then proceed to take out your remaining worth. So it would seem there's no amount you can insure for to truly, 100% guarantee against a rare/freak accident wiping out your entire net worth.
    – user12515
    Sep 11 at 19:34
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    @corsiKa - that comment makes no sense. If you anticipate a $2m judgment then no one would insure you. Also lawyers are really really good at knowing how to bleed a turnip dry. Meaning if you took out a $2m policy and had $1m... they would just go after $3m. Lots of personal injury lawyers will offer to take your case for free and after doing background check and financial vitals of the person who hurt you, if they have little money or insurance they drop your case.
    – blankip
    Sep 12 at 17:57
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    Then what's the point of insurance if you're just going to be wiped out anyway? Why insure yourself for $1MM instead of $2MM (assuming your net worth is << $1MM) if the lawyer will just go after what you're insured for?
    – HorseHair
    Sep 12 at 19:16
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    @blankip Obviously no one would insure you if you, say, have a pending legal matter. But if in the course of your business operations you expect to be liable for a $2M judgement, naturally it makes sense to get that level of protection.
    – corsiKa
    Sep 12 at 19:25
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    "to >$10M for death or lifelong care of multiple people" - I live in Germany, and any car insurance here (that I know of) covers at least 15 mio Euro (for damage to people, not property), and even up to 100 mio is not unheard of, exactly for that reason (actual payouts are exceedingly rare, else premiums would probably go through the roof). Sep 13 at 8:12
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The keys here is both that Bankruptcy is a thing, and you are going to fight much, much harder against a suit that goes after your assets than one that goes after your insurance coverage.

The distribution of accidents is going to be very non linear. Some cases are going to be 1000$, some 10000$, some 100000$, some 1 million$ and some 10 million dollars. And some even larger.

Carrying enough insurance to handle a 100 million dollar accident when you are worth 1000$ is a waste of money. Simply going bankrupt if and when it happens is cheaper than the cost to carry that policy. You lose 1000$.

If you are worth 100 million dollars, the same policy and accident costs you your entire 100 million dollars, minus the amount you are insured. Here, there is increased benefit to you from the higher insurance values; meanwhile, for the person with 1000$ net worth, all insurance short of 99,999,000$ doesn't matter. You go bankrupt regardless.

The same holds at every level.

The next is the fact that people might decide to sue or settle for an amount based on your insurance coverage, if the benefit of going over is limited.

If you have a 100,000$ policy and 1000$ net worth, asking for more than 100,000$ isn't going to benefit the person bringing the lawsuit much. Even if there was an 1 million dollar accident, why not settle for 100,000$ if it can get the other witness (you) on side.

If you are worth 10 million dollars, putting that full 1 million dollar lawsuit through becomes a lot more tempting.

When your coverage is roughly equal to your net worth, people settling for half as much as they could get in exchange for you being a cooperative witness to the settlement becomes tempting. When your coverage is much smaller than your net worth, it becomes more tempting to fight it out.

So, lets look at Alice and Bob. They get in a 500$ accident. No difference.

They get in 5,000$ accident. Again, no difference.

They get in a 50,000$ accident. No difference.

They get in a 100,000$ accident. In Alice's case, the cost is only on her insurance. In Bob's case, it will wipe him out. Who do you think will fight harder against the lawsuit, and who might be more tempted to be a cooperative witness in the lawsuit?

Next, they get in a 250,000$ accident. You can't get blood from a stone; if Bob offers to settle for 50,000$, they have to choose between a potential 100,000$ payoff or a 50,000$ payout without a fight. If the costs of the lawsuit plus chance of winning is 50% of the payout, you take it.

In Alice's case, the calculus of the other side is 50,000$ payout or a potential 250,000$. It looks a lot more tempting to not settle. The costs and risks of not settling can be 4x higher and still be worth it.

Going bankrupt isn't the end, and what liability insurance protects is your net worth (well, and your garnished earnings while bankrupt; you can factor that into a pseudo-net-worth). If you have no net worth, you have nothing to lose from your liability. If you are worth a lot, then you have lots to lose from liability.

7

In addition to what nanoman said, there's the factor that someone coming after you very well might choose to accept the policy limit with less of a fight rather than going after you in what's basically guaranteed to be a hard fight.

The insurance company will be looking at what they would spend in legal bills vs the chance of reducing the judgment. However, if they're after well above the policy limit the economics for the person become different--the total loss is capped at their assets, whether it's spent on a judgment or legal bills. Hence the individual will likely fight very hard even on cases they have little chance of winning.

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My auto insurance recommends taking out a policy with a liability limit of at least my net worth.

This is a bizarre recommendation for an auto policy. Maybe they are talking about an umbrella policy.

E.g. here's a Geico explainer of umbrella policies:

GEICO requires a minimum bodily injury limit of $300,000/$300,000 and a property damage limit of $100,000 or $250,000/$500,000 and a property damage limit of $100,000 on your auto policy to qualify for an umbrella policy. Homeowners/Renters Personal Liability coverage of $300,000 is also required.

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  • Or his net worth is under $300k. Sep 11 at 2:18
-4

The other answers miss a fairly obvious point: insurance companies and insurance agents have a strong financial motivation to sell you the largest practical policy. If they can use fear to sell you $1 million coverage rather than $100K, you'll pay them a lot more.

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    except that, in my experience at least, premiums don't scale linearly with the coverage limit. I assume this is because they have actuarials which determine the expected size of claims and know, for example, that it's much more likely they will have a $5,000 or $50,000 claim on your $1M policy than a claim for the whole amount (which they may also defend more vigorously in court.)
    – user12515
    Sep 11 at 19:42
  • @Michael: While that's true, of course, it still doesn't change the fact that the $1 million policy will cost more, and thus both the insurance company and the agent have an incentive to "up-sell" customers. I'd also expect a larger policy to be more profitable, since the costs of issuing it are the same.
    – jamesqf
    Sep 11 at 23:19
  • This may well be true but then why don't they just tell everyone they "need" a $1/10/100 million policy?
    – stannius
    Sep 12 at 14:44
  • @stannius: Because not everyone can afford to pay the premiums, of course.
    – jamesqf
    Sep 12 at 16:10

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