Why is net worth a recommended minimum for insurance coverage

Question

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.

Answer 1

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.

Answer 2

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.

Answer 3

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.

Answer 4

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.

Answer 5

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.