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I'm confused about the Liability auto insurance. Some online resources appear to say that you must have as much liability insurance as the total value of all your assets, whereas others just say to have as much as possible.

Say, in the event that your total assets are at or below X, will having the liability insurance at X for "each accident" protect all of your assets, or, if the accident is severe enough and X will not be sufficient, are you on the hook for all of your assets to cover the rest? (I'm most interested in the jurisdiction being Texas or California.)

Basically, does having the liability insurance protect as much of your assets as the insurance is for, or is it instead simply the first line of defence against a claim?

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It is simply the first line of defense against a claim. In theory, the assets don't have anything to do with it. In a perfect world, the court would decide that you had caused X amount of harm to the other party without knowing the amount of your insurance coverage or your overall assets.

However, in the real world, people do have some idea of your overall assets (property records, guess based on your occupation, etc). So they may base the lawsuit amount on that guess.

If you're looking for overall asset protection, you generally want to move beyond auto insurance into something called Umbrella Liability:

An umbrella policy kicks in when you reach the limit on the underlying liability coverage in a homeowners, renters, condo or auto policy. It will also cover you for things such as libel and slander.

These are sometimes called "Personal Catastrophic Liability"

Some of the benefits of Umbrella/PCL policies are:

  • They have higher coverage limits than you can choose for your auto policy
  • They cover liability for other causes (e.g. someone slips and falls on your property)

For more discussion of umbrella policies, see these questions:

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Your assets are totally protected, up to the point where the damage exceeds the insurance limit. For example, say you have an insurance for $1,000,000 and assets of $500,000.

Damage = $990,000 - Insurance pays all. 
Damage = $1,000,000 - Insurance pays all. 
Damage = $1,010,000 - Insurance pays a million, they come after you for $10,000.
Damage = $1,700,000 - Insurance pays a million, they come after you for $700,000.

Your assets don't come into play as far as the insurance is concerned. It only makes a difference in that you can afford to pay the $10,000, and all your assets are gone if they want $700,000 and then you still owe money. The insurance doesn't protect your assets, but for example a $2,000,000 cover would make it much less likely that your assets are touched. Still, after a $2,500,000 damage, your assets are gone.

In other countries, for example in Germany, much higher insurance limits are quite common and actually very cheap, because damage over $1,000,000 would be very, very rare.

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The reason liability insurance is often chosen according to a person's quantity of assets is not because the insurance shelters assets up to the insurance amount, but rather because the quantity of assets defines downside risk of having insufficient insurance and the situations in which extra insurance will be useful. If someone only has $5,000 worth of assets, their personal level of risk exposure even if they were found liable for $10,000,000 worth of damage, would only be $5,000. Losing that $5,000 may be very painful, causing pain and hardship that the person would in relative terms value at ten times that amount ($50,000) but it would still be a lot less than $10,000,000.

Suppose the aformentioned person faces a choice between a $100,000 policy (legally-mandated minimum) and a $1,000,000 policy; consider how the policies will compare if he's found liable for different amounts:

  • If he's liable for $100,000 or less, both policies are equally good.
  • If he's liable for $100,000-$150,000, the extra cost to the insurer will be less than the extra value to the insured.
  • If he's liable for $150,000-$1,000,000 the insurer will have to spend more than $50,000 extra in order to provide $50,000 worth of value to the insured.
  • If he's liable for $1,000,000-$1,005,000, the insurer will have to spend over $900,000 extra to provide less than $50,000 worth of value to the insured.
  • If he's liable for $1,005,000 or more, the insurer will have to spend over $905,000 extra while providing no value to the insured.

Note that there's a rather small range of situations where the cost to the insurer is less than the value to the insured. Now suppose the person facing that decision had $75,000 worth of assets that would as above cause tenfold pain if lost.

  • If he's liable for $100,000 or less, both policies are equally good.
  • If he's liable for $100,000-$850,000, the extra cost to the insurer will be less than the extra value to the insured.
  • If he's liable for $850,000-$1,000,000 the insurer will have to spend more than $750,000 extra in order to provide $750,000 worth of value to the insured.
  • If he's liable for $1,000,000-$1,075,000, the insurer will have to spend over $900,000 extra to provide less than $750,000 worth of value to the insured.
  • If he's liable for $1,075,000 or more, the insurer will have to spend over $975,000 extra while providing no value to the insured.

The same qualitative scenarios would apply as when the person had $5,000 worth of assets, but the likelihood of hitting the "sweet spot" where the value to the insured exceeds the cost to the insurer would be much greater. Note that what matters is not the quantity of assets, but rather the pain that would result from losing them. Someone who had assets which were of great personal significance, and whose liquidation value would be too high to shelter in a bankruptcy but far below the sentimental value, might rationally decide to buy more liability insurance than someone whose assets were primarily liquid and who had little emotional attachment to any of them.

  • your examples seem more confusing than helpful; i don't think they're even correct – cnst Jun 4 '15 at 18:04
  • Just because you don't have assets to cover the damages doesn't mean you are off the hook. The court can still garnish your future wages to pay the damages. – psusi Jun 4 '15 at 22:28
  • @psusi: While some kinds of liability aren't erased by bankruptcy, most are. The risk exposure of someone with $5,000 in assets is greater than $5,000 but it's generally going to be a lot less than $1,000,000. – supercat Jun 4 '15 at 23:52
  • @supercat, yes, you can declare bankruptcy, but that does destroy your credit rating, and you can only do that so often. You might not have to pay the full debt that your insurance does not cover, but it isn't like that debt just goes way scott free. – psusi Jun 5 '15 at 2:27
  • @psusi: Should I amend my answer to include that as part of why the pain of a loss in excess of assets exceeds the value of the assets by a significant but not infinite amount? I think my fundamental point is sound: someone with $1,000,000 in assets has a lot more to lose from being under-insured than someone with $5,000, and thus receives far more benefit from a larger policy than would someone with less to lose. – supercat Jun 5 '15 at 15:04

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