The Asset Protection Misconception: Why Insurance Alone Isn’t Enough

“Why did my financial advisor tell me that in order to achieve asset protection for my investment properties, I only need a general liability policy?” This is a question I am consistently asked by investors when I am speaking throughout the country. Don’t get me wrong, I am a huge advocate of insurance, but in order to achieve proper asset protection, insurance must be used in conjunction with a proper legal entity.

Not to state the obvious, but an investor invests in real estate to build net worth, not to deplete his or her personal holdings if an injury occurs. Insurance is a contract between an investor and the insurance company. The investor pays the insurance company a monthly premium to provide coverage for injuries arising from activities associated with the policy. The most common type of policy that is acquired is a general liability policy, which provides coverage for damages caused to other persons in the form of personal injury. This coverage makes sense to the investor because the purpose of the insurance is to provide a shield between the investor’s investment properties and the investor’s personal assets. However, the investor must always remember that this policy is a contract with the insurance company and both the investor and the insurance company each have goals. The investor is seeking to minimize loss while the insurance company is seeking to make money by minimizing losses. The lack of focus on these competing goals often causes the investor to overlook the most important part of the contract: The Exclusions.

Beware of Exclusions

Exclusions are written into policies to allow insurance companies to achieve their goal of making money while minimizing losses. This is not a knock on insurance companies, they are a business and their goal is to generate profits. The methods that insurance companies use to control potential losses are through the exclusions in the contract. The exclusion that investors should be most mindful of is that environmental claims are going to be specifically excluded on all general liability policies. Most investors will glance right over this exclusion because the first thing that pops into an investor’s mind is chemical or oil dumping, but the biggest claim for environmental harm is Stachybotrys chartarum, commonly known as toxic black mold. Between the years of 2001 and 2002 there was an explosion of toxic black mold cases in the United States. With the dwindling number of asbestos cases at that time, the real estate litigators had found their new cash cow. I have attended classes on how to litigate toxic black mold cases in the past and the phrase thrown around is that “Mold is Gold.”

This left the insurance companies scrambling to minimize their loses, thus the exclusions in the policies. There are a handful of insurance companies that will insure for environmental injuries but the policies are often cost prohibitive to the standard investor and extensive study of the property is required by the insurance company before the policy is issued. Therefore, for most investors that only have insurance for protection, if a tenant brings a claim for toxic black mold exposure don’t look to your insurance company for assistance. You are literally on your own. Since the investor held title to the property personally, the investor is personally sued. Not only is the investment property at risk but so is every other asset that the investor owns. Unfortunately, the legal system in our country is now viewed with a lottery mentality and new lawsuits are filed at a staggering rate of 1 new lawsuit every 1.5 seconds. It is no wonder that it takes an average of two years from the time the case is filed to reach the trial date. Now that the investor is sued personally, he or she has to hire an attorney out of his or her own pocket to cover the defense costs.

No Need to Play the Lottery Just File a Lawsuit

Defendants have a saying “Even when you win, you lose.” If the investor has the significant financial resources to cover the tens of thousands of dollars it will cost to defend the lawsuit, if the court enters a judgment for the investor, the defendant is still out of pocket tens of thousands of dollars. Therefore 98% of all lawsuits filed end up settling before going to court. As an investor, you want to minimize your loses so it often makes sense to settle because our nation’s juries are treating these cases like lotteries.

Some examples are:

• $1.08 million in Delaware when the landlord failed to fix a leaky faucet and mold grew;
• A Texas jury awarded $32 million, which was reduced to $4 million on appeal;
• A California case where a jury awarded $18 million for toxic mold claims, but the award was reduced on appeal to $3 million.

These cases are not random occurrences, they happen every day in every state of our country.

Be Proactive Implement a Solution

So what is the investor to do? When the investor holds the investment property in his or her name, the investor has everything to lose in a lawsuit. The first course of action is to immediately minimize risk exposure. Risk exposure is minimized by transferring the titles of the investment properties into business entities that provide liability protection. These business entities include corporations, limited partnerships and limited liability companies (LLC). Each of these entities have different levels of protection and different tax implications depending on the type of investing, i.e. holds, wholesale, lease options, etc., but that will have to wait for another day. The purpose of using a business entity is to contain the risk exposure inside of the business itself. The problem with holding investment assets personally is that there is no legal way for the investor to separate his or herself from the investment property. Therefore, any harms associated with the property potentially risk the investor’s personal assets.

If a business entity is properly created and maintained, there is a layer of separation between the investor who owns that company and the activities of the business. Courts are extremely reluctant to allow liability exposure to flow outside of the business to attach to the personal assets of the owner of the company. This level of protection has been maintained not only via state statutes but in court cases over the last two centuries. The government wants to promote investment in businesses and this is achieved by not making businesses owners and investors personally liable for harms arising out of the business. There are cases where the “veil” is pierced by actions of comingling assets, fraud, gross negligence and failure to follow formalities, but as a whole the owners are well protected if the owners acted as reasonably prudent persons.

Putting it all Together

A business entity alone will not guarantee liability protection if the business does not operate in a reasonably prudent fashion. What is reasonably prudent for an investor’s business holding investment property? Having adequate insurance. Just as individuals need to carry insurance, the business needs to also carry insurance to minimize its loses. Just as insurance is not a substitute for business entities, the business entities are not a substitute for insurance. There have been cases where the “veil” was pierced resulting in an injury on the business property because the business did not have insurance.

You may be wondering “why even bother setting up a business entity if a lawsuit can still occur?” An investment property can never be protected from harms arising from the property itself. However, the investor must be proactive to insure that the harm does not wipe out everything that he or she has accumulated over the years. The use of the business entity in conjunction with insurance helps to insure that if the harm exceeds the insurance coverage, or if the harm arises from an excluded injury like toxic black mold exposure, the investor only has that particular property at risk and not his or her personal assets.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.