I am often asked how liability insurance is different from limited liability protection. Liability insurance is purchased from an insurance company to cover claims against the business. Business entities such as limited liability companies (LLCs) and corporations provide limited liability protection, which prevents creditors from seizing the business owners’ assets.
Business owners do not realize that liability insurance and limited liability protection serve two different purposes. Both liability insurance and limited liability protections help to minimize the risk of financial losses as a result of a lawsuit.
According to this source, one in three small businesses are sued or threatened with a lawsuit, which makes proper planning and liability protections extremely important.
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Liability insurance protects the assets of the business while a limited liability entity protects the assets of the owners.
Liability insurance is purchased from an insurance carrier and protects the assets of the business (such as equipment, real estate, surplus funds, investments, etc.) in the event of a claim or lawsuit.
Limited liability protections come from forming a business entity that separates the business assets from the owners’ personal assets (such as their homes, vehicles, retirement accounts, savings accounts, etc.).
Liability insurance is purchased from an insurance carrier and provides coverage for claims or lawsuits against the business. Insurance comes in many forms, but the most common types of policies covering lawsuits include:
Liability insurance is an important consideration for small business owners. Even if the business is not making huge profits, often times the money is well spent for peace of mind. The best way to explore the costs and benefits of liability insurance is to speak to your local insurance broker.
There are several key limitations to liability insurance including:
If the insurance policy does not cover the entirety of the claim, creditors will typically pursue the assets of the business as the next source to cover the claim. If the business doesn’t have sufficient assets either, creditors could come after the personal assets of the business owners.
With these inherent limitations, liability insurance does not provide complete protection. Not only is it important to obtain adequate insurance coverage, but it’s also important to create backup protections in case the insurance policy is not enough.
Business owners should consider limited liability protections to decrease their risk of experiencing personal financial losses.
A limited liability entity such as an LLC or corporation provides liability protection for the business owners. Business entities prevent creditors from coming after the personal assets of the owners including their homes, cars, savings and retirement accounts, etc. The entity forms a “corporate veil” that shields the owners from liability risk provided that the entity is setup and maintained properly.
Let’s suppose a company makes a mistake and a client is harmed. The client sues the company, wins the lawsuit, and is awarded $400,000. Say the insurance policy has limits of $250,000 per incident, which means it would not cover the entire claim. In this case, the plaintiffs may choose to pursue the remaining $150,000. If the business does not have assets to cover the remainder, the plaintiffs could come after the owners. If the owners are operating as a general partnership and not a limited liability entity, then they could be held responsible for paying the $150,000. If they are operating under a limited liability entity, then it would be difficult for the plaintiffs to successfully recover any money from the business owners.
A business entity protects the owners’ personal assets but does not protect the business assets. The business entity would help prevent creditors from being able to seize the personal assets of the owners but will not prevent creditors from coming after the business assets. In the above example, if the business has assets, creditors could use those assets to cover the remainder of the claim not covered by insurance.
It is important to consider obtaining adequate business insurance coverage and setting up limited liability protections as a further safeguard. Since obtaining liability insurance or forming a business entity alone do not provide complete protection, it is wise to consider doing both.
Only you with the help of your attorney can decide which strategies are right for your business. Your attorney may be able to advise you on additional ways to protect your personal and business assets.
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Originally published March 2013
Updated October 2019