Do I Need Liability Insurance, Limited Liability Protection, or Both?

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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What is the key difference between liability insurance and limited liability protections?

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.).

What is liability insurance?

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:

• General liability insurance – also known as an umbrella policy, a general liability policy protects against common legal issues due to accidents, injuries, and claims of negligence.
• Product liability insurance – companies that manufacture or sell retail products may be responsible for the safety of those products.  Common areas of risk include a product that causes personal injury or harm.
• Professional liability insurance – also called errors and omissions insurance (E&O), professional liability insurance protects against mistakes made by service providers that harm the clients.  Malpractice and negligence are common causes of action.  Some professionals are required to carry professional liability insurance, such as physicians.

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.

Limitations of liability insurance

There are several key limitations to liability insurance including:

• Coverage exclusions – there are a number of ways that an insurance policy would not cover a specific claim, the most common of which are the following:
  • The policy does not cover the specific nature of the claim.  Policies commonly list certain types of claims that are excluded from coverage.  For instance, many professional liability carriers do not cover certain services that are deemed to be high risk.
  • Depending on the type of coverage, a claim can occur outside of the period of coverage.  Often times, incidents do not develop into claims for many months or even years later.  A policy may not cover claims that were in development prior to the policy going into effect.
  • There is always the risk that the carrier finds a technicality which they use to base a denial of coverage such as if a policy holder does not follow the carrier’s guidelines or comply with their procedures.  A common cause of coverage denial is when the policy holder provides incomplete or inaccurate information on the application for insurance.
• Policy limits – policies have two limits, per incident and aggregate.  The limits of a policy are expressed with two numbers; the first being the limit per incident and the second being the aggregate limit (for instance $500,000/$1,500,000).  Any claims that occur over this amount may be the responsibility of the business to pay.
  • Per incident policy limits – per incident is the maximum amount the policy will pay per claim.  If the limit is $500,000 and the claim is for $1,000,000 then the business may be responsible for the difference.
  • Aggregate policy limits – aggregate limits are the maximum amount a policy will pay over the course of a policy period.  If the limits are $1,500,000 then the carrier will only pay that amount for all claims and the policy holder may be responsible for all claims that occur after the aggregate limits are reached.

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.

Limited liability protection

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.

Limitations of limited liability protection

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.

Which liability protections do I need?

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