Plugging the Holes in Asset Protection Plans
An increasing number of Americans are transferring personal ownership of residential property to trusts, limited liability corporations (LLC), limited liability partnerships (LLP), and other entities designed to protect assets or take advantage of favorable tax treatment Although transferring residential and other real property to an entity can provide numerous benefits, it might also result in an unintended lapse in insurance coverage for both the families transferring the property and their professional advisors. Although it is impossible to document with precision how many trusts and other entities are created each year for asset-protection or tax-advantaged purposes, a review of IRS records verifies past and projected growth in fiduciary tax filings (Exhibit 1).
'Personal Property and Casualty Insurance 101'
Much has been published on the proper use, design, and implementation of the tax and asset-protection benefits available to individuals who transfer residential property to entities. This article focuses on the need to properly structure the insurance policy that is used to protect the majority of residential properties-the common homeowner insurance policy.
An insurance policy is a legal contract in which one party agrees to indemnify another party against certain risks in exchange for an agreed-upon sum of money. Many advisors operate under the logical but false premise that the common homeowner insurance policy covers the actual home. In fact, the party that receives the benefit of coverage is the named insured.
The contract language used in homeowner policies was developed when people, not entities, owned homes. As a result, the definition of "insured" was carefully crafted to protect the interests of a very specific group of people. Although definitions used by carriers can vary in subtle ways, the insurance industry's leading supplier of statistical, actuarial, underwriting, and policy language, the Insurance Services Office (ISO), uses the following language in its commonly adopted broad-form homeowners policy to define an insured:
"Insured" means you and residents of your household who are:
a your relatives; or
b. other persons under the age of 21 and in the care of any person named above. "You" includes the named insured and spouse if a resident of the same household.
The definition of "insured" has been tested many times in court to determine who is eligible to receive the benefits of coverage provided by a homeowner insurance policy. Regardless of the actual ownership interest in the property at the time of loss, in no known instance has a court required an unendorsed homeowner policy to provide coverage to any party other than those defined by the insurance contract.
Given this background, one can see that when residential property is transferred from a person to an entity, the insurance policy that protected the individual owners is not structured to protect the new entity owner of the property. When asset protection is among the primary reasons for transferring the property, the resulting absence of insurance protection is an especially problematic unintended consequence.
Critical Form of Asset Protection: Liability Insurance
Although often overlooked, the very broad liability coverage provided by a homeowner insurance policy serves as a critical form of asset protection. Indeed, homeowner policies not only provide protection against many forms of suits alleging bodily injury or property damage associated with residential premises, but protection is also extended to the named insured for acts arising away from the home. In addition, regardless of the merits of such legal actions, the liability protection provided by a homeowner policy obligates an insurance carrier to provide the insured with a legal defense for covered losses.
Compared to other causes of loss, liability losses occur with far less frequency than those that result in damage to the home (Exhibit 2). …