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January 23, 2019

Best Practices: A Review of Life Insurance Requirements

by Timothy D'Lauro

When underwriting an SBA loan, a Lender has many different issues to consider. The Lender must look to the Borrower and decide whether or not lending money to the Borrower is an acceptable risk. In addition to the real estate, personal property, and other types of collateral the Lender uses to secure the loan, the Lender will also look for other ways to mitigate its risk. One of the ways Lenders do this is to require the principals of the business to obtain life insurance.

Under the SOP 50 10 5 (J) at page 192, the SBA lays out the requirements for when life insurance is required, how much, and when life insurance is not necessary. During the underwriting process, the Lender must first review the borrowing entity and the ownership structure to determine what is the appropriate requirement to meet SBA loan guidelines, and who, if anyone should be required to obtain life insurance. For loans under $350,000, Lenders should follow their internal guidelines. For loans over $350,000 and 7(a) Small Loans that do not meet the minimum credit score, Lenders may follow their internal guidelines, except if the loan is not fully secured. If the loan is not fully secured, life insurance will be required for the principals of a sole proprietorship, single member LLC, or a business dependent on one owner’s active participation. When the owner of the business is crucial to the every day operations of the business and its success, the owner’s well-being will directly affect the Borrower’s ability to repay the loan. If this owner dies, and the business is no longer able to function, and in turn does not make payments on its loan, the SBA would most likely view this as a reason to repair or deny the guaranty. For example, a business with 4 equal partners, who are each equally qualified to perform all tasks of the business, is less likely to suffer financially from the death of one of the partners. To the contrary, a small, single doctor veterinarian practice where only one doctor sees patients and treats the animals is far more likely to collapse financially if that doctor were to die. In the first scenario, the Lender can make a justified decision that it will not require life insurance on the owners because the viability of the business will not be compromised by the death of one owner; in other words, there is an adequate succession of management. In the second scenario, a Lender will most likely require life insurance on the veterinarian, as the viability of the business is wholly dependent upon one individual.

The next consideration for the Lender, if it decides that life insurance is necessary, is how much life insurance is needed. The amount of the life insurance must be commensurate with the size and term of the loan. The Lender may also take into account the amount and types of collateral securing the loan. If the Lender obtains a substantial amount of collateral which may be easily liquidated, it may require a lesser amount of life insurance. For example, if the Lender is providing a $1 million dollar loan, and it is secured by real estate with a liquidation value of around $500,000.00, the Lender may not require the Borrower to obtain life insurance for the full loan amount, but instead an amount that bridges the gap of the monetary difference between the liquidation value and loan amount.

There are also scenarios that the Lender may encounter whereby the owner or principal is deemed uninsurable. When the health of the owner or other factors make obtaining life insurance impossible, such as extraordinarily high costs, the Lender must document its file accordingly. If the Lender determines that obtaining life insurance is not feasible, it must obtain written documentation from a licensed life insurance provider stating the same.

If the Lender decides life insurance is required, the Borrower must then obtain a collateral assignment, naming the Lender as Assignee, not beneficiary, and the assignment must be acknowledged by the Insurer’s home office. The Lender must also monitor that insurance premiums are paid and kept current. In the event that the Lender receives a cancellation notice, it must evaluate whether or not it should bring the premiums current.

SBA Lenders should be mindful of SBA’s requirements for life insurance. In the event a loan defaults because of the death of an owner, failure to follow the SBA guidelines may result in a denial of the SBA guaranty. For more information on SBA life insurance requirements, contact Tim at 267.470.1223 orĀ  tdlauro@starfieldsmith.com.