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June 22, 2011

Firm News for June 2011: Best Practices: SBA Insurance Requirements for Construction Financing

By: Jessica Conn, Esq.

Lenders utilizing the SBA’s guaranteed loan programs to finance construction projects are often uncertain regarding the SBA’s insurance requirements for such loans. The SOP 50 10 5 states that “if the construction component of an SBA-guaranteed loan is more than $350,000.00, prior to the commencement of any construction, lender must obtain from borrower…evidence that contractor carries appropriate builder’s risk and worker’s compensation insurance” (SOP 50 10 5, pages 213-214).

Builder’s risk insurance is a particular type of hazard insurance that protects against physical loss or damage to the structure in its various stages of completion as well as the materials and/or equipment used in the construction or renovation of the real estate. Builder’s risk insurance can be obtained and kept by either the general contractor or the owner of the real estate. The amount of coverage that should be obtained is based on the completed value of the project. Lenders should be aware of the amount of insurance obtained and require borrower’s to increase their coverage to the extent the project changes and additional costs will be incurred, rather than just insuring for the value of the loan. Lenders should keep in mind that the insurance proceeds can be used to rebuild the structure to the stage of completion at the time of the casualty and to replace the materials lost and the replacement costs may exceed the amount of the loan. Regardless of which party is carrying the insurance, lenders should be named as mortgagee and lender’s loss payee on the builder’s risk policy. Builder’s risk insurance is meant solely as temporary coverage. The lender will want to ensure that the policy either rolls into commercial hazard coverage or obtain evidence of the borrower’s separate commercial hazard insurance when the builder’s risk insurance policy terminates.

In addition to builder’s risk insurance, the lender will need to obtain general liability insurance and workmen’s compensation insurance from the contractor. The general liability insurance provides coverage for bodily harm, personal injury and certain property damage caused by the contractor’s negligence when the contractor is on and in control of the Borrower’s property. Workman’s compensation insurance provides wage and medical coverage for employees and subcontractors that are injured while working on the project. This coverage is essential to ensure that your borrower does not have the liability for any injuries to the contractor’s employees.

Lenders should keep in mind that these guidelines pertain to the construction portion of the project only. If the borrower is operating its business on separate premises while construction is in process, the lender should obtain evidence of the Borrower’s insurance as it typically would. Likewise, if the borrower is operating out of the premises that is being renovated during the renovation, in addition to the contractor’s liability insurance, the lender should obtain evidence that the borrower has liability insurance. If only a portion of a property is being worked on, the builder’s risk insurance likely will not cover the portion of the property that is not being renovated so the lender will want to obtain evidence of hazard insurance that covers any such property not being renovated. In all such cases, thoughtful analysis of the insurance required to adequately protect the Borrower and Lender is essential.

It is imperative the lenders obtain the proper insurance when financing construction projects. The SBA expects lenders to take such actions to ensure that the collateral is adequately protected against loss. For more information regarding insurance requirements for construction financing, contact Jessica at jconn@starfieldsmith.com or 267-470-1188.