Best Practices: Common Insurance Errors and Their Impact on the SBA Guaranty

Insurance requirements are different for every loan and are based on the type of collateral being taken, the type of business that is borrowing funds and the project for which such funds are being utilized. Two types of business insurance are required for almost every loan: hazard insurance and liability insurance. Lenders must follow SBA guidelines in obtaining the proper insurance documentation as a failure to do so can jeopardize the guaranty.

Hazard insurance is generally required for all collateral being pledged for a loan. The SBA 7a Authorization boilerplate requires that coverage for real estate or personal property hazard insurance be equal to the higher of: full replacement cost or the maximum insurable value. For real estate hazard insurance, the lender must be named as a mortgagee on the policy. For personal property hazard insurance, the lender must be named as lender’s loss payee on the policy. In both cases, the endorsement to the policy “must provide that any action or failure to act by the…owner of the insurance property will not invalidate the interest of [l]ender” and lender must have at least 10 days prior written notice of policy cancellation.

One common error with respect to hazard insurance is that the lender is named as loss payee and not lender’s loss payee. This error can impact the lender’s ability to collect under the policy when a borrower is not entitled to payment under the policy.  Another common error is that the coverage does not include replacement cost of the assets insured. If any of these errors result in a loss to lender because a default has occurred and lender is unable to collect proceeds following an insurable event, SBA is likely to recommend a repair of the guaranty in the amount of such a loss.

Lenders should obtain evidence of general liability insurance for all borrowers. While the SOP does not specifically outline the amount of general liability insurance required, most borrowers have $1,000,000 coverage for each occurrence and $2,000,000 in the aggregate. Lenders should be named as an additional insured on the general liability insurance policy. Failure to be named as an additional insured could result in lender not receiving notice of cancellation of the policy.

One common error with respect to liability insurance occurs when the proper parties are not named on the policy. For example, for an EPC/OC loan, the EPC may be named on the liability insurance, but the operating company is not named (or vice-versa). It is important that the lender confirm that all borrowers, the EPC and OC, are covered on the general liability insurance policy. If the borrower (or operating company) is not covered and its business fails due to the entry of judgment or from litigation costs that would typically be covered by such insurance, a denial of the guaranty is possible.

With respect to both hazard and liability insurance, lenders must ensure that appropriate systems are in place so that updated certificates are obtained in a timely manner when servicing the loan. When not properly serviced, lenders may not be aware when coverage has lapsed. Also, many lenders rely on Acord certificates to close, but Acord certificates state that they are for information only and do not confer any rights on the certificate holder/additional interest (as applicable). Therefore, it is imperative that lenders obtain copies of the policies (or declaration pages) and the required endorsements in order to properly confirm coverage, even if such documentation is obtained post-closing. Again, if the borrower does not maintain the proper coverage and lender is not aware because it did not require updates or copies of policies, the SBA may recommend a repair or denial if lender is unable to recover on collateral that should have been insured.

For more information on insurance requirements and other SBA related topics, contact Jessica Conn at jconn@starfieldsmith.com or 215-542-7070.