When a responsible lender considers a loan application, their topmost priority is safety of capital. Can they be reasonably assured that the borrower will pay back investors’ hard-earned money as promised? Or will they be stuck holding the bag if things don’t work out as hoped?
The Small Business Association is in a similar position. They don’t lend money directly, but they guarantee loans, and if the borrower doesn’t pay back the money, it’s the SBA – and the taxpayer – that’s left holding the bag.
They don’t want to be stuck. That’s why the Small Business Association requires entrepreneurs seeking SBA loans to have their own life and disability insurance lined up before they will agree to guarantee the loan, in many cases.
According to Small Business Association guidelines, the lender should require life and/or disability insurance to be in place whenever there is doubt about the business’s ability to go on functioning in the event of the death or disability of a key founder or executive or group of such individuals. If the death or disability of one or more key persons would likely put the repayment of the loan in jeopardy, then the combination of available collateral and insurance should be sufficient to pay off the balance, or the SBA will not want to approve it for their program.
When life insurance is required, borrowers should not name the lender as a beneficiary, but instead arrange an interest in the insurance policy as a collateral assignment. To set up a collateral assignment, contact your insurance agent. It’s generally just a matter of signing a form. The insurance company will then send a notice to the lender, though the process could take a couple of weeks.
For businesses that are very concerned about short-term cash flow, a term policy or series of term policies may be appropriate. For businesses with higher margins, a permanent policy such as whole or universal life that allows the business or owners to accumulate cash value on a tax advantaged basis, separate from the business and not subject to the ordinary claims of creditors may be a smart strategy. Speak with your insurance agent about what approach or combination of approaches may work best for you.
Just as the lender or the SBA must protect itself and its stakeholders against being stuck with a loss in the event of the death of a key individual or executive, they must also take the same precautions to protect themselves against the risk of disability impacting the business, as well.
Borrowers can show that they will be able to make good on the loan even in the event of disability via a combination of collateral and disability insurance. This is sometimes accomplished with a traditional disability insurance policy that leaves enough income to continue to make loan payments as promised. Business owners may also elect to use a specialized form of coverage specifically designed to protect lenders, called business loan protection insurance. With these loans, benefits are paid directly to the lender. Specifics and available riders vary from carrier to carrier, so speak with your insurance professional to work out a strategy that is optimal for you.
Note that SBA lenders may require a number of additional types of insurance, depending on your business model and situation, including worker’s compensation, flood insurance, business interruption insurance, errors and omissions or malpractice coverage, product liability insurance, dram shop/host liquor liability insurance, and many others.