Life insurance is a contract between a policyholder and insurer where the insurer promises to pay the insured’s beneficiary an agreed amount upon their death. The most common application is between heads of household and their dependents.
Life insurance is also leveraged by commercial lenders as a risk mitigation tool for loan applicants of privately held, family owned businesses.
Similarly, the SBA requires that loan applicants obtain a collateral assignment of life insurance in favor of the lender when the business is formed as a sole proprietorship or single member LLC and is otherwise dependent on one owner’s active participation.
Examples of businesses dependent on one owner’s participation include businesses where special training or licenses are required such as doctor’s offices, assisted living facilities, contractors, mechanic shops, etc.
The required face value of the insurance policy for 7(a) loans is established by the lender who takes into consideration the operating businesses industry classification code, loan amount, length of loan term and available collateral.
On the other hand, Certified Development Companies (CDC) which fund the 504 2nd Deed of Trust, also known as the Debenture, must require a collateral assignment of life insurance with a face value equaling the Debenture minus the available collateral’s discounted liquidation value based on the following schedule:
- Commercial real property including buildings: 75% of appraised value
- Residential real property including buildings: 80%. of appraised value
- Land only and Equipment: 50% of appraised value
- Leasehold improvements, Furniture and fixtures: 5%. Of appraised value
Now, pay close attention to these three important points.
- A collateral assignment of Term Life insurance is acceptable to meet the SBA’s requirement. No lender should require Universal or Whole Life insurance which are generally more costly.
- A loan applicant may assign to the lender or CDC an existing policy that meets their underwriting guidelines.
- A lender can waive the requirement to obtain life insurance if a licensed insurer provides written documentation that the loan applicant is unable to obtain life insurance. Some lenders require denial letters from a minimum of two licensed insurers.
As a best practice, I recommend loan applicants discuss the requirement to obtain life insurance with their loan broker or SBA business development officer upon or before the loan is submitted to underwriting or is scheduled to be presented at loan committee.
The length of time it takes to obtain life insurance is between one to six weeks, or more depending on the life insurance company’s pipeline density, underwriting practices and the loan applicant’s age and health status.