If you are reading this, you are very likely on your way to realizing your business dreams. Depending on how far along you are in the loan application process, you have jumped through many hoops and checked off a great deal of the long list of Small Business Administration’s requirements to get financing. You may even be approved and the money is already on its way!
Now you need a life insurance policy as collateral for the loan before you can close the deal? Let’s talk about that.
Why Does An SBA Loan Require Life Insurance?
The Small Business Administration (SBA) Loan Program is designed to help new and existing small businesses acquire the funding needing to grow or expand. The SBA offers several types of loan options but the most common is the 7(a) Loan Program. The SBA’s role is not to lend money but to guarantee a portion of the loan made by participating lenders, usually banks. The lender initiates the loan, and if the SBA agrees to provide guarantees, the lender funds and services the loan.
The specific reasons why the SBA requires life insurance can be found in the SOP 50 10 5(H), Lender and Development Company Loan Programs manual provided by the U.S. Small Business Administration’s Office of Financial Assistance. This exhaustive document is an excellent resource for all things concerning SBA Loan Programs.
Under the SOP 50 10 5(H) Subpart B section, it states,
For loans processed under standard 7(a) over $350,000, lenders may follow their internal policy for similarly sized non-SBA guaranteed commercial loans, except:
If the loan is not fully secured, life insurance is required for the principals of sole proprietorships, single member LLCs, or for businesses otherwise dependent on one owner’s active participation, consistent with the size and term of the loan. The amount and type of collateral available to repay the loan may be factored into the determination of the appropriate amount of life insurance. If lender determines the principal is uninsurable, lender must obtain written documentation from a licensed insurer of the same.
There are really two reasons for the SBA life insurance requirement:
- Most of the loans processed under the 7(a) Loan Program are not fully secured. In other words, unless the SBA agrees to guarantee these loans, they would otherwise not be made. In many cases, start-up companies and even existing business have little capital and very few assets. The SBA requires life insurance for the assurance the funds will be available to satisfy the loan if the business owner dies.
- Most small businesses, and especially start-up companies, depend on the expertise and skills of one key person. This person is critical to the execution of the business plan which is the basis for the loan. If this person dies, what is going to happen to the company? Consequently, life insurance is required as collateral to protect the SBA guarantees. This type of insurance is commonly referred to as key man life insurance for this very reason.
What Kind of Life Insurance Policy Do You Need?
The SBA does not specify the type of life insurance required to secure a loan.
They just want coverage in effect if the key person dies. Your lender may have certain requirements though and you need to make sure that you are getting the type of policy that they require. The type of life insurance policy that is best for you depends in large part to your answers to three questions:
- How much does it cost?
- What is the health of the key person?
- How quick do you need the coverage?
We will discuss each of the types of life insurance policies available in light of these three questions.
Term Life Insurance
Term insurance is the most effective way to satisfy the key man life insurance requirement to secure an SBA loan.
The primary reason is cost. Term policies are really cheap and not too difficult to get. Term life insurance is “death protection only”. There are no bells and whistles or any cash value to drive up the cost.
With term insurance, you are covering exactly what is required by the SBA at the lowest possible rate.
Within the term life insurance category, there are several policy types.
Decreasing Term Life Insurance – Decreasing term usually has a fixed cost with a declining insurance amount over time. These policies were used years ago for mortgage protection. They were really inexpensive and the amount of insurance decreased over time as you paid down your outstanding mortgage. It would seem that a decreasing term life policy would be perfect to cover an SBA loan. However, today you can buy a level term policy with a fixed rate and a fixed benefit for less than it would cost to buy a decreasing term plan.
Annual Renewable Term Life Insurance (ART) – Annual renewable term policies provide a fixed amount of insurance with a rate that increases every year. These plans are generally really cheap the first 2-3 years. However, they are not cost effect over time. If your loan is a very short duration you may consider an ART policy but if the loan payoff is longer than 3 years, a level term plan will be more cost effective.
Level Term Life Insurance – Level term life offers a fixed rate for a fixed number of years and is guaranteed not to change during the level term period.
No Exam Term Life Insurance – No exam level term is exactly what is sounds like: level term life insurance which does not require a medical exam. These policies are a first option if you need coverage fast. They are always slightly more expensive, but in some cases, timeliness is the most critical factor. No one wants to wait 3-4 weeks to get a life insurance policy approved when the bank is ready to close on their loan. With no exam term life, you can usually lock-up coverage quick and move to close on the loan faster. In some cases, you can be approved for coverage in as fast as 2-3 days.
With that said, level term plans are the most popular choice for satisfying SBA life insurance requirements for several reasons:
- First, they are the least expensive policy option for loans with durations longer than 3-4 years.
- Secondly, they are perfect for tailoring a policy to meet the exact maturity of the loan. For example, if you have a 10 year note, you can buy a 10 year term policy to essentially lock-in your cost and guarantee your insurance amount for the life of the loan. There are even plan options that can “dial-in” the level term period to the exact term of the note. For example, if your note is 18 years, there is an 18 year level term option.
- Finally, you can drop the policy at any time without penalty. If you pay off your loan faster than expected, you can cancel the policy simply by discontinuing premium payments.
If you are age 60 or under, and in good health, there are several companies offering competitive no exam term life policies. Most companies will offer a maximum of $500,000 of insurance, though a few may let you apply for up to $1,000,000. In cases where more is required, you can always buy from multiple companies, essentially “stacking” policies to equal the amount of life insurance needed.
TIP: If you want to save money but need coverage as soon as possible, you can always go the no exam route first, securing the loan, and then apply later for a traditional level term insurance policy (requiring the exam), and replace the existing coverage.
Limitations On No Exam Life Insurance
- First, you need to be age 60 or less to qualify. If you are over age 60 an exam will be required with every company.
- If you have any marginal health concern or pre-existing condition, the no exam life insurance policy is likely not a good option. If you do have a health issue, every no exam life insurance company will order your medical reports from your physician(s). This process can take several weeks which doesn’t turn out to be too fast!
- Many companies offering no exam life policies do not guarantee they will approve a policy without an exam! You may apply for a policy which does not require an exam, only to find out later, once you’ve submitted your application, an exam is required.
- It is not easier to get a policy in all cases. We have found the underwriting, or how an insurance company evaluates you medically, can be more difficult with no exam policies. For example, if you are taking a depression medication, there are traditional insurance companies (requiring an exam) which may offer “Preferred” rates. With no exam companies, “Standard” rates will be the best available and may even be “Rated” at an even higher health class. In other words, the exam option would be significantly cheaper in this case. And, there are many more examples like this one.
- The limit with nearly all companies is $500,000, with just a small handful going up to $1,000,000. You can stack coverage with multiple companies, as described above, but this takes time and can get complicated.
It is our opinion, anyone trying to buy a policy to cover an SBA loan requirement should only apply for no exam life if they are really healthy and need the coverage in effect as soon as possible.
Just be very careful, there are many online calls centers who will insist on the no exam life insurance option simply because it is an easy sell, requiring less work on their end. The truth is, if there are any complications with health, or any other issue, it will not be faster and will cost more.
Sample Rates on Life Insurance to Cover an SBA Loan
10 Year Term Life Insurance to Cover an SBA Loan
All rates in the table below are guaranteed for 10 years, and include policy options requiring an insurance exam, as well well as those which do not. All rates quoted are based on annual payments (other payment modes available) and assume the top non-tobacco health class for both male and female. Rates are from A+ Rated insurance providers and are subject to change.
If you are over age 65, No Exam policies are NOT Available.
Return of Premium Term Life Insurance (ROP Term) – Return of premium policies are essentially level term life insurance plans which return 100% of paid premiums to the policy owner at the end of the level period. For example, if a policy cost $2,000.00 annually, and the level term period is 20 years, at the end of the 20 years, the insurance company would return $40,000 to the policy owner.
The concept is simple. You pay a higher premium for the life insurance for the opportunity to get your money back at the end of the term.
It is the basic time value of money scenario where the insurance company takes the extra premium and invests it over time to earn a higher return, and then pays you a little less. Sounds attractive, but if your company is a start-up, controlling costs is probably going to be your main objective!
This option may make sense if your loan has a very long maturity 25 or 30 years. On the other hand, if the term of your loan is less than 25 years, the cost difference between a level term life policy and ROP term is considerably large.
Permanent Life Insurance
Whole life insurance or universal life is protection designed for situations where coverage is needed forever or cash accumulation is a primary goal.
Like term insurance, there are many variations of permanent insurance. These policies have many attractive features and benefits, including cash value potential and guaranteed life insurance for the lifetime of the key person.
Permanent life insurance would really only be an attractive solution for more mature companies with significant cash flow. Companies in this position normally have assets and other collateral which can be used to guarantee any SBA loan.
In these instances, life insurance would not normally be required by the lender or the SBA. Therefore, permanent insurance is rarely purchased to satisfy the collateral requirement for SBA loan purposes.
What If You Have a Pre-existing Medical Condition?
A significant health issue can be a real concern if you are trying to get key man life insurance to cover your loan.
However, even with a serious medical condition, like coronary artery disease, insulin dependent diabetes, or by-pass surgery, you can likely still find reasonable coverage. The anxiety comes from how much it will cost.
If you have a medical problem, the following information is critical to guarantee the best results:
- If you have any history of even marginal health, it is crucial to disclose to your agent and the insurance company, right up front, as much detail as possible about your situation.
- You should, provide as early as possible, everything you know about the date of diagnosis, the severity of the condition, treatments including medications and your physician’s prognosis.
With this information, we can go to work to find the insurance company who might be best for you. In other words, you cannot just compare prices, submit an application and hope for the best.
If an insurance agent attempts to submit an application without going over all aspects of your health, you are dealing with the wrong agent. And, depending on the severity or your past health, you are likely wasting your time applying for any type of no exam life policy.
For more information, check out our key man insurance underwriting guide.
We have worked with virtually every medical condition, and have been very successful at helping people who have had major difficulties.
How to (Properly) Set Up Your Beneficiary
The whole purpose of the securing a key man life insurance policy is to satisfy the requirements for an SBA loan. When naming the beneficiary, it is important you set up the policy to meet the lender conditions.
However, under no circumstances should you name the lender as the policy beneficiary!
As with all key man life insurance, if the business is making the loan, the proper thing to do is to name your business, not the lender, the primary policy beneficiary.
Under this scenario, the company will:
- Own the policy
- Pay the premiums
- Receive the proceeds
Any variation from this method is NOT recommended.
The Solution Is A Collateral Assignment
A collateral assignment is a legally binding document familiar to every bank and lending institution. In fact, both lenders and life insurance companies have their own variation of a collateral assignment.
A collateral assignment places the lender or bank in a primary lien position for any death benefit payout of policy proceeds. Once the key man life policy is effective, both the lender (bank) and the policy owner (the business) sign a collateral assignment.
The business, which owns the policy, is commonly referred to as the “assignor,” and the bank is referred to as the “assignee.”
The agreement is then sent to the insurance company to be recorded as binding in the official policy file. Copies of the recorded assignment are then sent to the lender or “assignee” as proof they have the first rights to the policy proceeds in an amount equal to the loan balance in the event of the death of the key person.
At the death of the key person, the bank only gets the loan payoff balance, and the remainder of the death benefit is payable to the primary beneficiary, which is the company.
Let’s go through a quick example:
ABC Company, owned by John Smith, has taken out a $1,000,000 loan from DEF Bank which was guaranteed by the SBA.
As part of the deal, a key man life insurance policy was purchased for $1,000,000 by ABC on the life of John Smith, with ABC as the primary beneficiary of the policy.
Prior to the closing of the loan, a collateral assignment was signed by John Smith, the assignor, and DEF Bank, the assignee, and made effective by the insurance company.
Six years later, the loan balance was $675,500.00 when John Smith suddenly passed away. Upon the payment of proceeds, the insurance company notices a collateral assignment is in effect naming DEF as the assignee.
DEF is notified by the insurance company and submits proof of the outstanding loan balance. A check is then made payable to DEF Bank for $675,500.00, which satisfies the outstanding loan balance.
The remaining $324,500.00 is the payable to ABC Company.
The main advantage of a collateral assignment is the lender (DEF) only receives proceeds equal to the amount of the outstanding loan balance.
If the DEF had been made primary beneficiary, at John Smith’s death, they would have received a check for $1,000,000. This would obviously be a problem for ABC Company.
Under no circumstances is it ever advisable to name a lender the beneficiary of a key man life insurance policy!
An important point to note is that once the loan is paid off, the bank will release any collateral assignment. There is a simple form which needs to be signed and submitted to the insurance company and the assignment can be released.
What You Should And Should NOT Do When Buying Life Insurance to Cover SBA Loans
First, let’s discuss what NOT to do, so you can avoid the common pitfalls of improperly set up policies.
DON’T Wait Until The Last Minute. If you do not give yourself enough time to apply for the key man life insurance, you may be forced to go the no exam route when it may not make sense otherwise. As mentioned, doing an exam nearly always saves you money. Also, if you start early, you can be prepared for the unexpected. For example, you may need to transition from one company to another to get the best rate. By starting early, you give yourself the time and flexibility to go to “Plan B.”
DON’T Try to Get No Exam Coverage If You Have Significant Health Issues: We have covered this but the point needs to be emphasized. Do not think the insurance companies will overlook medical conditions. You will waste your time and likely have to start over, and eventually complete an exam.
DON’T Withhold Important Medical and Health Information: This point cannot be overstated. If you are not up front with your health details, you will waste time and overpay!
DON’T Name Your Spouse As a Beneficiary: We have noticed others suggest naming a spouse for a key man life insurance policy. This is not appropriate unless you are borrowing the funds personally, and paying the premiums personally. This is rarely the case with an SBA loan. If your company is borrowing the funds, your business should own the policy, pay the premiums, and be the primary beneficiary 100%. If you structure the beneficiary to be your spouse and the company is paying the premiums, you may very well create a tax nightmare.
DON’T Buy Annual Renewable Term (ART): You may find yourself saying, “Well, I will only need the loan for 3 years, as my business is projected to grow quickly and I won’t need the insurance.” This is a shortsighted approach, and will generally result in you overpaying for the insurance. We have written thousands of policies, and the concept of buying annual renewable term for the purposes of securing a loan has never worked. Additionally, the lender may not approve!
DON’T Use An Agent With Little or No Experience: You must use an independent agent representing many insurance companies. In many cases, the bank who is making the loan has a “life insurance department” who will push for your business; be very careful in using the bank, as they will not have the capacity as a specialized agent, as we do.
DON’T Let Your Policy Lapse: Once the key man policy is in effect, pay your premiums when due. In the unfortunate event your policy lapses, the lender may default the loan or you may have to go back through the underwriting process which may prove costly.
Now, what are some things you can do in order to get a better shot at a faster approval with lower rates?
DO Start Early: If it looks like your loan is going to be approved, start the process of acquiring a key man policy, if required. We recommend beginning to shop around very early in the process, so when the loan looks promising, you can act accordingly. Having all of the facts up front allows you to complete any due diligence needed for the best results.
DO Consider the Exam Route: As noted, the exam option is always going to result in the lowest rates. Unless you are extremely healthy, under the age of 60, need $500,000 of life insurance or less, and don’t mind paying more, undergo the exam when applying for life insurance for an SBA loan.
DO Use a Broker to Assist You: That’s right, only by working with an independent agent, who represents many insurance companies, will you give yourself the best chance of getting the right insurance policy at the best possible price.
DO Shop Around: You obviously know this already, but the internet is a fantastic tool for shopping for a life insurance policy to cover an SBA loan. By talking to 2 or 3 agents, you will gain all of the information necessary to make the best policy decision. We highly recommend a second opinion before applying for coverage.
DO Use a Collateral Assignment: Never name the lender as a beneficiary on any key man life insurance policy. Collateral assignments are easy to implement, and will protect both you and the lender. And, they are readily accepted by lenders to satisfy the existing collateral requirements for all SBA loans.
Common Questions and Their Answers
Q: How long does it take to get a policy?
A: That depends upon your age, health and your choice of insurance company. The biggest factor is health. If you are young and health and fall under the guidelines for a no exam policy, you may get approved for coverage within 2-3 days. However, this is not the norm.
If you are in good health and are willing to complete an insurance exam (which we recommend in most cases), you can be approved in as little as 2 weeks. This assumes that your medical reports are not ordered from your physician(s). The normal processing time for people without significant health histories that do an insurance exam is 3-4 weeks.
If you have a history of medical conditions, all insurance companies will require medical reports from your attending physicians. This is a routine requirement and can extend the underwriting time to 4-6 weeks. The key to shortening this window is how quick your doctors will respond to the request for your records.
Q: How much does a policy cost?
A: Ultimately, the cost of any key man life insurance policy is determined by three things: age, health and amount and duration of the insurance policy. We have provided sample rates in this article. You can also get an instant key man life insurance quote here.
Q: Which companies are best?
A: We represent over 80 insurance companies. The reality is that there are only about 30-35 life insurance companies that are ultimately competitive. The key is to match up your health circumstances with the company that is going to look at you most favorably in underwriting. As mentioned previously, working with a broker that has the underwriting expertise is going to guarantee that you choose the right company!
Q: What if I am uninsurable?
A: Although rare, there are situations where life insurance is just not an option due to health conditions. In these cases the SBA/Lender Guidelines are as follows:
If the lender determines the principal is uninsurable, the lender must obtain written documentation from a licensed insurer of the same.
In most cases, after attempting to get a life insurance policy and being “denied” due to a medical condition, the lender will accept written proof from a licensed insurance company who claims you are uninsurable. At this point, it will be up to the lenders discretion how the loan is handled.
Q: Can I cancel the policy?
A: Yes, life insurance policies are “unilateral contracts”, which means the policy can be cancelled at any time, without penalty, by simply stopping premium payments. If you pay-off your loan early, you can cancel the key man life policy at any time.
In Summary, What Is Your Next Step?
- Identify What the Lender Requires. The bank will tell you exactly what they need to satisfy their requirements. These are your marching orders.
- Shop Around. This is more than just going to a website and getting rates. No one wants to overpay! However, there are many factors that need to be considered in addition to price.
- Talk to a Pro. Then talk to one more. Thoroughly review your situation and listen carefully. Tell them about your medical history and any other important information that may impact your rates such as scuba diving, tobacco use, moving violations, etc.
- Discuss Your Options. Ask questions about the insurance company’s financial strength. Are there any features or benefits that make one policy better than another? While price is the number one concern, there may be equally priced policies where one company offers significantly better features.
- Apply for the Insurance. Review and complete your application, sign and submit to the agent for processing to the insurance company. If you are doing an exam, remember to fast prior to your appointment. See, “What is an insurance exam.” LINK
- Get Approved. After a few weeks, your policy is approved. Hopefully, your exam results are good and you are approved at the quotes price. At this point, all that is required is a check and a few signatures to make the policy effective.
- Draft A Collateral Assignment. Effect a collateral assignment with the bank and submit to the insurance company to record.
That’s it! You have satisfied the collateral requirements to finalize your SBA loan. Now all you need to do is execute your plan to realize your vision!
Contact us right away to get started.