Reducing Key-Person Risk with Life Insurance for SBA Loans

It’s a common belief that all U.S. Small Business Administration (SBA) loans require a collateral assignment of life insurance policies for business owners, managers or other key personnel who have significant responsibility for running business operations. Often, the life-insurance death-benefit policy is assigned to a lender as a part of the required SBA loan collateral. Yet while many SBA loans are at least partially secured with these policies, it’s not a requirement for all SBA-backed loans.

Instead, the SBA requires lenders to evaluate how an individual or individuals are tied the business’s viability or to the overall risks associated with the loan. Using the lender’s assessment, any required or recommended loan protections can be put into place, including life-insurance death-benefit assignments.

Prudent Lenders helps guide our partners through every step of the SBA loan process. This article provides an overview of the SBA’s key-person risk considerations, including practical examples where the assignment of life insurance is likely required.

Do you have a question regarding your borrower’s collateral assignment of life insurance or need some additional information? Our team is just a phone call away.

Overview of key-person risk considerations

While the SBA may not explicitly require all SBA-backed loans to include collateral assignment of key-person life insurance, there are certain situations in which it’s required or warranted to mitigate loan risks.

Specifically, if the death of an owner or a key operational member of a business may cause significant risk to the repayment of the business loan, life insurance will likely be required as collateral. Other examples of these scenarios may include:

• When an owner is the principal of a sole proprietorship or single-member LLC; or when a business is primarily dependent on one owner’s active participation
• When the business is owned or managed by people who work in professional fields wherein licenses are required to perform key duties
• When individuals in ownership or management positions have rare and specialized skills, experiences or talents that can’t be taught or transferred to successive owners or managers

Keep in mind that amounts and types of other collateral available to repay a loan (such as real estate and equipment) are also factored into the assessment. In these cases, if the other pledged collateral sufficiently covers the amount of the loan, then life insurance may not be required even for key personnel.

Additional key-person risk assessment

The SBA leaves it up to lenders to perform key-person risks assessments, including evaluations to decide how the loss of a specialized personnel could potentially put a business and its related debt at risk.

One reliable way to acquire necessary information for an educated assessment is to review bylaws, operating agreements or buy-sell agreements. These important documents indicate ways a business has already considered (and likely addressed) key-person risks, which can reduce or eliminate the need for a lender to require life insurance to secure a loan.

When available, these documents may shed light on key considerations, such as:

• Type of business entity
• Number of business owners, who they are and the roles they play in day-to-day operations
• Value of the business
• Anticipated funding of a buyout

Additionally, and when relevant to a business, lenders should consider:

• How shareholder interests are transferred or sold
• How the value of shares is determined for the transfer
• How the transfer of shares will be financed
• Whether or not the successor(s) has the managerial and industry experience to operate the business in the absence of the key person(s)

However, since many small businesses don’t have sufficiently detailed bylaws, operational agreements or buy-sell agreements in place, the collateral assignment of a life insurance policy on a key owner or manager can often provide the risk mitigation a lender needs, or that the SBA may require, to approve a loan.

Contact Prudent Lenders for more information

As a lender service provider, Prudent Lenders partners with financial institutions to expand their loan portfolios and to strengthen their relationships with small business clients. We help lenders and their borrowers successfully navigate the SBA loan process – from application and approval through closing and servicing.

Looking for more information on SBA loan collateral requirements? Don’t hesitate to reach out with any questions – our team is here to help!