SBA Loans: Insurance Requirements and Considerations

When underwriting and servicing SBA loans, it is important for lenders and CDCs to ensure appropriate insurance coverages are in place to protect the collateral. The SBA does require some types of insurance coverages to be in place on all loans. However, it is the responsibility of lenders and CDCs to carefully consider whether other types of insurance coverage should be in place to help minimize risks and increase chances of recovery on all SBA loans.

Hazard Insurance

As a condition for the loan, the SBA requires borrowers to maintain hazard insurance on all pledged collateral. If the borrower’s business is located in a state that requires additional coverage, such as wind, hail, or earthquake, the borrower must provide a separate policy. 13 CFR § 120.160; SOP 50 10 5(K).

Lenders and CDCs are required to ensure that all collateral with a recoverable value is adequately insured in order to protect the ability to recover on the SBA loan. The hazard insurance coverage requirements should be set out in the loan authorization and should not be terminated or reduced, unless the insured assets have been sold or have significantly depreciated. If a borrower allows the insurance coverage to lapse, lenders and CDCs can force-place insurance, if it is consistent with prudent lending practices. Lenders and CDCs who continue insurance coverage can treat the cost of insurance as a recoverable expense. SOP 50 57 2; SOP 50 55.

The borrower should name the SBA or the lender/CDC as the loss payee on their hazard insurance policy. As a general rule, the proceeds should not be released unless supporting documentation has been submitted, which verifies that the insured collateral has been properly repaired or replaced, and that no construction or repair related liens have been filed against the property. This is particularly important for insurance checks over $10,000. In the event the borrower does not have appropriate supporting documentation, the lender or CDC must control and monitor the release of insurance proceeds. The lender or CDC can release the insurance proceeds pursuant to an escrow agreement approved by legal counsel, or otherwise allow the borrower to open a federally insured joint savings or custodial account with the lender/CDC and make progress payments. SOP 50 57 2; SOP 50 55.

Real Estate Insurance

If the SBA loan is secured by real estate, lenders and CDCs should request proof of real estate insurance. The real estate insurance policy must:

(a)  Have coverage in the amount of the full replacement cost;
(b)  If full replacement cost is not available, the coverage must be for the maximum insurable value;
(c)  Contain a “mortgagee clause” in favor of the lender/CDC and provide that any action or failure to act by the mortgagor or owner of the insured property will not invalidate the interest of the lender/CDC/SBA; and
(d)  Provide at least 10 days prior written notice to lender/CDC of policy cancellation.

SOP 50 10 5(K).

Personal Property Insurance

 Likewise, if the SBA loan is secured by personal property, lenders and CDCs should request proof of personal property insurance. The personal property insurance policy must:

(a)  Have coverage in the amount of the full replacement cost;
(b)  If full replacement cost is not available, the coverage must be for in the maximum insurable value;
(c)  Contain a “lender’s loss payable clause” (or a substantial equivalent) in favor of the lender/CDC and provide that any action or failure to act by the borrower or owner of the insured personal property will not invalidate the interest of the lender/CDC/SBA.
(d)  Provide at least 10 days prior written notice to lender/CDC of policy cancellation.

SOP 50 10 5(K).

Life Insurance

For loans that are processed under standard 7(a) loans over $350,000 or 7(a) small loans that do not meet the minimum acceptable credit score, lenders may follow their internal policies for similarly sized non-SBA guaranteed commercial loans when deciding whether life insurance is appropriate. However, if the 7(a) loan is not fully secured by collateral, or if the loan is a 504 loan, the SBA requires life insurance for the principals of sole proprietorships, single member LLCs, or for businesses otherwise dependent on one owner’s active participation. Lenders and CDCs may factor in the available collateral when determining the appropriate amount of life insurance required. SOP 50 10 5(K).

If a life insurance policy is required by the loan documents, this requirement should not be modified or terminated unless the reason for requiring the policy no longer exists. Lenders and CDCs should set up an escrow account to ensure that the borrower pays the premiums on the policy. If the premium payments are not made, lenders and CDCs can decide whether to continue coverage based on prudent lending practices and treat the cost as a recoverable expense. SOP 50 57 2; SOP 50 55.

As a general rule, the proceeds from the assignment of a life insurance policy should be applied to the principal balance of a loan, without a subsidy recoupment fee. All or part of the life insurance proceeds should be released if the death of the insured will have no significant impact on the management of the business, and:

(a)  The proceeds are needed for a valid business purpose;
(b)  The proceeds are needed to prevent financial hardship; or
(c)  Based on the strength of the business, there is no reason to anticipate that the loan will not be repaid in full.

Lenders and CDCs may also decide to place the insurance proceeds in an escrow account for distribution after the lender/CDC has had the opportunity to observe the borrower’s on-going operations and is able to make a prudent decision. SOP 50 57 2; SOP 50 55.

Flood Insurance

The SBA requires all borrowers to obtain flood insurance if any collateral is located in a special flood hazard area. Collateral is in a special flood hazard area if it is located in a Federal Emergency Management Agency designated special hazard area, and the community participates in the National Flood Insurance Program (“NFIP”). It is the responsibility of lenders and CDCs to notify borrowers if flood insurance must be maintained for the life of the loan. The flood insurance policy must be at least equal to the outstanding principal balance of the loan or the maximum limit of coverage available under the National Flood Insurance Act of 1968, whichever is less. The policy must contain a “mortgagee clause/lender’s loss payable clause” (or a substantial equivalent) in favor of the lender/CDC. This clause must provide for at least 10 days prior written notice to the lender/CDC of policy cancellation.13 CFR § 120.170; SOP 50 10 5(K).

Sometimes, personal property collateral is located in a non-collateral building, which is located in a special flood hazard area. In this case, the lender or CDC must require the borrower to obtain flood insurance for the personal property collateral. However, the lender or CDC may waive this requirement if: (a) it uses prudent lending standards to determine that flood insurance is not economically feasible or not available; and (b) it includes a written justification in the loan file that fully explains why flood insurance is not economically feasible or available, and the steps taken to come to this decision. SOP 50 10 5(K).

Whenever a borrower makes a servicing request, lenders and CDCs must review the adequacy of flood insurance and the need for flood insurance. Lenders and CDCs should decline all servicing requests until the borrower obtains proper flood insurance. If, at any time during the life of the loan, collateral is not adequately covered by flood insurance, lenders and CDCs must instruct the borrower to obtain proper flood insurance within 45 calendar days. If the borrower fails to do so within 45 days, lenders and CDCs must purchase flood insurance on the borrower’s behalf and treat the cost as a recoverable expense. In the event a borrower is no longer able to obtain flood insurance because the community dropped out of the NFIP, lenders and CDCs must keep the documentation establishing why the property is no longer covered by flood insurance in the loan file. SOP 50 57 2; SOP 50 55.

Other Types of Insurance to Consider

Lenders and CDCs must carefully consider whether other types of insurance coverage should be in place on each SBA loan. Other types of insurance to consider include:

(a)  Marine insurance;
(b)  Malpractice insurance;
(c)  Workers’ compensation insurance;
(d)  Dram shop insurance;
(e)  Liability insurance;
(f)  Product liability insurance; and
(g)  Any state specific insurance requirements.

Consequences of Failure to Ensure Collateral is Insured

Failure to ensure proper and adequate insurance coverage is in place may lead to a “Repair” on 7(a) loans. A Repair is defined as “an agreement between SBA and a 7(a) lender as to a specific dollar amount to be deducted from the funds SBA pays on the lender’s guaranty in order to fully compensate SBA for an actual or anticipated loss caused by the lender’s actions or omissions.” SOP 50 57 2.

Conclusion

Lenders and CDCs should use prudent lending standards to ensure that appropriate insurance coverages are in place to minimize risks and ensure maximum recovery on SBA loans. In most cases, several types of insurance coverage will be required on each SBA loan. To avoid any potential issues, it is imperative that lenders and CDCs keep all decisions on insurance requirements in the loan file.

Authors:

• Brandon C. Meadows, Esquire
• Melissa Murrin, JD Candidate

Continued reading in the series:

• Which Liquidation Actions Require SBA’s Pre-Approval: Part 1 – SBA 7(a) Loan Liquidation
• Which Liquidation Actions Require SBA’s Pre-Approval: Part 2 – SBA 504 Loan Liquidation
• Classifying SBA Loans in Liquidation Status
• How SBA Lenders Ensure Expense Recovery in Loan Liquidation and Litigation
• What Responsibility and Authority do SBA Lenders Have in Servicing and Liquidating Loans?
• Loan Modification and Deferment Requirements for SBA Lenders
• SBA Loan Site Visits: How to Prepare and What to Expect
• SBA Loans: How to Maximize Recovery by Liquidating Real Property
• SBA Loans: How to Maximize Recovery by Liquidating Personal Property
• How to Maximize Recovery on a SBA Loan by Negotiating a Workout Agreement
• Assumption, Assignment and Sale of SBA Loans
• SBA Loans: Offers in Compromise