Life Insurance Requirements and Options for SBA Loans

If you’re an entrepreneur and are considering or have already started down the path of pursuing an SBA loan, it may benefit you to learn the life insurance requirements of SBA.

Part of our core mission at insuranceandestates.com is to support and empower entrepreneurs and visionaries who seek to turn dreams into reality. If your dream includes starting a business, you may have considered funding your startup with an SBA loan. An SBA loan can be a powerful way to obtain the needed funding to start your dream venture; however, life insurance may be one of the requirements for making this happen.

What is an SBA Loan

It is important to have an idea what an SBA loan is, including a summary the pros and cons, before launching into the role of life insurance in this process.

SBA is the acronym for “Small Business Administration” which is an agency of the federal government tasked with encouraging the development and growth of small businesses in the United States. An SBA loan then is a type of small business loan that is backed by the U.S. government and thus may be easier to qualify for than other loans.

The catch is that these loans will tend to have a few more requirements than conventional bank loans. SBA loans are primarily designed for those who are starting or expanding small business ventures. There are also loans available for funding development projects that offer a benefit to the community. For simplicity, loans for helping existing start up and small businesses are called 7(a) loans whereas development loans are CDC 504 loans.

CDC refers to a “certified development corporation” that is created to contribute to the economic welfare of the community.

7(a) loans may be obtained to provide financing for a variety of business purposes including funding start up costs, real estate or equipment acquisitions, marketing or personnel costs. SBA does not make loans itself but rather guarantees the repayment to various participating lenders throughout the country. This guarantee reduces the risk to the lender, while the borrower will be obligated to repay the full amount of the loan.

Eligibility for an SBA Loan

While many businesses are eligible for SBA loans, some are not. The following requirements generally apply:

1. Operating for profit (applies to 7(a) loans and NOT CDC 504 loans)
2. Engaged in business (or proposed to engage in business) in the United States
3. Have reasonable owner equity to invest
4. Using alternative financial resources (including personal asserts) before investing

In general, the requirements for obtaining an SBA loan may be less stringent than most conventional loans, but extensive documentation is still required.

SBA Requirements for Life Insurance

One way that SBA protects itself (as guarantor) with 7(a) loans is by requiring life insurance for those who are responsible for the loans. Generally, participating lenders for SBA 7(a) loans may follow their normal internal policy for commercial loans when it comes to life insurance.

However, if the loan is not “fully secured” by assets such as real estate or equipment, then life insurance is required for the principals of the business which may include sole proprietors, partners or members of LLCs, or those other individuals upon whom the business is dependent. If a principal is deemed uninsurable, then a letter from the insurer may be required.

In general, the procedural rules of the SBA require that any business that is tied to an individual or individuals must purchase life insurance to protect the individual and his/her family as well as the lender. Life insurance policies are often purchased for the full amount of the loan, but the amount of any collateral may be factored into the requirements.

SBA Options for Life Insurance

Because the SBA is concerned only about the death benefit of the policy held with the principal as the insured, your life insurance options for SBA loans are very broad. All life insurance offers a death benefit. However, as we’ve often discussed, there are major differences between temporary or term life insurance vs. whole life insurance. Additionally, the categories of term life insurance AND permanent life insurance offer many coverage and policy design options.

Before we get into the various types and options of life insurance for SBA loans, I would like to offer a little bit of background. Without some context, you might conclude that there is no reason to purchase anything other than cheap term life insurance to satisfy the SBA requirements and in one sense this assumption might be right but for a few important strategic considerations.

Term Life Insurance for SBA Loans

As we discussed above, the SBA is mainly concerned with protecting against the loss of a key business person in order to protect his/her family as well as the lender. In this respect, the analysis parallels some of our recent discussions highlighting the best key person insurance.

On one hand, term life insurance is the cheapest way to procure a death benefit. The principals can simply purchase a specific death at costs that are based upon the person’s health status and the duration of the term.

On the down side, purchasing term life insurance, even for SBA loan purposes, can be rightly referred to as “renting a death benefit”.

Tip: The cost of term life insurance increases as the insured ages or if health declines. Coverage is likely to become cost prohibitive as some undetermined time in the future. Thus, at a minimum, we suggest that “convertible term life insurance” is purchased which allows the policy to be converted into a permanent life insurance policy.

The critical downside of term life insurance, for SBA loans (also applicable to other key man insurance) is that zero cash value accrues within the policy. There is also a high likelihood that the death benefit will never be used because the policy will likely expire first. This actuarial fact is why longer duration term policies are more expensive than shorter duration policies.

Permanent Life Insurance for SBA Loans

For purposes of our SBA loan topic when considering permanent life insurance, it is most important to understand that (in addition to term life) the required death benefit to satisfy SBA can be purchased in a number of ways that offer additional lifetime and strategic benefits.

Inverting the logic discussed above about term life insurance reveals the key differences between term life and permanent life insurance. Permanent life insurance is of course more expensive than term life insurance. Permanent life insurance is not designed to expire and thus offers permanent protection and other advantages. The advantages and uses of permanent life insurance will vary based upon the type of permanent life insurance selected. As an overview the major categories of permanent life insurance are:

1. Participating Dividend Paying Whole Life
2. Indexed Universal Life
3. Guaranteed Universal Life
4. Variable Universal Life
5. Private Placement Life

Most of the major life insurance companies offer a varying mix of the above types, with the exception of private placement life insurance, which is handled by a smaller pool of companies and skilled experts. Any of the above policy types will provide a death benefit that should satisfy SBA, so the analysis becomes focused on your budget and policy goals.

The major types of permanent life insurance summarized are:

Dividend whole life insurance is the most conservative type of permanent life insurance. These policies generally offer a “guaranteed” rate of return on the cash invested in the premiums. A closer look also reveals a history of returns that are higher than conservative guaranteed rate, and this difference is often referred to as the non-guaranteed or projected return. These policies do not engage is market risk and the premiums are generally NOT flexible, so there is little doubt that the policy will be funded properly if all premiums are paid.

While some pundits and financial entertainers such as Dave Ramsey tend to bash this type of life insurance as too expensive, other experts pinpoint whole life insurance as the most immune from speculative market risks AND the source of massive wealth accumulation for many of America’s top banks and corporations.

Indexed universal life insurance (IUL) is a type of permanent life insurance that offers the opportunity to invest your policy cash value in the financial markets tied to any number of market indexes such as the S & P 500. Most of these policies offer much greater flexibility for payment of premiums and provide a maximum gain in booming markets as well as a stop loss point (such as 1 or 0%) in down markets.

The key risk for these kinds of policies is usually under-funding resulting from a lack of discipline in paying premiums and having the policy reviewed, thus resulting in the policy lapsing. Insurance companies have attempted to deal with these issues by adding riders such as guaranteed death benefit. So, these policies may lend themselves to those who intend to be more disciplined and proactive with the policy.

Guaranteed universal life insurance (GUL) is a more conservative version of universal life insurance that is mostly used for securing a permanent death benefit , in a way that is similar to whole life insurance but at a lower cost.

Variable universal life is similar to the IUL except the cash values are actively invested in the financial markets, in assets such as mutual funds. This type of permanent life insurance may be rightly viewed as more risky and can only be sold by financial professionals who are licensed to sell securities.

Private placement life is a type of variable universal life insurance that is customized for high net worth individuals. Only certain companies, such as Blackrock are active in providing this type of life insurance. If you’re eligible for this kind of policy, you’re most likely not pursuing an SBA loan, but for some high net worth individuals seeking SBA financing to expand due to tied up assets, this may be an option.

ALL PERMANENT LIFE INSURANCE OFFERS THE FOLLOWING BENEFITS [while fulfilling SBA requirements]

Permanent Death Benefit

As discussed, term life insurance becomes increasingly expensive with aging and health complications. For this reason, spending a bit more in the short term to purchase a permanent death benefit to cover your SBA loan can be an important strategy. Because your SBA loan will eventually need to be repaid by you, and loan terms and repayment obligations can sometimes be long term, your future cost of life insurance should be considered. So your cost of insurance now should be weighed against potential future costs as part of your overall strategy session. A permanent death benefit is also important to support your estate planning, business continuity succession planning and family business succession planning goals.

Accruing Cash Value

Whether the return of cash value is guaranteed, as in a whole life or guaranteed UL policy OR whether based upon the financial markets, as in IUL and Variable UL policies, the idea behind permanent insurance is to accrue a nest egg of usable cash value within a life insurance policy. This nest egg of cash can be a source of private family financing for your business and could be used to ultimately repay the balance of the SBA loan. This is a strategy that is often referred as the infinite banking concept® and offers many advantages as well as asset protection for business owners who are seeking to build assets on their company balance sheet.

Tax Advantages

An exciting aspect to the accrual of cash value with a permanent policy is the associated life insurance tax advantages. In general, cash value that accrues within the life insurance policy not taxable if not withdrawn from the policy. This tax benefit can help create financial momentum for a business owner in a way that cannot be achieved otherwise.

Private Source of Financing

We’ve now come full circle, back to financing. In fact, your permanent life insurance policy can be used to eventually repay your SBA loan and replace conventional banking as a source of capital for expansion and pursuing new ventures.

Looking past the immediate need to purchase a death benefit for SBA and considering other long term possibilities can offer amazing benefits. Of course, this will require some thinking outside of the box.

Call or email today to discuss your unique SBA loan scenario or other business objectives.