Ensuring that a borrower maintains current insurance may not seem like a high priority, but it is critical to mitigate risk in an SBA loan portfolio. In this article, we’ll discuss the importance of requiring borrowers to maintain current insurance, present a brief overview of SBA loan requirements regarding insurance, and specifically address a few areas of confusion drawn from our experience as a lender service provider.
Why Insurance is Important
The most immediate reason to ensure that borrowers maintain current insurance is that the SBA can issue a repair if insurance is not kept current. Take for example a loan that is secured by a piece of commercial real estate with an appraised value of $500,000. If this building were destroyed in a fire, and the lender had allowed the insurance to lapse, the SBA would likely issue a repair for the SBA’s share (the guaranteed portion) of the missed recoveries that would have been issued by the insurance company. In most cases, this would amount to $375,000 ($500,000 x 75%). Needless to say, this is an outcome that lenders should be eager to avoid.
Ensuring that borrowers maintain current insurance has important benefits beyond protecting the guarantee. In a non-liquidation scenario in which a business is still operating, insurance can help pay down a loan in the event that a piece of collateral is damaged or destroyed.
Overview of SOP Insurance Requirements
Let’s take a quick look at the main SBA loan requirements regarding insurance, as outlined in the SBA’s Standard Operating Procedures (SOP). SOP 50 10 5(J), Subpart B, Chapters 4 and 5 require the following types of insurance:
- Hazard Insurance: The SBA requires hazard insurance on all real property taken as collateral. This coverage must be for the full replacement value of the collateral or, if this is not available, for the maximum insurable value, and must provide for at least 10 days prior written notice to the lender of policy cancellation. There are a few additional requirements depending on the type of collateral covered:
- Real Estate: Hazard policies covering real estate must contain a Mortgagee clause in favor of the lender, providing that any action or failure to act by the mortgagor or owner of the insured property will not invalidate the interest of the lender.
- Personal Property: Hazard policies covering any non-real estate property (business personal property, equipment, vehicles, etc.) must contain a Lender’s Loss Payee clause in favor of the lender, providing that any action or failure to act by the debtor or owner of the insured property will not invalidate the interest of the lender.
- Flood Insurance: The SBA requires flood insurance on all real property taken as collateral if any portion of the collateral is located in a special flood hazard area as determined by FEMA. The additional requirements for real estate and personal property coverage are the same as those for hazard coverage.
- Life Insurance: As a rule of thumb, for any loan over $350,000 that is not fully secured by other collateral, 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.
- Other Insurance: Finally, the SBA also requires any other insurance appropriate to the loan. Some of the most common are general liability insurance, liquor liability insurance, malpractice insurance, and worker’s compensation insurance (required in accordance with state law).
Points of Confusion on Hazard and Flood Insurance
The SBA loan requirements regarding hazard and flood insurance can be confusing, so let’s take a moment to clarify a few points. The simplest way to think about hazard and flood insurance is as follows:
- The lender must be listed as Mortgagee on any real estate coverage, whether commercial or residential;
- The lender must be listed as Lender’s Loss Payee on any non-real estate real property; and
- Insurance policies that contain both real estate and non-real estate property coverage must list the lender as both Mortgagee and Lender’s Loss Payee.
Note that a Lender’s Loss Payee endorsement is not the same as a Loss Payee endorsement, with which it is often confused. A Lender’s Loss Payee endorsement allows a lender to recover under the policy even if the policyholder would be prohibited from doing so. This is not the case with a Loss Payee endorsement, which only allows the lender to recover under the policy if the policyholder is permitted to do so.
In summary, ensuring that a borrower maintains current insurance is of critical importance in mitigating risk in an SBA loan portfolio. SBA loan requirements are designed to protect the interests of the lender. If the time is taken to understand the requirements and implement a process to maintain updated insurance, a lender can potentially avoid significant future losses.
About Windsor Advantage, LLC
Windsor Advantage provides banks and credit unions with a comprehensive outsourced SBA 7(a) and USDA lending platform.
Since 2010, Windsor has processed more than $1.7 billion in government guaranteed loans and currently services a portfolio in excess of $1.0 billion for more than 75 lenders nationwide. With over 150 years of collective government guaranteed lending experience, cutting-edge technology and rigid controls, Windsor Advantage is uniquely qualified to assist clients with implementing a thoughtful and profitable lending initiative.
Windsor Advantage has a team of 30 professionals with offices in Chicago, Illinois; Indianapolis, Indiana; and Charleston, South Carolina. For more information, please contact Andrew Sheaffer at (312) 248-8530.
About the Author: Since joining Windsor in October of 2015, Sam Cloghessy has held a variety of roles within the Intensive Servicing and Portfolio Management functions. Prior to joining Windsor, Sam worked at a law firm in Chicago after graduating from the University of Notre Dame with a degree in political science. He can be reached at 312-284-8534.