Insurance requirements when buying a business with an SBA 7(a) Loan

Whether one owns, operates or invests in a Small and Medium-sized Business (SMB) there are many rules and regulations that an owner, operator or investor must follow when trying to borrow an SBA 7(a) certified loan. First and foremost, the business has to meet all legal standards. In other words, the business has to be a legal entity that can operate in the United States. The other requirement is that an SMB has the appropriate insurance coverage for its business. For example, a restaurant is going to have different insurance requirements than a financial services firm. It’s the latter part, insurance, that this blog post expounds on for SMBs.

Why does a Bank Require Insurance?

A bank requires insurance to protect itself from adverse situations. Note the example below:

Specifically, when a bank makes a loan to a grocery store, the grocery store has the legal obligation to make monthly payments to the bank until it pays off the loan. As an example, the grocery store (the borrower) takes out an $800K loan for a building that is worth $1M. The very next day, a tornado rips through the local grocery store; thus making the building unusable. Due to the building being out of commission, the value of that property no longer holds its value. Instead of that building being worth $1M, now the building is worth $200K. From a bank perspective, the loan is considered “under water” because they are holding an $800K loan on a building that is worth $200K. This is where insurance acts as the collateral and will pay for the repair/rebuild of the building to push the value of the building back to its original value (assuming no issues with construction, processing time, etc.).

In short, insurance protects the owner, operator or investor and the bank from unexpected losses (assuming it is covered under insurance). It should be noted that if a SMB asks a bank for an SBA 7(a) loan and the SMB presents the bank with all of the correct insurance information and coverage then the chances of gaining loan approval increases. The reason for that is lenders view the business as having adequate risk controls, processes and procedures in place to operate a business. In other words, the SMB is on top of rules and regulations and is prepared to run the business.

Now that there is a solid understanding of why a bank needs proof of insurance, let’s review common insurances that a bank requires in order to be approved for an SBA 7(a) loan.

What Type of Insurance is Required for an SBA 7(a) Loan?

The type of insurance required for a business is dependent on the size of the business and the industry the business operates in. For example, it is highly recommended, if not required, that a restaurant have liquor liability or DRAM shop insurance to protect against intoxicated patrons.

Hazard Insurance/Commercial Property Insurance:

The most common insurance required is hazard insurance (also called commercial property insurance). If the SBA 7(a) loan size is greater than $500,000 then the SBA requires that all assets pledged to the SBA 7(a) loan have hazard insurance. If the loan amount is less than $500,000 but collateralized by real estate then the SBA requires hazard insurance. However, if the loan is less than $500,000 and is not collateralized by real estate then it is up to the lenders (banks) discretion whether the business needs hazard insurance. 

What’s the importance of hazard insurance? Hazard insurance is used to pay out when buildings are damaged in accidents or natural disasters. In other words, hazard insurance protects the business from extreme loss. In certain situations, that loss could push a business into solvency. 

An owner, operator or investor of a SMB can purchase hazard insurance right away and their business should be protected within a few days from purchase. From a cost perspective, the cost of insurance is dependent on the size of the loan, building, location of property, etc.

Liability Insurance:

Liability insurance (sometimes called general liability insurance) will help cover a business from property damage and bodily harm. Most SBA loans will require this type of insurance and/or flood insurance depending on the location of business. 

For general liability insurance it can take approximately 24-48 hours for proof of insurance to come through and the cost of insurance is highly dependent on the size and complexity of the business. For example, the cost of flood insurance for a business that operates in Florida is going to be significantly higher than a business that is near a lake in Kansas.

Worker’s Compensation Insurance:

If the business has employees or will have employees, it is critical that the business has worker’s compensation insurance. Worker’s Comp can offer benefits to employees if those employees become injured or ill on the job. Common coverage examples are listed below:

• Medical treatment

• Wage benefits

• Funeral expenses

• Disability benefits

Worker’s compensation insurance is meant to protect the business from unforeseen injuries of its employees. If there is no insurance, the cost could hit the bottom line of the business or worse, the employee could sue the business for lacking worker’s compensation insurance because it is required by law in 49 of the 50 states. Texas is the only state that does not mandate worker’s compensation insurance.

Again the cost of workers compensation insurance is dependent on the size and complexity of the firm. In terms of speed, a business could get workers compensation insurance within a few days; however, it is beneficial to start the process early to optimize the cost, coverage and service of the insurance.

Life Insurance:

Life insurance for a business is set-up for worse case scenarios where the owner or operator passes away. For SBA 7(a) loans, life insurance will be required on sole proprietorships, single member LLCs, or any person deemed essential to the business if the SBA 7(a) loan is not fully collateralized. In essence, the life insurance policy is meant to protect the bank if there's an unexpected death in the business and the business shuts down or becomes insolvent.

For life insurance, it can take a few days to show proof of insurance; however, it is recommended to start early that way the owner is properly covered. The cost of life insurance is going to depend on many variables such as the size and complexity of the business, health of the owner, and size of the SBA 7(a) loan.

Where do you Find the Above Insurances?

There are two primary ways to find the listed insurances above. One is through individual research by researching these insurance plans online and comparing cost, coverage and service across the many different products and services offered by insurance companies.

However, if the SMB is larger and has the funds, it may be beneficial for the business to have its own insurance broker who can research all of this information for the business and recommend insurance products and services.

Common insurance providers:

• Geico

• Progressive

• Nationwide

• Chubb

• AIG

• Travelers

Tips and Tricks for Insurance Shopping

Some quick tips and tricks for finding proper insurance is to start early and research as much as possible for the specific insurance that is wanted or required by law. From there, move on to research insurance companies known for high customer service and proper coverage.

Starting the process early allows a business to find the best insurance for that business by taking into account cost, coverage, service, timing, etc. In addition, the early process allows businesses to shop with different providers. Whereas if finding insurance is done at the last minute then the chances of success for adequate coverage, service and cost is significantly lower.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.