Here are two scenarios you may face as an entrepreneur:
You've got a great idea. You just need some funds to put it in action, make profits, and be a successful business owner and entrepreneur.
The only thing standing between you and starting a business is some funding.
SBA loans are a nice way to get funding. The Small Business Administration partially insures loans given by banks and other lenders. Because the loan is insured, the risk for the lender is lower.
However, SBA loans require life insurance for the business owner can take on the loan. The death benefit from the life insurance policy would cover the remaining balance of the outstanding loan.
You realize that most of your business’s success depends on you, your business partner, or one of your employees.
If that person gets sick or passes away, your business would be negatively affected.
Depending on your business goals and the kind of business you have, you may want to purchase key person insurance that will help your business stay solvent, recover from the loss, or pay employees severance as the company closes.
As you start your business, you may also want to consider key person life insurance that can help keep your business solvent in the event that a person directly tied to the success of your business passes away.
Whether you're looking for key person insurance or life insurance for loan collateral, here's what you need to know about how much to buy and what kind of life insurance to buy.
How much life insurance to buy
Life insurance coverage is the cash the insurance company pays you when you make a claim. This is called the death benefit.
When you're determining how much to buy, think about how much you would need for expenses if the insured person were to pass away and the purpose of the life insurance policy.
For SBA loans, you'll need to have enough to pay off the balance of the loan as required by the lender.
“The first step is to consult with your loan officer at the bank writing your SBA loan. The loan officer will know the specific requirements for the life insurance policy you need. Typically, the lender will require a 10-year or 25-year term policy with the death benefit that is the same size as the loan. You should also find out your closing date to help the insurance agent determine when the policy needs to be in place by. With this information, you can then move on to choosing a life insurance policy,” says Jason R. Hill, FSS Client Focused Advisors CEO and financial adviser and Life Insurance for SBA Loans founder.
Keep in mind that you may need life insurance policies for your business partners if you’re not the sole founder.
“In the case of business co-founders or multiple principle revenue-creators, you likely will need a policy on each person,” adds Jason Fisher, BestLifeRates.org CEO and founder.
Once you know how much life insurance the lender requires, you’ll be prepared to work with the life insurance company to find a policy that meets your needs.
“Often life insurance policy terms and amounts won't precisely match what you need, so you'll want to choose a larger coverage amount and longer term than the SBA loan. That way, in the tragic event the policy does need to be used, any additional amount above the loan repayment amount will go to whomever you name as an additional beneficiary. If you pay off your SBA loan before the end of your life insurance term, you can usually cancel the policy to avoid continuing to pay the premiums,” says Fisher.
As you’re weighing life insurance policies, verify with the insurer how much of the loan they’ll cover in the event of a claim.
“The biggest thing a business owner should look out for are the rules regarding the collateral assignment. Most insurance companies will only cover 80 percent of the loan which won't be enough to satisfy the lender. So make sure when you apply you confirm with your life insurance agent that the life insurance company will cover the entire amount,” says Jeff Root, owner of Rootfin.com.
If you’d like to purchase additional life insurance to take care of your family’s needs, you can purchase more life insurance with the single policy or a separate life insurance policy.
Once you have the policy and are approved for the loan, the last thing to wrap up is the collateral agreement.
“The most important part is getting a collateral assignment form signed off on by the lender, borrower and life insurance company. This makes so as you pay down the loan, the life insurance will only pay what’s left on the loan and pay the rest to your beneficiaries,” says Root.
Key person insurance
“Key person life insurance reimburses a business for lost income when the owner or key executive in the business passes away. The business purchases the policy on the life of the owner or key employee. This type of insurance is especially critical for businesses in which one or a few people are responsible for the business's income,” says Priyanka Prakash, Fundera business finance expert.
This kind of insurance is important for people applying for an SBA loan. However, it’s also important to recognize that you may have other employees that play a key role in your business’s success that may be difficult to replace.
“For example, the owner might have the bulk of the technical expertise or bring in the majority of sales leads. In this case, key person insurance helps to ensure the continued success of the business if that key person passes away. SBA lenders look for factors which will aid in the continuity of the business, so having this type of life insurance this can help an applicant qualify for an SBA loan,” adds Prakash.
Depending on the purpose of the key person policy, the amount you purchase my vary.
- Are you trying to offset the costs of replacing this person?
- Are you trying to protect revenue and profits while replacing this person?
- Are you trying to keep your business’s cashflow stable while it recovers from the loss?
Knowing your purpose will help you know which costs to consider and how much coverage to buy. In most cases, you’ll want to consider what the revenue and profit loss would look like without this person, the person’s salary and bonuses, and how expensive the hiring process would be.
Key person life insurance is a wise investment if your business would struggle if a team member passed away. However, life insurance does not offer disability coverage.
“While life insurance is the main focus of some brokers because of the commission, keep in mind that there is a four times greater chance between the ages of 50 and 60 for a person to become disabled long-term that to die. Therefore, disability coverage that is of the 'key man' type (pays a lump and/or termed payment to replace key talent and keep the business running until the owner or key person can return to productivity. These policies should be a matter of negotiation, rather than just caving to a demand or automatically offering; they obviously sweeten the deal for a previous owner providing owner financing and they reduce risk for other lenders,” says Dan Gallagher ScoreSense personal finance expert.
What kind of life insurance to buy
Life insurance falls into two main categories: term life insurance and permanent life insurance.
Term life insurance only offers coverage during a specific period of time, usually between 10 and 30 years. Permanent life insurance has no expiration date as long as you make premium payments. Keep in mind that if you stop making premium payments, you’ll lose the coverage.
Jacobitz Wealth Management Group financial adviser Robert Forrest offers some helpful tips on choosing between a term and permanent policy:
“As a general principal, one could say that people need term life insurance for temporary situations and permanent life insurance for permanent situations. For example, things like debt or replacing income are temporary matters; once the debt is paid off you no longer need to insure it. Once you stop working, you no longer need to replace your income. But if you want to guarantee you leave a $1,000,000 legacy to kids or a charity? That’s a permanent life insurance situation.”
While there will be some situational differences as you approach this decision from a business perspective, distinguishing temporary and permanent coverage needs will help ensure that you find the right policy fit.
SBA loans are temporary needs because once the loan is paid off, you no longer need life insurance as collateral.
“Getting an SBA loan takes a bit of work. The process of obtaining a life insurance policy as collateral for the loan is one of the many hoops an entrepreneur will need to jump through in the process. For this reason, most people want the quickest, cheapest form of life insurance to satisfy their loan requirements. That option is almost always term life insurance,” says Alex Enabnit, TermLife2Go life insurance expert.
Most life insurers offer term life insurance. Depending on your needs, you can find guaranteed policies or policies with accelerated underwriting. Guaranteed policies tend to be more expensive because they premiums are set. You may be able to qualify for lower premiums on a policy with underwriting if you’re in good health.
Some term policies have decreasing coverage. This option can be tempting, especially since the coverage you need for your loan decreases as you pay it off.
“I do not recommend any kind of decreasing term life insurance products because they tend to cost more,” says Fisher.
Purchasing life insurance can be daunting. It’s easy to become overwhelmed by industry jargon. And, with the busy life of an entrepreneur it can be tough to make time during the day to meet with a life insurance agent.
Some companies, like Bestow, make it easier by allowing you to purchase term life insurance online. This makes buying life insurance a simple process once you know what you need.
Key person insurance
When choosing between a term life insurance policy or a permanent one for key person insurance, it can vary based on company needs.
Keep in mind that key people may decide to take a job elsewhere and will eventually retire. Term life insurance is also cheaper, so it can make sense to go that direction instead of another.
If the key person is going to be with the company in the long-term, permanent life insurance may make sense. In some cases, these policies can be transferred from the business to the individual insured.
Life insurance for entrepreneurs
Keep in mind that life insurance for your business is there to protect your business. Life insurance for your family or beneficiaries is to protect your beneficiaries finances. These are two different purposes. Depending on how you’ve set-up your business, you may want policies to serve both purposes or just need a policy to protect your family.
Working with a life insurance agent can help you understand your options and find the best fit for you. Choosing a trustworthy life insurance company will also ensure that your beneficiaries will be paid when they make a claim.
Bonus: Expert tips on life insurance for entrepreneurs
Finding the right fit
Jason Fisher, BestLifeRates.org CEO and founder
“Finally, whether you have only one policy that covers your business loan and has an overage for your beneficiaries, or you have two separate policies, really depends on the needs of your beneficiaries. If you were to pass away, would the amount be enough after the loan is paid off first? Remember, the loan becomes the first beneficiary and your loved ones become secondary.”
Jason R. Hill, FSS Client Focused Advisors CEO and financial adviser and Life Insurance for SBA Loans founder
“Once you determine the right carrier that fits you, the final step is to review your needs. If you do not currently have life insurance, this may be the perfect time to secure additional coverage for your family. You can buy one policy to fit your needs. It's is a myth that you need two policies. For example, if you were required to have $1,500,000 as the SBA life insurance requirement for 10 years. You instead can purchase $3,000,000 for 20 years to fit the needs of your family. If something were to happen to you, then the bank would get the balance of the loan and the primary beneficiary would receive the remainder.
Additionally, you could consider all other term lengths, or lifetime coverage such as universal or whole life policy. Once the SBA loan is paid off then the policy is owned 100 percent by the owner and the collateral assignment is removed. One reason to keep it separated is on smaller policies if you want to go through the no-exam or accelerated process if you have a short closing window.”
Protecting your business and your family
Robert Forrest, Jacobitz Wealth Management Group financial adviser
“When advising business owners on finances, we always recommend keeping them as separate as possible. Even if you’re a sole proprietor just getting started. It’s wise to keep business and family finances separate. That includes debts, cashflow, and insurance. Let your business income (and checking accounts) pay for your insurance for your business.”
Brian Cairns, ProStrategix Consulting CEO
“If you are not a sole-proprietorship, you probably don’t need to take out two policies. If you are a sole-proprietorship, you may want to consider two policies since your family’s assets are at risk if you default for any reason, including disability, death, etc.”
Luis Avalos, Deductible Funding Solutions, Inc. COO
“Setting aside a life policy for the SBA loan and purchase a separate policy to protect their family in the event of an unfortunate circumstance is a great option. Entrepreneurs should not only consider but always name the lender as primary beneficiary for the one term life policy associated with the SBA loan. Entrepreneurs should also be aware that SBA loans for business tied to an individual or individuals do require life insurance to protect the lender. Our lives can change from one day to another. Please keep your options open and protect your assets.”
“If you’re starting a business with one or more partners, please, please, please be sure to set up a buy-sell agreement and fund it with life insurance. A buy-sell agreement is a legal contract that requires the other owner(s) to buy out the portion of an owner when they die or become permanently disabled. Otherwise, your ownership of the business goes to your spouse and the people who went into business with you, may not want to go into business with your spouse. The most cost-efficient way to fund a buy-sell agreement is with insurance.”