INSURANCE POLICY LEVERAGE IN SME FINANCING

SYED ALAMDAR ALI
Hailey College of Banking & Finance Lahore
Apr 14 - 20, 2008

Secured finance practitioners are scrambling to educate themselves about the benefits of insurance. Insurance in effect provides a lender coverage that its security interest is validly created and is enforceable, and that its lien has been properly perfected and has priority as insured, subject to the policy exclusions and exceptions to the coverage. In other words, insurance indemnifies a named insured and its successors and assigns against loss it incurs if a perfected security interest in scheduled collateral fails as a result of any of the following insured risks:

(a) Failure of the security interest to attach to or be created as to the collateral;

(b) Failure of the security interest to be perfected;

(c) Failure of the security interest to have priority against

* Other security interests in the same collateral;

* The lien of a lien creditor; or

* A party acquiring an interest in the collateral after the date of the policy;

(d) Failure of the security interest to be valid and enforceable due to fraud, forgery, undue influence, duress, incapacity, incompetence or impersonation;

(e) Failure of an assignment of the security interest by its holder; and

(f) A claim in an adversary proceeding under the Bankruptcy Code asserting that the security interest is not valid or does not have the priority insured.

As a general proposition, any lender which is secured by a material amount of tangible or intangible personal property (e.g. a loan to a hotel operator who pledges its interests in fixtures, fittings and equipment; a project finance loan where equipment or machinery are a major portion of the collateral; or a loan against inventory) should consider the protections offered by insurance. Most lenders will therefore benefit from insurance, unless (as in the case of a loan secured only by a mortgage on raw land) the lender is not secured by any personal property of value.

Apart from involving the Insurance policies to secure the collaterals, assigning a life insurance policy as collaterals is a popular credit tool in developed countries of the world. Whether a business is acquiring funds from a local bank, or a private lender, many of these institutions will require life insurance on the business owner(s) as security for the loan. In most cases, inexpensive term life insurance policies that offer guaranteed level rates for the duration of the loan can be purchased to satisfy this requirement. When buying life insurance to secure a loan, the company pays the premiums, owns the policy and is the named beneficiary.

As soon as the key man policy is effective, a collateral assignment agreement can be signed by the business owner and the bank. The collateral assignment is a lien against the policy proceeds. In the event of the business owner's death, the bank would have first rights to the policy proceeds in the amount of any outstanding loan balance due. The business would then receive any remaining proceeds.

A collateral assignment is standard practice in most countries when using life insurance as collateral for a loan. Upon death, the life insurance company pays the claim to the creditor and any excess is given to the beneficiary. Although a collateral assignment adequately protects the lender, many of these ask for extended guarantees such as an absolute assignment or irrevocable beneficiary designation.

ABSOLUTE ASSIGNMENT

An absolute assignment transfers all the rights and obligations in a contract to the lender and the borrower loses control of the policy. The transfer to secure a debt is not taxable, but there may be adverse legal and tax consequences later.

CONCERNS ABOUT ABSOLUTE ASSIGNMENTS

* While owning the policy, the lender has complete control over the policy and can execute transactions without advising the borrower.

* After the loan is paid, the lender can refuse to transfer the policy to the borrower.

* There is no provision to transfer the excess death benefit to the borrower, heirs or a corporation.

IRREVOCABLE BENEFICIARY DESIGNATION

In the case of the irrevocable beneficiary designation, the borrower maintains ownership but the lender gains control over some transactions and is entitled to the full death benefit and not only the portion which represents the unpaid balance of the loan.

CONCERNS ABOUT IRREVOCABLE BENEFICIARY DESIGNATION

* The lender must agree to policy loans or withdrawals.

* The borrower may experience problems trying to undo the designation later.

* Without any provision to force the transfer of the portion of the death benefit in excess of the balance of the loan, the borrower, the borrower's heirs or the corporation could experience problems in trying to recover the excess.

CONCLUSION: With many small and medium businesses the key man or key employee in the business is the business owner. In these cases, key man life insurance can be purchased on the life of the business owner to protect the company in the event that he/she unexpectedly passes away. With key man insurance, the business owns the insurance policy and pays the premiums and is also the beneficiary. If the business owner dies, the business receives the policy proceeds and can use the funds to hire a capable replacement, pays off debts or simply uses the funds to buy time until the business assets can be liquidated and the business can be closed. In any event, key man life insurance on the business owner can provide much needed stability if there is a sudden and unforeseen death.