As the worst financial crisis since the Great Depression grew in magnitude in recent weeks, many small businesses struggled, often desperately, to fund operational expenses by securing credit from suddenly loan-averse banks. Others took the easy (and frequently overlooked) route: tapping into their permanent life insurance policies’ cash values.

“Being able to tell business owners that they can access the cash value for whatever business purposes they see fit is important,” says William Bell, a director in the advanced design unit at Pacific Life, Newport Beach, Calif. “Especially, in today’s tough economy, knowing there is ready source of liquidity is a point that many businesses owners will be excited about.”

They may also be interested to learn that securing access to funds is a fast and painless relative to alternative funding sources. “It’s quick cash,” says David Smucker, a senior consultant in advanced sales at Nationwide Financial Services, Columbus, Ohio. “There is no loan underwriting. You don’t have to make an appointment with a loan officer. You just have to call the carrier and ask for money.”

That could be music to the ears of millions of small business owners. But no-hassle access to cash is not the only reason businesses are turning to their life insurance policies to meet short-term liquidity needs.

The cash values inside such policies, which are purchased to informally fund long-term commitments, such as an executive compensation arrangement or a buy-sell agreement between business partners, can generally be tapped on favorable terms, in part because of the product’s tax-efficiency.

A business owner can borrow or withdraw against a permanent life insurance policy up to basis (the total of premium payments) without incurring income or capital gains tax. What is more, values grow inside the policy tax-deferred, while death benefits come out tax-free. If the business does not own the policy, as in the case of an executive bonus arrangement, premium contributions are also tax-deductible.

Another big benefit: low loan interest costs. Sources say carriers generally charge significantly less than their bank counterparts. The going rate at Nationwide, says Smucker, is 3.9%. Contrast this with bank interest rates averaging between 6% and 8% for business loans. Add to this the fact that businesses are in effect paying themselves back–recapitalizing the cash value they own–when they retire a policy loan.

If, adds Rich Wessel, an advisor and principal of Wessel Capital Group, Jeffersonville, Pa., the policy is a non-direct recognition contract, then cash values continue to grow–earning interest and (potentially) dividends–as if the business had not taken out a loan or withdrawal against the policy.

“We can also buy business owners time before they have to start retiring a loan,” says Wessel. “Policy owners can pay back a loan according to a schedule that best suits their cash flow needs, whether over 5 or 10 years. That can be extremely valuable in an economic crisis or slowdown.”

The market for such borrowing is huge–and growing. Contract loans totaled $113.4 billion in 2007, according to Highline Data, an affiliate firm of The National Underwriter Co. and a unit of Summit Business Media. This compares with $109.7 billion and $106.4 billion in 2006 and 2005, respectively.

What are businesses using the cash for? As with bank loans, commercial paper and other sources of credit, businesses employ the money to meet any number of short-term liquidity needs: purchasing inventory for resale; replacing aging manufacturing equipment; or (particularly for severely cash-strapped firms) covering basic overhead costs, such as payroll.

Bob Smith, an investment advisor representative for Nationwide Securities LLC, Columbus Ohio, recalls that one of his clients, a building materials dealer, borrowed a total of $320,000 last July against 4 contracts: two universal life policies and two variable UL contracts used to fund buy-sell contracts and non-qualified deferred compensation plans for the company’s two partners. The funds enabled the partners to honor a $3.5 million bid to supply materials for a commercial job.

This firm’s connection with the construction business doesn’t surprise Wessel, who observes that clients of his practice that have also taken out policy loans are active in this space, as well as the real estate and mortgage businesses. He cites a profitable construction rental equipment firm that resorted to a policy loan because the company was unable to get favorable financing to buy a -mounted backhoe. Another client, a real estate company that was refused a bank loan, tapped its whole life policy to meet immediate business expenses.

“The contract loan bought the company time to get to the next real estate deal,” says Wessel. “The firm’s owners were very thankful they had the capital they needed inside the policy.”

All well and good. But sources caution that clients need to be mindful of the dangers inherent in policy loans. Chief among them: The prospect of a policy lapse because of a failure to adhere to the loan’s repayment terms. If ignored for too long, the loan interest can compound to such an extent as to render a continuation of the policy unsustainable.

“A policy loan needs to be treated like a bank loan,” says Mark Weber, a chartered financial consultant and principal of Private Client Services at Silverstone Group, Omaha, Neb. “Clients need to prepare a repayment plan that amortizes the loan over time out of cash flow. Where people get into trouble is when they take out a loan with no intention of paying it back. The interest accrues and, sometimes, the contract will lapse without prior notice.”

The threat of a policy lapse hovers over even those with good intentions. Businesses that borrow against variable UL and secondary guarantee UL products are especially vulnerable, experts say. The cash values of such contracts can dip to perilously low levels, in the first instance because of a market downturn; and in the second because (as is often the case) the client covers only mortality costs. Upshot: The funding needed to recapitalize the policy becomes overly burdensome.

One option to mitigate such risks, says Wessel, is to buy a paid-up additions rider, which can increase the cash value by overfunding the contract during the early years of the policy’s life. In cases involving VUL contracts, clients can also shift funds from variable subaccounts to the policy’s general or fixed account during the period when a loan is outstanding, says Terri Getman, a chartered financial consultant and vice president of advanced marketing at Prudential Financial, Newark, N.J.

Inadequate funding of a policy could also render unfeasible a commonly used alternative to borrowing against the policy: pledging the contract as collateral for a bank loan (a strategy that is also used among the affluent to finance premium payments of expensive contracts). Weber notes, however, that banks don’t generally specify which part of a policy has to be collaterally assigned. In most cases, a financial institution will accept the death benefit, allowing the policy owner to hold onto the cash value.

A second alternative to a policy loan, a partial surrender of the contract in exchange for a reduced death benefit, may also be considered (excepting in most cases whole life contracts). But experts warn that such withdrawals generally make sense only after a contract has been in force for 15 years. The reason: Withdrawals made within the first 15 years can be taxed even though there is basis in excess of the distribution. Contracts issued after January 1, 1985 are subject to this “forced out gain” rule.

Clients who do elect to borrow against a policy should generally strive to repay the loan within a short period, such as 60, 90 or 120 days. The less interest that accrues on the loan, experts say, the better positioned the client will be to meet long-term obligations for which the policy was intended.

Wessel, however, says that a short-term repayment commitment can actually put business objectives–and potentially the business itself–at risk, particularly in instances where the firm is experiencing severe cash flow difficulties.

“If the loan is taken out under duress, then paying it back fast could negatively impact what the business is trying to accomplish,” says Wessel. “For businesses that are already experiencing financial troubles, an aggressive repayment schedule may kill cash flow.”

For Weber, businesses experiencing a severe cash crunch and those in volatile industries that cannot count on a steady revenue stream would do well to purchase convertible term insurance, converting the policy to permanent insurance only when they achieve financial greater stability.

“If the business doesn’t know what cash flow will be or what impact a downturn will have on their ability to meet business obligations, then I would recommend purchasing convertible term insurance,” says Weber. “You don’t want the premium to be one of the causes that drags the business down.”