Structured Settlements

History

What is a structured settlement and what led to this innovation? A structured settlement is an arrangement which compensates the injured party over a period of time (usually through the use of annuities), rather than with a single lump sum. Although this seems like a very practical and rational way to pay certain claims, the use of the structured settlement is a relatively new phenomenon.

The structured settlement is the offspring of an explosion in large award settlements in the mid-70’s and Internal Revenue Service rulings which grants a tax-free status to periodic payments when certain conditions are met. Although widespread use of structures began in earnest in the early 80’s, the first reported cases of periodic payments associated with personal injury claims date back to the 1960’s.

One of the more notable early cases involved tragic birth defects caused by the drug Thalidomide. The insurance policies held by the manufacturer, Richardson Merrill, did not cover the claims resulting from Thalidomide use. If the company were to make lump sum payments to all the claimants, they would have been forced into bankruptcy. To meet the needs of the injured parties and to avoid an almost fatal hit to their cash position, Richardson Merrill agreed to compensate the victims over their lifetime. The payments were backed by annuities scheduled to increase two percent each year.

The above demonstrates one of the most common uses of the structured settlement: cases in which the injured party requires ongoing medical attention and the awarded or agreed settlement is very large. Until the rapid increase in jury awards in the mid-70’s there was little incentive to make periodic payments. It was easier, more economical, and prudent to make the lump sum payments. However, when multi-million dollar awards became de rigueur a new need arose.

The rise in the use of structures resulted from a combination of two factors. The other side of the equation was favorable rulings by the Internal Revenue Service. Tax laws are created to achieve stated public policy, and the laws related to structured settlements are no exception. Because of studies which demonstrated that many claimants were unable to properly manage large lump sum settlements and, as a result, later became dependent on welfare programs, many believed that the government had to create a mechanism that encouraged good financial management of large settlement awards. One of the studies "Variable Periodic Payments: An Alternative to Lump Sum Awards" published in the Iowa Law Review in 1978, a year before two of the significant IRS Rulings were issued, chronicled some of the abuses in lump sum settlements.

Often quoted in the article was a study by the US Railroad Retirement Board which interviewed 1700 workers and survivors to discover the manner in which lump sum settlements were being spent. A typical case noted by the Retirement Board involved the widow of a freight brakeman who disposed a significant part of her lump sum settlement on trips to Hawaii and California and on a fur coat. Another study by the Industrial Accident Board of Idaho discovered 90% of the time the lump sum settlement did the claimants "absolutely no good, they lost it."

Then in 1981, a year prior to the enactment of the Periodic Payments Act of 1982, a study entitled "Structured Settlements for Tort Victims, Settlements and Plea Bargaining" by Krause was published in the Journal of American Trial Lawyers Association 178. The article stated that 90% of claimants exhaust lump sums received for personal injuries within five years. This report, as well as the others, became a catalyst to government action in the area of structured settlements.

Product or a Process?

As previously mentioned, the underlying principle of a structured settlement is rather simple: an arrangement which compensates the injured party over a period of time. However the actual implementation of this principle is not so easy. The driving force behind a good structured settlement is that the benefits will be paid when the cash is needed.

This is rather a lofty goal and some believe unattainable. This impression would be correct, if one just looked at the product and not the process. The structured settlement is more than just the payments which are made to the injured party over a period of time. The heart of the structure is in the creation of a suitable payment stream. Before structures, little time or effort was given to figuring out the day-to-day expenses, needs, treatments, and rehabilitation an injured person would require over a lifetime. This is the void the structured settlement specialist fills. In addition to other attributes, the specialist brings to the negotiation table something that was missing in the old days: an in-depth knowledge of the costs and treatments associated with the seriously and catastrophically injured. Often the defense and plaintiff attorneys are too involved in the technical legal issues of the case to focus in on the real matter at hand: the welfare of the injured party. A good specialist should be able to redirect everyone’s attention and energy to the main topic.

Our Role: The Structured Settlement Specialist

After all the smoke has cleared and the case has been settled, the attorneys will go home ready to fight another battle, but the injured party must live with the settlement. And in a sense so must the structured settlement specialist. Although the specialist is usually there as a consultant to the defense team, they are quite aware of the plaintiff’s veto power. Therefore, it is the specialist’s lot in life to create settlements which benefit both sides of the table. The specialist’s existence depends not only on the defense’s satisfaction of how the case was disposed, but also on how happy the plaintiff and his/ her attorney are with the settlement.

Although at first glance it seems like a hard way to make a living, it isn’t if the focus is proper. The attention, as mentioned before, is on the injured party. If a settlement is created which truly addresses the needs of the claimant, then the specialist has done his job. Taken at face value this is a rather curious statement, when it appears that only the plaintiff’s needs have been met. In a properly structured settlement the needs of the claimant are first met, but once these needs are addressed the hidden benefits of the structure and the specialist become apparent. Following are some of these benefits:

In any injury settlement, one of the prime considerations is rehabilitation. Although rehabilitation is an important piece in any recovery program, its effect on future costs is usually underestimated. The specialist knows the sooner the claimant is placed in a good rehabilitation program, the better the chances for a full or partial recovery and reduced long -term medical costs.

During negotiations, the specialist may consult with life care planners who assess the medical, rehabilitation, care costs and apply economic factors to project all those to the future needs of the claimant. Actuaries are consulted as well. The purpose of these contacts is to match the claimant’s long-term medical needs with the most economically prudent choice.

By negotiating a structured settlement, potentially costly and acrimonious legal proceedings are avoided. In addition to the various cost savings for the insurer and the benefits to the claimant, there are a number of other reasons why the specialist should be present at all negotiations between plaintiff and defendant: the specialist interjects a third party who is not a direct participant in the adversarial relationship; he has the ability to make on-the-spot changes to the offer in order to keep negotiations moving; and the specialist is equipped to handle any objections or questions the plaintiff or his attorney may have.

Building Blocks

The Internal Revenue Service issued two rulings in 1979 (79-220 and 79-313) which set the guidelines for structuring settlements. These rulings made it clear that a claimant could receive all amounts from a periodic payment settlement free of federal income tax, provided certain conditions were met. The guidelines for the structuring of settlements were first set by these rulings, and then etched into federal stone by the Periodic Payments Act of 1982. Some of the basic tenets are as follows:

• The claimant should have no right to the present value of the settlement.
• The claimant should not be able to change in any way the payment structure of the settlement.
• The claimant should not be named in the annuity contract, other than as the "measuring life" to determine the cost benefits.

The law is very clear on what kind of relationship a claimant can have with the vehicle which funds the periodic payments: none. Once the payment streams are established, the claimant can do nothing to alter them without losing the tax-free status. At first glance this appears to require the purchase of an annuity by the defendant or its insurer. Tax laws do not require annuities or other funding vehicles, the defendant or its insurer can make the periodic payments themselves.

However, because of the tax implications and administrative nightmares of a long-term periodic payment obligation, the defendants and their insurers will rarely take on this chore themselves. Additionally, very few, if any, claimants and their attorneys will agree to a structured settlement where the defendant makes the periodic payments as they come due. The claimant will usually sleep better knowing that the agreed upon periodic payments have been completely funded at the time of settlement.

Funding and the Qualified Assignment

Once a settlement is reached and the structure has been agreed to, the next step on which a meeting of the minds is needed is the funding of the settlement. At this point there are several options, some of which have been previously alluded to:

The defendant or its insurer can make the periodic payments as they come due.

The defendant or its insurer can remain liable on the obligation, but use some other type of funding vehicle to make the payments.

The defendant or its insurer can make a "qualified assignment".

Option 1 is the most unpalatable choice and rarely used. For reasons mentioned in the previous section this choice is disliked by most parties involved. The only reason it is listed as an option is because it is theoretically possible under the tax laws.

Option 2 is also seldom used. This option allows the defendant or its insurer to go out and purchase a funding asset (under the tax laws any funding asset is permissible) which will satisfy the periodic payment obligation. However, the defendant or its insurer will still remain liable for the payments in the event the funding asset fails. This choice would rate high among claimants since it keeps the most parties liable for the periodic payments, but it would not be an option for most defendants. The defendant’s rational is why continue to be liable on a long-term obligation which you’ve completely funded?

Option 3 is the most used. The qualified assignment was authorized by Internal Revenue Code (IRC) #130, enacted in 1983. This practice allows the defendant or its insurer to assign their periodic payment obligations to a third party who is acceptable to the plaintiff.

The list of approved funding assets for a qualified assignment is very restricted. This restriction is to provide the claimant a high degree of comfort in the security of their periodic payments. If the defendant or its insurer wish to relieve themselves of this long term obligation, they have only two options under IRC #130:

1. An annuity contract issued by a life insurance company licensed in any state.
2. An obligation of the United States.

The overwhelming favorite is the annuity contract. The annuity’s principal strength is its flexibility. Because of the many forms a structure can take, due to the lifetime needs of the injured party, an extremely flexible funding asset is needed. Following are some examples that illustrate the many shapes an annuity can take:

• Monthly payouts that increase by a pre-determined percentage each year.
• A combination of monthly and lump sum payments to be made throughout the settlement period.
• A lifetime annuity which provides a steady stream of income for an undetermined period. Additionally this type of annuity can also have a guaranteed period, which insures that the claimant’s estate will receive payments for an agreed upon period in the event of the claimant’s death.
• Annuities can be created which address the future educational needs of injured minors or the children of the claimants.

The main advantages of using an obligation of the United States, is its security and in some cases the yield to maturity will be greater than that of an annuity (usually when the payment period is not too long). However, even in the case where a settlement is funded by a U.S. obligation, the claimant can only look to the assignee (the party which was assigned the obligation to make the periodic payments by the defendant/insurer) for performance and not the U.S. government. If anything should go wrong with the assignee, an interruption in the payment stream may occur. This possible event can be mitigated by the assignee creating an irrevocable trust with a financially sound corporate trustee naming the claimant as the payee. Additionally, U. S. obligations cannot be used in cases where lifetime needs must be addressed. The longest duration bonds that may be used in this type of funding are 30 year Treasury bonds and 40 year Resolution Trust Corporation (RTC) bonds.

Determining which funding asset to use will depend upon the particular characteristics of each case. In most instances, however, the choice is to purchase an annuity.

Annuities: Here Today, Gone Tomorrow?

With the financial troubles of Executive Life, getting the claimant to agree to the purchase of an annuity is not as easy as it once was. The claimants and their attorneys are more cautious and suspicious of the financial obligations issued by life insurance companies. To avoid another Executive Life fiasco, more claimant attorneys are requesting lump sum settlements. Unfortunately, such a reaction may end up hurting their clients more than they realize.

The real concern is not with annuities, but with their backers: life insurance companies.

Is the life insurance industry healthy and can they meet their financial obligations? Prior to the savings and loan debacle, Executive Life may not have been the news item it grew to be. But of the billions of dollars associated with the S&L failures, observers are drawing comparisons and bracing for the worst in the life insurance industry.

A calm inspection of the numbers has shown that the life insurance industry is financially sound and in no danger of a collapse. Over the years the industry has continually posted one of the lowest failure rates among depository institutions and insurers . In 1989 10% of Savings and Loans failed, 1.4% of commercial banks failed, 1% of life and health insurers failed, and .7% of property and casualty insurers failed.

The disparity between insurers and the depository institutions is even more dramatic when a comparison is made of the size of the failures. The life industry experienced its largest failures in 1986 when the asset value of the failed institutions was calculated at $4 billion. However the Savings and Loans posted an all time high of $93.2 billion in 1988.

It is generally agreed that the life insurance industry is in very good condition. In a study completed by the Insurance Information Institute (Rating the Risks: Assessing the Solvency Threat in the Financial Services Industry), the following conclusion was made, "Although individual companies that assumed unreasonable risks in the 1980’s will be under severe pressure over the next several years, for the industry as a whole, trend lines in the core businesses suggest a more favorable environment in the 1990’s."

The Executive Life downfall was primarily due to their heavy investments in "junk bonds". More than 60% of their assets fell into this category. An article by the New York Times noted that, "the life insurance industry as a whole limited its junk bond exposure to about 5 % of assets." This comparison only highlights that Executive Life was more of an aberration rather than an indication of standard behavior.

The conclusion must be that annuities are still an extremely safe investment for the funding of periodic payments. Steps must be taken, as in any long term investment decision, to insure that the institution backing the annuity is financially sound. The use of the three rating organizations (A.M. Best, Moody’s, and Standard~Poor’s) help in the selection of a healthy company. To further protect the claimant’s rights, legislation passed in 1988 elevated the recipients of structured settlement payments (for transfers made under Section 130) to the level of secured creditor. This significantly increased the claimant’s financial clout.

To Structure or Not to Structure?

A structured settlement is not appropriate for every case. The structures very own characteristics and the tax laws to which it must comply make its use appropriate only in certain situations, although theoretically it could be used in almost any settlement. The publication Structured Settlements and Periodic Payment Judgments by Hindert, Dehner, and Hindert cites three guidelines which should be considered when contemplating the use of structures:

Particular Claimants, Predictable Stream of Obligations, and Amount of Settlement.

A. Particular Claimants. The facts surrounding the claimant and his/her injury are the foundation to a structured settlement. Minor injury claims are not candidates for a structured settlement, with the exception of cases involving minors. Claims which involve future economic assistance and ongoing medical care (e.g. wrongful death, serious head injuries, spinal cord injuries, etc ) stand to benefit the most from a periodic payment stream.

Can the claimant manage and prudently invest a large settlement? There are certain classifications of claimants who will be unable to handle this responsibility. People with poor financial skills, minor children, mental incompetents, people with addictions, and people who are easily pressured by others fit the profile of a structured settlement candidate. It is for these claimants that the structured settlement works best. It protects the settlement from quick dissipation and insures that money will be available in the future when most needed.

B. Predictable Stream of Obligations. If the claimant has or will incur a predictable stream of future expenses, regardless of their nature, periodic payments may be what the doctor ordered. A lump sum settlement may not be around down the road when the expenses come up.

C. Amount of Settlement. A structured settlement only becomes meaningful if the settlement is large enough that the periodic payments generated will make a difference to the claimant. The figure of $100,000 has often been used as the break-even point.

In 1990 the National Conference of Commissioners on Uniform State Laws (the Conference) approved the Uniform Periodic Payment of Judgments Act (the Uniform Act). The purpose of the Uniform Act was to provide model legislation for the states in their handling of periodic payments. The Act suggests that the threshold be $100,000, without reduction to present value. In other words, although the Act does not prohibit periodic payments that fall below the threshold, the various provisions of the Uniform Act (which are there for the protection of the claimant) would only apply to those-periodic payments which are equal to or greater than the suggested threshold.

Pros and Cons

Depending on who you talk to, you’ll most likely get differing opinions as to the benefits of a structure. The bottom line is that in some cases a structure is extremely beneficial to the parties involved and in others it is completely inappropriate. It is crucial to examine both the advantages and disadvantages of this arrangement for all the parties involved in order to anticipate potential objections, questions or concerns.

Advantages to the Platintiff

A. Tax-Free Receipt of Income

The primary benefit of a structured settlement, and the one usually first mentioned in a settlement negotiation, is the tax-free status of the payments received by the plaintiff. The feature of not having to pay the U.S. government income taxes is always a good selling point.

B. Financial Management

In many large dollar injury cases, the plaintiff will not have the financial management skills which would insure the proper investment and handling of the settlement. In too many cases, large settlements are quickly dissipated, leaving the plaintiff and his/her family destitute and possibly relying on public assistance. The structured settlement relieves the claimant of this overwhelming responsibility and at the same time insures the security of the settlement. This also applies to (sometimes not so) well-meaning relatives who want to "invest" for the injured party.

C. Flexibility of Payment Structures

Because of the nature of annuities, the settlement can be structured in a number of different ways. Depending on the needs of the claimant and his/her family, a payment stream can be created which addresses a number of financial problems (e.g. future medical expenses, college education for minors, mortgage payments, inflation, living expenses, etc.). Additionally, structures can be developed with a lifetime payment feature with a guaranteed payment period.

D. Settlement

One of the unsung benefits of a structured settlement is its ability to settle a case more quickly than the conventional route. When presented with this alternative, defendants may be more willing to settle. The prospect of a large lump sum payment may be enough incentive for more than a few defendants to take their chances on a jury verdict and delay settlement.

Disadvantages to the Plaintiff

A. Lack of Liquidity

Once the payment stream is agreed upon and the structure is finalized, there can be no alteration in the future. Therefore, if any or all of the assumptions used in calculating the payment stream (e.g. the inflation rate or anticipated medical costs) prove to be misguided, and as a result the periodic payments become inadequate, the claimant will not be able to access additional funds. There are, however, other options (e.g. a trust which empowers the trustee to invade the corpus or income and make payments to the claimant) in structuring a settlement which can make funds available in the future if needed.

B. Misunderstanding of the Present Value Concept

One of the more difficult hurdles to overcome in a settlement negotiation is the perception by the plaintiff of being shortchanged by the periodic payment structure. This view is more a product of a lack of understanding of how present value works than anything else. Demonstrating the concept of present value to the plaintiff and his/ her attorney goes a long way in alleviating this resistance.

Advantages to the Plaintiff’s Attorney

A. Better Service to the Clients

In helping to create the structure, the plaintiff’s attorney must provide tax, estate, financial and medical planning up front. In a lump sum environment, these services are addressed, if at all, after the case is settled and the payment received by the plaintiff. In a structured settlement the plaintiffs attorney has the opportunity to provide these services at the beginning (when they’re most needed) rather than at the end (when it may be too late).

B. Protection Against Malpractice Allegations

In many cases, lump sum settlements are not used for the purposes intended. This is usually a result of the plaintiff’s financial naiveté. The attorney can protect the plaintiff from quickly spending the settlement and prevent an allegation of malpractice (i.e. claims that the plaintiff’s attorney should have been aware that his client was unable to manage such a large amount, and therefore should have taken steps to insure the settlement was used for the purposes intended) by exploring the structured settlement route.

Disadvantages to the Plaintiff’s Attorney

A. Increased Professional Liability

Although structures give the attorneys an opportunity to provide their clients a wider range of service, this opportunity also increases their liability exposure. The proper handling of the many complexities in a structured settlement requires specialized knowledge.

Advantages to the Defendant/Insurer

A. Cost Savings

Cost savings is the major advantage and incentive to the defendant/insurer. Several articles cite significant cost reductions.

B. Better Understanding of Claimant

The whole process of creating a structure requires a better understanding of the claimant's medical and financial needs. This new perspective makes the defendant more of a problem solver than an adversary, and lends to smoother negotiations.

Disadvantages to the Defendant/Insurer

A. Long-Term Financial Obligation

If there is no qualified assignment, the defendant or its insurer is the obligor on the liability until paid. Once a settlement is achieved, all parties like to walk away from the table with their hands clean. An arrangement which keeps the defendant/ insurer as obligors prevents this. This is a major drawback, but can be completely avoided by utilizing a qualified assignment (thus transferring the obligation for future payments to a third party.)

B. Misleading Publicity

Misleading news articles have been generated as a result of structured settlements. The large payments made over time by the structured settlements have given the impression of multi-million dollar settlements. However, the reality is that the present value of these settlements is but a fraction of the total payout. The impact, though, has been a perception that large dollar awards are the norm and a desensitization of the juries. This makes it very difficult for the defendant/insurer to get a reasonable jury settlement for other cases.

Advantages and Disadvantages to the Defense Attorney

The structured settlement arena has given the defense attorney another method of settling cases. However, this is a specialized area which requires a wider range of knowledge than traditional personal injury litigation. Trying to settle a case without this additional information puts the defense attorney and his client at a distinct disadvantage, and may cause problems years down the road.

Epilogue

Are structured settlements the panacea for what ails the country’s claim disposition process or is it merely a placebo. Looking at the explosion in tort filings for the period 1975-1985, it is clear that the old method of disposing of claims is no longer sufficient. The structured settlement, although not a cure-all, is definitely a powerful tool that disposes claims more quickly than the old method of staring each other down. The end result is usually that all parties are satisfied, but more important, the real problems of the claimant are addressed.