The financial debacle that has denied hundreds of former Executive Life of New York (ELNY) policyholders much of the income payments once promised them has shone a light on a corner of the industry little understood by many life insurance and financial service professionals: annuity-funded structured settlements.
The solutions, used by property and casualty (P&C) insurers in worker compensation and other personal injury (PI) cases to settle claims, generate billions of dollars in premiums annually for the life insurance companies that fulfill the monetary awards owed to injury victims. When they work as intended, the structures are a win-win for the other stakeholders in PI cases: for the P&C carriers that secure tax and administrative benefits; for the attorneys and structured settlement brokers that generate fees and commissions designing and implementing the solutions; and for the PI claimants who depend on the tax-free periodic payments to cover living expenses or meet other financial objectives.
"Since 1983, more than 500,000 injury victims have opted to have at least part of their [award] in a structured settlement,” says Len Blonder, a Los Angeles-based structured settlement consultant and former two-term president of the National Structured Settlement Trade Association, Washington, D.C. “No other option today can match the structure’s mix of tax-free income and guaranteed security.”
Industry critics question, however, whether many of these half-million injury victims could have been better served. In respect to ELNY’s 1,500-plus payees, who stand to lose from 40 percent to 60 percent of the income originally due to them because of financial mismanagement by ELNY’s now defunct parent, Executive Life of California, and by the New York Liquidation Bureau that took the bankrupt ELNY into receivership, the answer clearly is yes. But such cases of failure to meet structured settlement obligations are rare, say market-watchers.
More worrisome, the critics contend, are industry practices, inadequate regulation and lobbying by key players to quash cost-saving product innovations. Among the complaints: that the market space is dominated by structured settlement brokers who too often favor annuities over alternative solutions because of the commissions they derive on sales; that industry stakeholders are impeding the development of commutation provisions in annuity contracts that can save payees desiring to sell their rights to future income payments much time and expense; and that state regulations governing product suitability, compensation disclosure and conflicts of interest are woefully lacking.
“Without effective regulation, bad business practices will continue,” says Patrick Hindert, an attorney and managing director of The Settlement Services Group, Loveland, Ohio. “Absent market reforms—and I’m not optimistic there will be—these practices will go on to the detriment of claimants and the industry.”
Anatomy of the Transaction
Key factors fueling demand for annuity-funded structured settlements, both among defendants (P&C carriers) and plaintiffs (injury victims) in personal injury cases are tax advantages. In “buy-and-hold” structures, the P&C company purchases an annuity from a life insurer and writes off on its corporate income tax return the amount paid in a given year to the payees.
The P&C carrier may, alternatively, elect a “qualified assignment,” transferring claims obligations and money to purchase an annuity to a 3rd party (often an affiliate company of the life insurer) charged with meeting the periodic payments. The P&C carrier enjoys an up-front tax deduction for the aggregate amount of the annuity payments. Also, by removing the structured settlement liability from its balance sheet, the carrier cuts both administrative costs and financial exposure.
Since passage of the Periodic Payment Settlement Tax Act of 1982, which codified IRS revenue rulings dating from the late 1970s, structured settlement payments have also been exempt from federal and state income tax, taxes on interest and dividends, capital gains tax and the alternative minimum tax (AMT) under Internal Revenue Code Section 104. Contrast this with lump sum distributions, the principal of which is tax-free, but not growth on the principal, unless invested in tax-free bonds.
“With a structured settlement, the payee enjoys not only the value of a lump sum, but also tax-free growth,” says Jeremy Babener, a tax attorney and structured settlement expert at the law firm Lane Powell PC, Portland, Oregon. “That can be a very significant tax advantage.”
Structured Financial Associates (SFA), an Atlanta-based structured settlement broker that compiles statistics on the industry, pegged new annuity premiums written for structured settlements at about $2.6 billion for the first half of 2012, the most recent statistics available. Premiums have dipped since the market peak in 2008, when SFA recorded a year-end total of $6.2 billion. From 2009 to 2011, aggregate premiums reached roughly $5.4 billion, $5.5 and $5 billion, respectively.
In tandem with the decline in new premiums there has been a dip in the number of structured settlement cases. In 2008, the case load totaled 35,371. In 2009, 2010 and 2011, the numbers fell to 32,399, 31,290 and 28,811, respectively.
What accounts for the decline? Joseph Dehner, a structured settlement attorney at Frost Brown Todd LLC, Cincinnati, Ohio, cites continuing low interest rates on the fixed annuities used to satisfy settlement claims as the key factor. Why, observers ask, lock oneself into a long-term, low-yield vehicle when greater investment returns can be achieved on alternative asset classes, such as stocks, mutual funds or ETFs?
Another factor may be a drop in suitable cases. Experts note that many settlements don’t lend themselves to structuring because the amounts involved are too small. It makes little sense, they argue, to write an annuity when the settlement calls for a payout of only $5,000 or $10,000 to a few individual plaintiffs. The better solution in these instances is to pay a lump sum. Indeed, most personal injury claims are handled in this manner.
The small fraction of PI cases suitable for structuring, sources say, generally entail large cash awards to claimants. Notable among them are individuals who, because of the nature of their injury, lack of maturity or other factors a judge would not be comfortable awarding a lump sum.
A structured settlement might happen in cases where, for example, the plaintiff is brain-damaged and thus not competent to handle an lump sum award. Some states also have rules against approval of lump sums over a certain cash amount for minors. Structured settlements frequently also are mandated in worker compensation cases.
“In general, it's not worth all of the fuss to pursue a structured settlement unless the suit entails a sizable claim—at least $100,000," says Dehner. "Conversely, a personal injury attorney for claimants who isn’t even considering a structured settlement in high damage cases is bordering on malpractice.”
Demand for High-End Expertise
Or, he might have added, when they don’t call on advance planning professionals to assist in more complex cases. Example: When the structured settlement calls for integrating a trust to preserve government benefits that otherwise would be foregone if monetary awards were received as a lump sum distribution. Hence the advent in recent years of special needs trusts and Medicare set-aside trusts.
“This is a relatively new trend,” says Dehner. “Structured settlements have become both more flexible and complicated because of the advanced planning that now accompanies these transactions.”
One result, he adds, is that many more professionals with diverse skills and expertise are now active in the structured settlement space. Many new practices started in the last 5 to 10 years focus just on Medicare set-aside allocations or trusts.
As the arrangements have grown more complex, plaintiff attorneys have increasingly turned to IRC Section 468(b) qualified settlement funds (or trusts) because of the flexibility the temporary vehicles afford in structuring settlements, particularly in mass tort cases involving multiple plaintiffs. The attorneys can control the settlement funds while negotiating medical liens, deciding on amounts to disburse to individual plaintiffs, determining attorney fees and planning clients’ estate needs.
“The qualified settlement fund (QSF) allows for a significant increase in the amount of time that payees have to make necessary determinations,” says Lane Powell’s Babener. “This is especially important for two reasons: First, it can take a lot of time to determine whether Medicare is entitled to any of the settlement proceeds; second, plaintiffs may want more time to decide whether to structure a settlement. And they can’t structure if they first receive a lump sum award in cash.”
The QSF, adds Babener, is frequently advantageous in cases involving multiple personal injury victims. But for the single plaintiff, use of the vehicle comes with uncertainty. That’s because it is unclear whether a single plaintiff is treated for tax purposes as receiving funds deposited into a QSF. If so, the tax advantages of structuring are reduced, if not lost entirely. The IRS has received requests to issue a private letter ruling on this tax question.
Of greater concern to market-watchers is whether payees of structured settlements are receiving adequate financial counsel. When defendants and plaintiffs in personal injury cases agree to such arrangements, they turn to structured settlement consultants or brokers to shop for a suitable annuity to settle claims.
Whereas in prior decades a single broker represented only the defense, in most cases today plaintiffs also work through their own—or else a consultant deemed suitable to the two parties—thereby insuring that plaintiffs are adequately informed about their options and that the annuity purchased is satisfactory to both sides.
Or so the thinking goes. Critics contend that the product is often inappropriately recommended by profit-seeking structured settlement brokers, chiefly those on the defense side, who specialize in shopping for annuities to settle PI claims and who enjoy an often hefty commission on the sale.
Wouldn’t claimants be better served by fee-based advisors who have a fiduciary responsibility to act in the claimants’ best interests and whose compensation is tied not to an annuity sale, but to a fee charged on the assets they manage? A more holistic approach to structured settlement planning, critics suggest, would yield a greater diversity of asset classes in PI cases, such as stocks, bonds, mutual funds or ETFs that might yield superior performance for claimants, depending on their risk profile and financial objectives.
“The financial analysis [by brokers in structured settlement cases] seems to follow a ‘lowest price is best price’ [rule], with no discussion about diversity of credit risk, diversity of asset class, lack of liquidity, and/or any discussion of an exit strategy,” says Timothy Morbach, Hindert’s business partner and national sales director of The Settlement Services Group.
To be sure, professionals who do comprehensive planning are available, among them NSSTA-certified professionals and those affiliated with the Society of Settlement Planners. Critics assert, however, that P&C companies continue to rely inordinately on brokers who derive compensation exclusively from commissions and who lack broader training in investments and financial planning. Some carriers may also restrict brokers to company-approved lists of life insurers from which the products may be sourced.
The NSSTA’s Blonder insists these claims are without merit.
“I don't think anyone would suggest that a casualty company should not be allowed to vet their own representatives of choice,” he says. “In any event, plaintiffs are free to hire any financial professional from among the tens of thousands that are available to them. And there are no restrictions as to product the plaintiff may use.”
Critics also question whether plaintiff attorneys should be advising their clients on the suitability of annuity-funded structured settlements—counsel that should be delegated in part to a financial advisor.
“More should be done to recognize that the field of settlement planning is highly specialized and that [claimants] should make efforts to retain separate and qualified financial and legal counsel with respect to the strategies they wish to implement,” says Morbach. “And this should be done before the first demand or offer [of a structured settlement] is made.”
Babener agrees, adding that attorneys often don't consult financial or tax professionals. Many attorneys are qualified to discuss the use of a structured settlement in general, but the degree to which a claimant should receive an award over time rather than all at once (and re-invest) is a financial decision—sometimes the biggest one of the claimant’s life. A claimant would therefore be wise to speak with a financial advisor, he says.
Even if an annuity is appropriate, critics add, PI claimants may be shafted by brokers whose advice is questionable because of conflicts of interest, as might happen when the broker is representing both defendants and claimants in a structured settlement.
“There are currently no state statutory requirements for full disclosure, not just of compensation, but of conflicts of interest—and there are many in the sale of structured settlement annuities,” says Hindert. “In conjunction with full disclosure, states need to mandate that the transactions have claimants’ informed consent.”
He adds claimants are also ill-served by the lack of product suitability standards.
“Lobbyists in the industry have convinced the National Association of Insurance Commissioners (NAIC) that they don’t need to address disclosure and suitability issues because, among other reasons, the transactions are ‘too complex.’ The NAIC did a disservice when it carved out an exception to the suitability standard for structured settlements.”
Hindert observes, too, that many abuses could be avoided if more PI claimants and their advisors were afforded access to qualified settlement funds to work through the issues—and potentially sidestep defense brokers. But he contends that industry lobbying by these brokers has left the vehicles underused.
Proponents of the current regulatory regime argue that the suitability standard governing annuities generally, much less a fiduciary standard that registered investment advisors are bound by, shouldn’t be extended to structured settlements because the arrangements are the product of legal negotiations among attorneys representing the opposing sides. This often arduous process, they add, would be only be lengthened and rendered more expensive if settlement consultants had to meet new state-mandated compliance requirements. Whatever gains would be achieved by an added regulatory layer, they add, would be marginal at best.
“If the plaintiff's attorney engages a settlement planner, then I would argue that, more likely than not, the product or plan recommended will be suitable,” says Charles Schell, principal of Hartwell, Ga.-based Forge Consulting LLC and president of the Society of Settlement Planners. “In any case, it’s not the job of a structured settlement planner to negotiate the legal aspects of a settlement.”
Defenders of the existing process note also that financially vulnerable structured settlement annuities of past decades, as exemplified by the ELNY case, are far less likely today. This is in part because life insurers are more financially diversified than Executive Life, which observers note was overly leveraged in junk bonds.
The evolution of insurers’ investment practices, market-watchers say, is reflected in their financial performance relative to industry peers. Peter Gallanis, president of the National Organization of Life & Health Insurance Guaranty Associations or NOLGHA, observes that the rate of insolvencies among life and health insurers, now at an all-time low, are but a fraction of the hundreds of failures within the commercial and investment banking and thrift sectors during the financial crisis.
Experts say also that many structured settlements today are funded by multiple annuities from separate carriers, thereby reducing financial risks associated with any one life insurer. The development of qualified settlement funds, too, have afforded plaintiffs and their advisors more time to consider solutions that are likelier to withstand the test of time.
Exiting from the Product
A chief area of contention among industry antagonists today, sources say, is the secondary market for structured settlement annuities. The issue: differences of opinion as to the difficulty (or ease) with which PI claimants should be able to sell part or all of their right to an income stream in exchange for a lump sum via a structured settlement “factoring” transaction.
Industry stakeholders agree there are legitimate reasons for such transactions. claimants may, for example, need to pay for emergency medical expenses or other unanticipated financial obligations. For a discounted value of a claimant’s periodic payments, specialty finance companies—among them J.G. Wentworth, Woodbridge Structured Funding and Peachtree Settlement Funding—are prepared to satisfy the liquidity need.
IRC Section 5891 permits a court-approved sale; absent a judge’s blessing, the IRS will assess a 40% excise tax on the buyer. Upshot: nearly all sales of rights to periodic payments are now court-approved in the 47 states that have passed structured settlement protection acts based on a model law of the National Conference of Insurance Legislators or NCOIL.
Despite the statutory and judicial protections, Hindert asserts that claimants are not being adequately educated about the availability of factoring transactions in settlement negotiations because of opposition by the primary market players—the annuity providers. Rather than promoting factoring as a potential benefit, he contends, the life insurers criticize secondary market sales—and indirectly undercut their own products.
Hindert adds that the NSSTA has helped promote this perspective by preventing its members from promoting or soliciting factoring. In a January-dated letter issued by the NSSTA’s board to its members (among them structured settlement consulting companies and life insurance/annuity providers) the organization reaffirms this position, noting that it views factoring as contrary to its mission to “promote the establishment and preservation of structured settlements to provide long-term financial security to personal injury claimants...”
Hindert also flags industry opposition for inhibiting the development of a potentially less costly alternative to factoring: commuting, wherein claimants sell rights to periodic payments back to the annuity provider. If, he says, more annuity contracts incorporated a commutation rider offering payees a discounted value of their future income stream, then the need for factoring sales to a third-party finance company charging higher discount rates would be much reduced.
But Hindert notes that many structured settlement annuity providers are staying out of the secondary market.
“That’s either because they view the secondary market as contrary to a principal aim of the structured settlement—protecting claimants against dissipation—or because of resistance from other industry players,” he adds. “Among them are traditional industry stakeholders who, owing to unenlightened self-interest, have pressured annuity providers to not offer a commutation rider.”
NSSTA Executive Director Eric Vaughn rejects allegations by critics that the organization’s members have squelched market innovations. Yet he also argues that current restrictions on the secondary market are justified.
He points to the quid pro quo established by the 1982 tax act: tax-favored treatment of structured settlement annuities in exchange for barring the modification of periodic payments pursuant to a settlement except in cases approved by a court. He notes also that IRC Section 5891 has effectively prevented many abuses—payees blowing through monetary awards all at once on discretionary expenses or forced to sell to a single factoring company that imposes excessively high discount rates—that commonly occurred in prior decades.
“If you let the secondary market grow unbridled by giving payees multiple new ways of cashing out their income payments, then the financial security rationale for the structured settlement begins to evaporate,” he says. “Giving the secondary market more room to ‘flourish’ could return us to the days before IRC 5891, when many abuses happened within a totally unrestricted secondary market.”