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.