Structured Settlements 101

Structured Settlements 101

   By William B. Fazio, Settlement Consultant, Fazio National

A Structured Settlement is an arrangement that is designed to compensate a claimant over time, rather than with a single lump sum cash payment.

Over the past several decades structured settlements have been codified in US tax law and become a preferred technique in the settlement of injury claims.

In recent years, compliance with the Medicare Secondary Payer Act has driven the use of structured settlement annuities.

Structured Settlements 101 is designed to:

  • Enhance understanding of structured settlements

  • Encourage the use of structured settlements

  • Simplify the use of structured settlements.

THE TAX CODE

Section 104(a)(2) of the Internal Revenue Code excludes from a claimant’s income tax damage amounts paid as part of suit or agreement to resolve physical injury or sickness claims.

Revenue Rulings 79-220 and 79-313 allow claimants to exclude the future value of payments (including increasing payments) and not simply the annuity cost or present value from income tax. These rulings also establish that the claimant does not have constructive receipt or the economic benefit of the present cash value of future benefits outlined in the settlement agreement.

ASSIGNED OR NOT?

Structured settlement annuities are used to resolve claims in workers’ compensation and in third party liability cases. A key distinction is whether or not the legal process of an assignment will be used.

Section 130 Internal Revenue Code allows for defendants to assign their obligation under the settlement agreement to a third party.

Qualified Assignment. When structured settlements are part of injury claim negotiations, the claimant settles for a lump sum cash payment and a promise to make future periodic payments in exchange for a full release.

The defendant assigns their obligation to make future periodic payments to a third party known as an assignment company. The assignment company is a subsidiary of the life insurance company that issues the annuity. Once the elements of Section 130 have been met, the assignment company agrees to accept responsibility for the future periodic payments and then purchases an annuity to guarantee financial performance. The assignment company will own the annuity policy.

When done properly, the Qualified Assignment results in providing a full release to the defendant and preserves the income tax-free status of the future periodic payments being paid to the settling claimant.

Workers’ Comp. Although in third party liability claims, the assignment process is frequently used, in workers’ compensation claims it is not always possible to utilize a qualified assignment. In some jurisdictions the settling defendant is not allowed to assign their future liability.

In jurisdictions where an assignment cannot be used, the defendant or their insurer would own the structured settlement annuity.

WHAT TYPE OF ANNUITY?

Structured settlement annuities come in various types and may also include a special policy provision known as a “rider.”

The different annuity types may be used with qualified assignment or the defendant may own the policy.

Period Certain. A period certain annuity provides payment for a pre-determined time period. For example: annual payments for twenty years. One payment will be paid each year for twenty years. At the end of the twenty year period the payments stop.

Life Only. A life only annuity only pays while the annuitant is living. When the annuitant dies the payments stop. The annuitant may die the day after the annuity is purchased or thirty years later, but the annuity only pays while the person is living.

Life with Period Certain. This type of annuity will pay for a pre-determined period or the life of the annuitant whichever is longer. For example: annual payments for twenty years certain and life. If the annuitant dies the day after purchase, the annuity pays for twenty years. If the annuitant continues to live beyond the twenty year period the payments continue until the annuitant dies.

Installment Refund. If the annuitant dies before receiving income at least equal to the premiums paid, the contract owner receives the difference in installments. If the annuitant lives after the income paid equals the premiums paid, the life insurance company continues to make income payments to the annuitant  as long as they are living.

Cash Refund. If the annuitant dies before receiving income at least equal to the premiums paid, the contract owner receives the difference in a single lump sum payment. If the annuitant lives after the income paid equals the premiums paid, the life insurance company continues to make income payments to the annuitant as long as they are living.

RIDER

Commutation Rider. When an annuitant dies, a commutation rider commutes the value of the remaining guaranteed payments into either a single lump sum payment or on a percentage basis. This must be set up at the time of settlement.

This calculation at death is different depending on who the annuity underwriter is.

SAMPLE APPLICATIONS

Medicare Set-Aside: The Centers for Medicare and Medicaid Service do not require life-contingent annuities for structured MSA’s. Period certain annuities are used to fund the future value of the MSA, often at a significant discount.

Special Needs Trust: A special needs trust is used to preserve an injured person’s Medicaid and SSI benefits. In these situations a structured settlement often pays into the trust. In many jurisdictions a commutation rider is used to provide cash to pay liens when the beneficiary dies.

Workers’ Comp: In jurisdictions where assignment is prohibited it may be attractive for a defendant to purchase an annuity to fund future obligations (i.e. future medicals). As the contract owner the defendant can use an installment refund or cash refund to recoup premiums paid in the event of the claimant’s death.

Beneficiaries: A claimant with beneficiaries is likely to choose riders, refund options and certain periods to provide for their beneficiaries or to cover estate taxes.

Annuity types and riders may be stand-alone provisions or used in combination. Not all underwriters will provide the same options. It is important to have access to all structured settlement annuity providers.

RATED AGE 

Rated age is widely misunderstood and misused.  It is often interpreted as a measure of life expectancy, which it is not.

An easy way to think of rated age is to consider a normal life insurance policy. A 35 year old male in good health will pay a lower rate than a 35 year old male who is a smoker for the same coverage. The two men have fallen into different “rate categories.” The smoker has a higher risk of death, but the life insurance company has made no determination of life expectancy.

With annuities the same concept applies. A healthy 35 year old male will likely live longer than a 35 year old male who smokes. Therefore an annuity provider may assign a rated age to the smoker.

Unlike the life insurance policy, annuity providers won’t penalize an individual due to their health condition, but rather offer a discount off of the premium by using the rated age process.  Depending on how aggressive or conservative the annuity provider is with their pricing can determine how aggressive or conservative they will be with their rated age of an individual.

Annuity providers use rated age as a competitive mechanism. Underwriters may aggressively “rate” an individual in an effort to provide higher payments than a competitor. Conversely, underwriters may provide no rated age at all.

HOW RATED AGE IMPACTS ANNUITY TYPES

SAMPLE CASE

Claimant:   Male age 35                                                Rated Age: 45

MSA Duration: 30 Years                                               Annual Payments: $10,000


1 Illustrative purposes only. Rate series NY20 02/23/2010.

PRACTICAL APPLICATION

Most individuals have spending and saving habits that are built on a lifetime cycle of weekly or biweekly payments.  It is the rare person who can budget around a payment cycle of less frequency when it comes to meeting their basic living needs.

An injury, regardless of its severity, disrupts this cycle. Claimants are faced with lost wages, medical bills and perhaps an ongoing disability. Settlements and awards are used to compensate claimants for these losses.

Structured settlements are by far the most effective tool for rebuilding the cycle of spending and saving.

Structured settlements provide guaranteed income tax free payments for:

  • Mortgage or rent payments

  • Vehicle expenses

  • Higher education expenses for the claimant or their children

  • Medical expenses

  • Retirement

There is simply no investment in existence today that matches the safety, convenience, and flexibility of a structured settlement annuity making them a powerful negotiating tool.

Any claimant who is tempted to forego the certain benefits of a structured settlement today and seek better yields in more risky markets may be left with much less, and in some cases, nothing.

At least part of every plaintiff's future security should be funded via a lifetime annuity, before other investment alternatives are considered.

CONCLUSION

When used properly structured settlements can be a powerful negotiating tool.

Medical underwriting or Rated Age may reduce an annuity’s cost or increase its benefits.

The structured settlement may utilize the assignment process or the defendant may own the annuity.

A rider can commute a periodic payment stream into a lump sum payment at death.

The structured settlement marketplace is competitive. It is important to request quotes from all available underwriters to ensure the best annuity cost and type. This is true regardless of whether or not there is a life contingency on the annuity.

A period certain annuity will not always be the least expensive option. In jurisdictions where assignment is prohibited, it may be attractive for the defendant to own the annuity.

When you require any type of life contingent annuity, it will be necessary to request rated ages from life insurers.

Medicare Set Asides utilize period certain annuities. Special Needs Trusts are likely to use life contingent annuities and riders.

Structured settlements are codified in the Internal Revenue Code.

THE A+ MARKETPLACE

To illustrate the competitive nature of the structured settlement market, we have included a market survey that we completed on a recent case on the following page. Each underwriter rated A+ or higher was given an opportunity to quote their cost for the desired benefit package.

MARKET SURVEY

Allstate = Allstate Life                                                              NYL = New York Life

JH = John Hancock Life                                                           Met = Metropolitan Life

Pacific = Pacific Life                                                                Pru = Prudential Insurance