STRUCTURED SETTLEMENTS
Periodic payment settlements, or structured settlements, refer to settling a claim by providing a schedule of benefits consisting of an initial lump sum payment and an agreed number of continuing payments.
Structured settlements are not new. During the 60s and 70s, increasingly liberal juries, influenced by inflationary trends, began to grant enormous verdicts for injured plaintiffs. Medical malpractice and product liability claims were in the forefront.
Casualty insurers turned to a method of reducing claim settlements similar to the payment of workers compensation judgments. These judgment payments were usually paid in periodic increments, not with lump sum distributions. The popularity of this method of settling claims encouraged several state legislatures to adopt laws specifically allowing any court judgments to be paid on a periodic basis. This led to the Model Periodic Payment of Judgments Act.
Another main reason for the popularity of structured settlements was the issuance of IRS Revenue Ruling 79-220. This ruling states that any recipient of compensation for injuries or sickness may exclude the full amount of the payments from gross income rather than the discounted present value. This applies as long as the insurance company purchased and retained ownership of the annuity contract that will provide the monthly payments.
TYPICAL APPLICATIONS
Structured settlements are generally used in the following claim circumstances:
A structured settlement is usually for a claimant with a catastrophic injury such as severe burns, brain damage, spinal cord damage and loss of limbs or organs. Catastrophic injury cases usually have all or most of the following characteristics:
These costs may also include family dislocations.
This sympathy occurs due to the severity of the injury.
ADVANTAGES TO THE RECIPIENT
There are certain reasons why personal injury claimants would consider agreeing to a structured settlement as opposed to receiving a lump sum settlement:
The payout is guaranteed and the claimant could lose from investing a lump sum.
If a lump sum were invested, it may not receive the same tax-free benefits.
There is no need for the claimant to monitor the investing and security, as with a lump sum payment.
WHY USE A STRUCTURED SETTLEMENT?
Every participant in a structured settlement case can benefit. A casualty insurer, to settle on behalf of its insured, can dramatically reduce the number of claim dollars it pays out in any year. The settlement costs less in current dollars because the total negotiated payment over the lifetime of the claimant is commuted to its present value cost - which is much lower than the lump sum otherwise needed to settle the claim.
An added benefit for the casualty insurer is that its claim reserves, which traditionally are carried at gross amounts equaling the expected final claim settlement, are reduced to zero. This reduction frees more surplus to enable the casualty insurer to write more business.
The court system can benefit with increased use of structured settlements because it tends to increase the likelihood of settlements and thereby reduces the burden on congested dockets. Less tax monies will be needed to support the court system.
The public may benefit because the future well being of the injured or disabled claimant is protected and guaranteed. There is no likelihood that the claimant will "squander" monies and then, once the funds are exhausted, become a ward of the state and a burden to taxpayers.
A life insurance company may benefit as it offers the product most often used in structured settlements, a substandard annuity. Substandard means it is being written on the life of a person who is physically impaired in such a way that the person’s life expectancy is shortened.
As a result, structured settlements offer the system further benefits. The plaintiff attorney does not have to become bogged down with the need to offer the client ongoing investment advice. The courts are also rewarded: the incentive to settle helps clear the calendar and simplifies the administration of some cases, such as certain guardianships.
Finally, it is better for the general public. Society will not have to take care of an indigent plaintiff because the funds that were intended for the plaintiff’s care and expenses have dissipated.
The advantages often become quite dramatic on a case-by-case basis. The "take the money and run" philosophy of lump sum settlements becomes self-defeating for plaintiffs in higher tax brackets.
UNDERWRITING CONSIDERATIONS
In these circumstances, underwriting considerations are the reverse of those for determining a premium to be charged for a life insurance policy. In the latter case, the policy owner would pay a higher premium for physical impairment. While with a substandard annuity, the policy owner pays less.
Generally these contracts are not underwritten, but are based on standard mortality. However, in case of substantial physical impairments, the annuity can be underwritten. If the recipient has a much shorter life expectancy, then a larger payment per $1,000 would be paid.
Since most structured settlements are for a fixed payment of money (which might escalate at a stated interest rate or in accordance with some index), rather than whatever can be purchased by a sum, the impact of substandard health is to reduce the premium.
WHY USE ANNUITIES?
Annuities offer fully competitive rates of return, comparable to such alternatives as municipal bonds and long-term treasuries. Interest rates, according to the experts, are not expected to rise dramatically over the next few years. Besides their guaranteed, federal tax-free advantages, annuities provide extraordinary flexibility that allows the terms to be tailored to the individual situation. The ultimate in investment safety, government bond trusts are much more limited in what they can provide.
The flexibility of annuities is apparent in addressing financial planning objectives. They can provide for inflation, for example, through the use of step annuities, compounding annuities or increasing lump sum payments at designated intervals. Special cash payments can be planned for a variety of contingencies such as medical rehabilitation and college education.
Structured settlements are a win-win alternative to some of the more frustrating and wasteful shortcomings of claims litigation. While they may not be the whole solution, they definitely offer a note of reason and responsibility all around.
Source: Tax Facts 1, 1999