changes in the structured funding industry

7/30/2019 Changes in the Structured Funding Industry

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The financial debacle that has denied hundreds of former ELNY also known as the executive lifeof New York companies policyholders much of the income payments once promised them hasshone a light on a corner of the industry little understood by many life insurance and financialservice professionals: annuity-funded structured settlements.

The solutions, used by property and casualty (P&C) insurers in worker compensation and otherpersonal injury (PI) cases to settle claims, generate billions of dollars in premiums annually forthe life insurance companies that fulfill the monetary awards owed to injury victims. When theywork as intended, the structures are a win-win for the other stakeholders in PI cases: for the P&Ccarriers that secure tax and administrative benefits; for the attorneys and structured settlementbrokers that generate fees and commissions designing and implementing the solutions; and forthe PI claimants who depend on the tax-free periodic payments to cover living expenses or meetother financial objectives.

"Since 1983, more than 500,000 injury victims have opted to have at least part of their [award] ina 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 structures mix of tax-free income andguaranteed security.

Industry critics question, however, whether many of these half-million injury victims could havebeen better served. In respect to ELNYs 1,500-plus payees, who stand to lose from 40 percent to60 percent of the income originally due to them because of financial mismanagement by ELNYs

now defunct parent, Executive Life of California, and by the New York Liquidation Bureau thattook the bankrupt ELNY into receivership, the answer clearly is yes. But such cases of failure tomeet structured settlement obligations are rare, say market-watchers.

More worrisome, the critics contend, are industry practices, inadequate regulation and lobbyingby key players to quash cost-saving product innovations. Among the complaints: that the marketspace is dominated by structured settlement brokers who too often favor annuities overalternative solutions because of the commissions they derive on sales; that industry stakeholdersare impeding the development of commutation provisions in annuity contracts that can savepayees desiring to sell their rights to future income payments much time and expense; and thatstate regulations governing product suitability, compensation disclosure and conflicts of interestare 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. Absentmarket reformsand Im not optimistic there will bethese practices will go on to thedetriment 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


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buy-and-hold structures, the P&C company purchases an annuity from a life insurer and writesoff 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 taxdeduction for the aggregate amount of the annuity payments. Also, by removing the structuredsettlement liability from its balance sheet, the carrier cuts both administrative costs and financialexposure.

Since passage of the Tax Equity and Fiscal Responsibility Act of 1982, structured settlementannuities have also been exempt from federal and state income tax, taxes on interest anddividends, capital gains tax and the alternative minimum tax (AMT) under Internal RevenueCode Section 130. 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 annuity, the payee enjoys not only the value of a lump sum, butalso tax-free growth, says Jeremy Babener, a tax attorney and structured settlement expert at thelaw firm Lane Powell PC, Portland, Oregon. That can be a very significant tax advantage.

Structured Financial Associates (SFA), an Atlanta-based structured settlement broker thatcompiles statistics on the industry, pegged new annuity premiums written for structuredsettlements 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 $5billion, respectively. (See charts for 2011 figures.)

In tandem with the decline in new premiums there has been a dip in the number of structuredsettlement cases. In 2008, the case load totaled 35,371. In 2009, 2010 and 2011, the numbers fellto 32,399, 31,290 and 28,811, respectively.

What accounts for the decline? Joseph Dehner, a structured settlement attorney at Frost BrownTodd LLC, Cincinnati, Ohio, cites continuing low interest rates on the fixed annuities used tosatisfy 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 dont lendthemselves to structuring because the amounts involved are too small. It makes little sense, theyargue, to write an annuity when the settlement calls for a payout of only $5,000 or $10,000 to afew 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 cashawards to claimants. Notable among them are individuals who, because of the nature of theirinjury, lack of maturity or other factors a judge would not be comfortable awarding a lump sum.


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A structured settlement might happen in cases where, for example, the plaintiff is brain-damagedand thus not competent to handle an lump sum award. Some states also have rules againstapproval of lump sums over a certain cash amount for minors. Structured settlements frequentlyalso 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 asizable claimat least $100,000," says Dehner. "Conversely, a personal injury attorney forclaimants who isnt even considering a structured settlement in high damage cases is bordering

on malpractice.

Or, he might have added, when they dont call on advance planning professionals to assist in

more complex cases. Example: When the structured settlement calls for integrating a trust topreserve government benefits that otherwise would be foregone if monetary awards werereceived as a lump sum distribution. Hence the advent in recent years of special needs trusts andMedicare set-aside trusts.

This is a relatively new trend, says Dehner. Structured settlements have become both moreflexible and complicated because of the advanced planning that now accompanies thesetransactions.

One result, he adds, is that many more professionals with diverse skills and expertise are nowactive in the structured settlement space. Many new practices started in the last 5 to 10 yearsfocus just on Medicare set-aside allocations or trusts.

As the arrangements have grown more complex, plaintiff attorneys have increasingly turned toIRC Section 468(b) qualified settlement funds (or trusts) because of the flexibility the temporaryvehicles 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 planningclients 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 Powells Babener. This is especiallyimportant for two reasons: First, it can take a lot of time to determine whether Medicare isentitled to any of the settlement proceeds; second, plaintiffs may want more time to decidewhether to structure a settlement. And they cant structure if they first receive a lump sum awardin cash.

The QSF, adds Babener, is frequently advantageous in cases involving multiple personal injuryvictims. But for the single plaintiff, use of the vehicle comes with uncertainty. Thats because it

is unclear whether a single plaintiff is treated for tax purposes as receiving funds deposited into aQSF. If so, the tax advantages of structuring are reduced, if not lost entirely. The IRS hasreceived requests to issue a private letter ruling on this tax question.

Of greater concern to market-watchers is whether payees of structured settlements are receivingadequate financial counsel. When defendants and plaintiffs in personal injury cases agree to such


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arrangements, they turn to structured settlement consultants or brokers to shop for a suitableannuity to settle claims.

Whereas in prior decades a single broker represented only the defense, in most cases todayplaintiffs also work through their ownor else a consultant deemed suitable to the two parties

thereby insuring that plaintiffs are adequately informed about their options and that the annuitypurchased is satisfactory to both sides.

Or so the thinking goes. Critics contend that the product is often inappropriately recommendedby profit-seeking structured settlement brokers, chiefly those on the defense side, who specializein shopping for annuities to settle PI claims and who enjoy an often hefty commission on thesale.

Wouldnt claimants be better served by fee-based advisors who have a fiduciary responsibility toact in the claimants best interests and whose compensation is tied not to an annuity sale, but to afee 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 asstocks, 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 lowestprice is best price [rule], with no discussion about diversity of credit risk, diversity of assetclass, lack of liquidity, and/or any discussion of an exit strategy, says Timothy Morbach,

Hinderts 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 compensationexclusively from commissions and who lack broader training in investments and financialplanning. Some carriers may also restrict brokers to company-approved lists of life insurers fromwhich the products may be sourced.

The NSSTAs 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 financialprofessional from among the tens of thousands that are available to them. And there are norestrictions as to product the plaintiff may use.

Critics also question whether plaintiff attorneys should be advising their clients on the suitabilityof annuity-funded structured settlementscounsel that should be delegated in part to a financialadvisor.

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


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with respect to the strategies they wish to implement, says Morbach. And this should be donebeforethe first demand or offer [of a structured settlement] is made.

Babener agrees, adding that attorneys often don't consult financial or tax professionals. Manyattorneys 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 afinancial decisionsometimes the biggest one of the claimants life. A claimant would thereforebe wise to speak with a financial advisor, he says.

Even if an annuity is appropriate, critics add, PI claimants may be shafted by brokers whoseadvice is questionable because of conflicts of interest, as might happen when the broker isrepresenting 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 interestand 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 dont 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 anexception to the suitability standard for structured settlements.

Hindert observes, too, that many abuses could be avoided if more PI claimants and their advisorswere afforded access to qualified settlement funds to work through the issuesand potentially

sidestep defense brokers. But he contends that industry lobbying by these brokers has left thevehicles underused.

Proponents of the current regulatory regime argue that the suitability standard governingannuities generally, much less a fiduciary standard that registered investment advisors are boundby, shouldnt 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 consultantshad to meet new state-mandated compliance requirements. Whatever gains would be achieved byan 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 thannot, the product or plan recommended will be suitable, says Charles Schell, principal ofHartwell, Ga.-based Forge Consulting LLC and president of the Society of Settlement Planners.In any case, its 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 settlementannuities of past decades, as exemplified by the ELNY case, are far less likely today. This is in


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part because life insurers are more financially diversified than Executive Life, which observersnote was overly leveraged in junk bonds.

The evolution of insurers investment practices, market-watchers say, is reflected in theirfinancial performance relative to industry peers. Peter Gallanis, president of the National

Organization of Life & Health Insurance Guaranty Associations or NOLGHA, observes that therate of insolvencies among life and health insurers, now at an all-time low, are but a fraction ofthe hundreds of failures within the commercial and investment banking and thrift sectors duringthe financial crisis.

Experts say also that many structured settlements today are funded by multiple annuities fromseparate carriers, thereby reducing financial risks associated with any one life insurer. Thedevelopment of qualified settlement funds, too, have afforded plaintiffs and their advisors moretime 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 secondarymarket 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 incomestream in exchange for a lump sum via a structured settlement factoring transaction.

Industry stakeholders agree there are legitimate reasons for such transactions. claimants may, forexample, need to pay for emergency medical expenses or other unanticipated financialobligations. For a discounted value of a claimants periodic payments, specialty financecompaniesamong them J.G. Wentworth, Woodbridge Structured Funding and PeachtreeSettlement Fundingare prepared to satisfy the liquidity need.

IRC Section 5891 permits a court-approved sale; absent a judges blessing, the IRS will assess a40% excise tax on the buyer. Upshot: nearly all sales of rights to periodic payments are nowcourt-approved in the 47 states that have passed structured settlement protection acts based on amodel law of the National Conference of Insurance Legislators or NCOIL.

Despite the statutory and judicial protections, Hindert asserts that claimants are not beingadequately educated about the availability of factoring transactions in settlement negotiationsbecause of opposition by the primary market playersthe annuity providers. Rather thanpromoting factoring as a potential benefit, he contends, the life insurers criticize secondarymarket salesand indirectly undercut their own products.

Hindert adds that the NSSTA has helped promote this perspective by preventing its membersfrom promoting or soliciting factoring. In a January-dated letter issued by the NSSTAs board toits members (among them structured settlement consulting companies and life insurance/annuityproviders) the organization reaffirms this position, noting that it views factoring as contrary to itsmission to promote the establishment and preservation of structured settlements to provide

long-term financial security to personal injury claimants...


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Hindert also flags industry opposition for inhibiting the development of a potentially less costlyalternative to factoring: commuting, wherein claimants sell rights to periodic payments back tothe annuity provider. If, he says, more annuity contracts incorporated a commutation rideroffering payees a discounted value of their future income stream, then the need for factoringsales 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 thesecondary market.

Thats either because they view the secondary market as contrary to a principal aim of the

structured settlementprotecting claimants against dissipationor because of resistance fromother industry players, he adds. Among them are traditional industry stakeholders who, owingto unenlightened self-interest, have pressured annuity providers to not offer a commutationrider.

NSSTA Executive Director Eric Vaughn rejects allegations by critics that the organizations

members have squelched market innovations. Yet he also argues that current restrictions on thesecondary market are justified.

He points to the quid pro quo established by the 1982 tax act: tax-favored treatment of structuredsettlement annuities in exchange for barring the modification of periodic payments pursuant to asettlement except in cases approved by a court. He notes also that IRC Section 5891 haseffectively prevented many abusespayees blowing through monetary awards all at once ondiscretionary expenses or forced to sell to a single factoring company that imposes excessivelyhigh discount ratesthat 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 settlementbegins to evaporate, he says. Giving the secondary market more room to flourish could returnus to the days before IRC 5891, when many abuses happened within a totally unrestrictedsecondary market.

changes in the structured funding industry

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