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What is a structured settlement

A structured settlement is one alternative to the conventional method of financial damages arising from a court case (or similar action) being awarded as a single lump sum. Instead the damages (or part of them) are awarded as a regular payment to the claimant, on behalf of the defendant, that is guaranteed to last for (normally) the claimant's life.

History

The idea of the settlement of a debt being spread over a period of time has long been a part of the British legal landscape. The first recorded modern case of this spreading of a repayment of a capital debt being Lady E. Foley in 1854, but the first reported personal injury case is that of Miss Stachnik, a Canadian tourist in 1981. Despite this case the landmark case in this field is Kelly -v- Dawes in 1988. This set the idea that part of the damages award would be replaced by a series of payments lasting for the claimant's life. These payments would be tax free as long as they arose out of a settlement reached in replacement of capital debt.

This "new" idea caught the imagination of both personal injury lawyers and Judges. The advantages to a claimant of avoiding what could be a substantial tax bill on the income from an invested lump sum, coupled with the attraction of a life long income were quickly recognized. At the same time defendants successfully persuaded claimants that the cash flow disadvantages to them (the defendants), and the administrative expense associated with the complicated payments needed to avoid tax liability, meant there should be some "discount" to the award. The agreement of such discounts (as fixed sums rather than a percentage of the award) to cover such costs resulted in structures normally needing to be in excess of £500,000 to be acceptable to the claimants.

In September 1992 when interest rates, and so annuity rates that feed the structure's payments, fell structures fell out of favor. The subsequent slow recovery in long term interest rates and the reduction of discounts where health authorities were involved, brought some renewal of interest. At the same time pressure was growing from some parts of the legal profession for legislative reforms to make structures more attractive.

As a result of such campaigns a small part of the 1995 Finance Act substantially reduced the cash-flow and administrative burden on defendant insurers offering structures. This enables more of the award to be available for structuring as the logical arguments for a discount are now almost entirely gone. The renewed drop in interest rates has slowed the expected resurgence, but it has been helped by a recognition that structures should also be considered for non-financial reasons (as outlined below).

The recent case of Wells -v- Wells et al. has had the effect that awards are now calculated at the same rate of future growth that most providers use when assessing the return they will offer. This is because the discount rate is now linked to the risk free rate of return available to the general market. This is the rate used as a basis for annuity rates by many of the structure providers.

This means the risk free rate used by the courts in assessing the discount rate is the same as that used by the life offices in assessing their risk. It in turn is used in assessing the annuities they are prepared to offer. The result of this is that theoretically, except for the profit costs of the provider, the returns offered by them should match the requirements agreed at court. This, and the generally larger awards following the Wells -v- Wells et al. decision, have caused the current reawakening of interest in structures.

Types of structures

The traditional approach to a structure is to start with the conventional award. Amounts are deducted for immediate requirements together with an amount for future contingencies (either quantified, such as a future property purchase, or to cover unspecified expenses). The various providers are then approached to find what level of annuity they would be prepared to offer for the lump sum on offer. The claimant then considers if that annuity is, for them, preferable to the lump sum. This approach is often referred to as a top down approach.

In acting in this way the claimant is considering whether the financial return they can achieve on their investment of the lump sum in the general market is better than that which the life assurance company will offer. They are in practice performing a balancing act. On the one hand there are the tax advantages of a structure and the security of income. On the other are the profit costs charged by the provider and the lower returns associated with that security or the claimants own ability to achieve an investment return.

An alternative argument often put forward in such considerations is to look at how long the lump sum could be expected to last if the full annual expected requirements of the claimant are met. This is compared to the reduced level of funding for life from the structured settlement. This approach means that the claimant is balancing their assessment of the quality of care after the fund runs out against the medical expert's assessment of life expectancy. They form a view of whether the partial lack of funds for life will cause more hardship than the total lack after the lump sum is exhausted.

In both these assessments the claimant will need to consider the risks that the investment market into which they could put their lump sum into will not achieve the growth rate they have assumed.

A newer approach to structured settlements is referred to as a "bottom up" approach. This starts from an assessment of the needs of the claimant. The structure provider is then approached to provide a quotation for the cost of the required annuity. The practical affect of this approach is to move the burden of the decision on whether to proceed with the structure from the claimant to the defendant. The defendant will have to consider the cost to them of the structure. In practice the claimant will also normally consider the "cost" to the defendant as few are willing to settle unless they see the defendant is paying an amount in line with the likely conventional award. If they are not the claimant could ask for a larger contingency sum.

A further type of structure is a composite structure. In this a larger part of the conventional award is taken as a lump sum than a simple traditional contingency fund, with the balance as a normal "top down" structure. The lump sum is invested to provide a return to supplement the annual income provided by the structure. The idea behind this is the higher rate of return perceived as being available through investment in the open market, complements the tax free income from a structure. It also provides an element of the lifelong income guarantee of a structure together with an element of the flexibility of a lump sum investment.

In recent months this third approach has become far more popular amongst both claimants and defendants. It is akin to the best of both worlds and careful consideration of the balance between the elements can maximise the return to the claimant while minimising the cast to the defendant.

Structured settlement providers

There are currently five commercial providers offering structured settlements to the general market plus one provider offering them in certain defined cases. The providers are all life offices but there is a mix of types of companies involved (public limited companies, mutual societies and friendly societies). These differences mean that the quotations offered by the different providers will vary from claimant to claimant, so it is essential to obtain quotations from all the available providers.

Claimants benefiting from a structure are protected under the Damages Act 1996. This provides an indemnity of 100% of the annuity should the life office providing the it become insolvent during the life of the structure. This should remove any uncertainty of the financial viability of the structure provider.

In addition many other bodies are able to offer self funded structured settlements. Health authorities are currently the bodies most commonly involved in actively considering structures. They offer structures based initially on quotations offered by the commercial providers and then assess the proposition having had an assessment from the NHS Litigation Authority. The resultant annuities are underwritten by the Secretary of State for Health.

There are also a large number of other bodies that are able to offer a structure and to benefit from the relaxation in administration dealt with in Section #12:12 pm. These include the Criminal Injuries Compensation Authority (who have completed a few structured settlements), the Motor Insurers Bureau and indeed any defendant who is liable to compensate a claimant. It is however worth pointing out that all together these other defendants amount to a handful of structures implemented to date.

The NHS executive

The National Health Service have issued guidelines that state that NHS defendants should consider a structure in all cases where damages are above £250,000. This requirement is the biggest single driver in the consideration of structures settlements today.

In cases involving NHS defendants, the NHS Litigation Authority compares the value for money report produced on the defendants' behalf based on the claimants needs, with their own assessment of the lump sum option and a self funded structured settlement. These assessments are based on treasury issued guidelines. They then make a recommendation based on the requirements of the claimant and the best value to the NHS.

In practice this means they are comparing the current cost equivalent to the NHS of providing the structured settlement payment, at the treasury indicated cost of capital, with the cost of the lump sum. They do not generate their own quotations of what payments could be made to a claimant from the sum available for structuring, instead relying on the quotations provided by the commercial providers. In this way they rely on competition within the market keeping annuity rates at an appropriate level.

There has recently been a growing reluctance on the part of the structure providers to supply quotations for the NHS or their advisors. This is as they have realised that they do not receive any significant number of instructions for this work. This may, in the longer term, mean that the NHS has to return to the original stance of it, or its advisors, providing the quotations based on its internal cost of capital.

The practicalities of implementing a structure

In implementing a structure, the starting point is that both sides will have obtained a good idea, usually definite quotations from third party providers, as to the level of the structure and any lump sum element of the compensation. The two parties will then have to sign a written agreement setting out the terms of the agreement. This is needed to obtain Inland Revenue Approval. There is a pre-approved standard agreement available with a choice of formats. This is sufficient for most structures and keeping to this is sufficient to ensure that the tax free status is maintained. If the agreement is different from this then written approval will be needed from the Inland Revenue.

At the same time the court will need to give approval as to the settlement. At the hearing the court will require [under a practice note of 12 February 1992]:

an opinion of Counsel assessing the value of the claim on a conventional basis and of the value of the proposed structured settlement;

a report of a forensic accountant setting out the advantages and disadvantages of the structured settlement to the plaintiff;

the draft agreement showing its approval by the inland revenue (unless it is the pre-approved standard agreement);

any necessary consent from the Court of Protection.

Once the court's approval has been obtained, then, with a purchased structure, the selected provider needs to be contacted to arrange for the payment to be made to them, and payments to be started to the claimant. For a self funded defendant, then all that is needed is the implementation of suitable internal systems to arrange for the payments to be made to the claimant and the amounts recorded to allow the correct assessment of tax at the appropriate time.

How to assess a structure

The first point to consider is whether the structure provides an income at least comparable with that available with a lump sum award, over the expected life of the claimant. If it does not, then the structure is only likely to be considered further in very unusual circumstances, such as where tying up the capital is desired, where there is a reasonable chance that the claimant will live substantially longer than the medical opinion suggests or some other such eventuality.

The only significant proviso to this is that an annual income from a structure can preserve some Social Security benefits. Benefits are often means tested so the existence of a large lump sum controlled by the claimant may remover their entitlement to many such benefits. A structured settlement however is a source of income which effects different benefits. While this seldom is a reason in itself for a structure, if it is a fine balance this can sway it in favor of the structure.

The biggest variable in assessing this question is the likely rate of return achieved on a lump sum investment. Since 1919 the stock market has achieved real returns of between negative 28.8% and positive 29.1%. This clearly shows the problem in assessing a realistic level for basing projections of the lump sum income. An average of around 7% for equity growth rates and 6% for gilts would be a moderate assessment of the past 60 years results, however it must be stressed that these past results are not necessarily reliable indicators for future returns.

An alternative approach to this problem is to say that equities achieve a growth above that of risk free investments (such as the structures annuities are based on) based on the risk people assume is related to them. If there is a risk return of 3%, for example, it follows that the equity capital value will grow by 3% more than the annuity. The model used in comparing the Structured settlement and the lump sum can use this instead of an absolute growth rate.

Using spreadsheet modeling techniques, and making various assumptions about taxation and other costs, it is possible to project the likely income from a lump sum. This is then compared to the quotations from life providers for the structure annuity.

It is when looking at these comparisons that spreadsheet modeling comes into greatest use. Structure providers normally indicate that their quotations are on a pro-rata basis. This means that if there is a quote for £35,750p.a. from £1,500,000, then it would follow that £24,500 would be available from £1,000,000. This enables different composite structures can be looked at and compared with out the need for a whole raft of quotations being obtained.

It is also often worth looking at deferred structures. These are structures where some, or all, of the annuity does not start to be paid immediately. This means that, when it is paid, the rate is increased. For a child living with parents at the present time, but needing far greater care costs at a future date, a good model will enable different strategies to be looked at. For example the model could be used to consider both a deferred annuity and a level annuity with the excess income in the early years reinvested into the lump sum so providing an increased income in later years.

The advantages and disadvantages of a structured settlement

The advantages and disadvantages of a structured settlement depend on the point of view of the assessor, claimant or defendant. I shall deal first with the claimant.

The most commonly quoted advantage to the claimant is the security. Under a structure the claimant is assured of an income for life. That income will normally be agreed to increase with an specified index, such as RPI, and will last for life. This is a powerful aid in settling the mind of a claimant. They will have often have few other certainties, and the certain income will allow them to budget in advance for their costs.

The need to prevent any ability to use the award faster than is good for the claimant can arise in many situations. Those cases with a young claimant potentially subject to undue influence, but not under the Court of Protection (such as a case involving a child where the father was serving a prison sentence for embezzlement), may be suitable for a structure. This may still be the case even if financially it is no more attractive than a lump sum compensation.

There are also wealthy claimants. They may not rely on their damages exclusively so the attraction of a fixed, tax free, annual income may complement their other investment incomes to provide a better portfolio of investments (see Section #).

The other related point in favor of structured settlement is that they avoid most of the need to consider the investment of the lump sum. This is a cost that must be considered when assessing the lump sum, and some claimants may wish to avoid this whole area. This should not be taken as the sole reason for choosing a structured settlement. To do so would be simply an abdication of the responsibility to choose with the best interests of the claimant in mind. It is however a contributory factor.

Disadvantages for the claimant are first and foremost the lack of flexibility. In the United States there is currently a debate over a market that has grown up for financial institutes to "buy" claimant's entitlement to future structured settlement payments. This is in return for a lump sum that effectively converts the structure back in to a conventional award at a later date. This is currently thought unlikely to spread to this country where, once agreed, a structure can not be altered. This rigidity means that any future changes in requirements have to met out of either the structure's regular payments or other resources (the contingency fund while it lasts or non-damages related moneys). This is often seen as a problem for plaintiffs who feel unable to assess the likely future for themselves.

The second most commonly raised problem is the fact that a lump sum investment has the potential to exceed initial expectations. If neither the lump sum nor the structure are expected to fully provide for a claimant's expected future needs, at least the lump sum may over achieve. This may be possible only through investing in more risky investments but the claimant does have the choice.

One area that claimants sometimes consider important is that with a structure it may require a smaller payment from the defendant. With a self-funded structure if the claimant dies before their life expectancy the defendant makes a saving. Some claimants feel this is unfair and are unwilling to take that chance. The converse is true if the claimant outlives their life expectancy.

While being more in the nature of an advantage for a lump sum than a disadvantage for structures, some claimants derive enjoyment from watching, and actively managing, their damages fund. While this is only to be considered for the financially aware claimant, some such situations do exist where this is a consideration.

From the point of view of the defendant, the advantages depend on whether the structure is to be purchased on the open market or self-funded. In both cases the prime factor is normally the cost. If the structure is purchased from a third party then the difference in cost between that and a lump sum is unlikely to be significant.

If however it is a self-funded structure then the quotations provided by the providers will make an allowance for their (the providers) profit costs. If some of these are maintained by the self-funding defendant then that will represent a saving.

The "saving" is because the providers base their quotation for the annuity on what capital sum that annuity would purchase on the open market at the present time. A body with a cheaper source of capital would, for the same annuity, be able to purchase a smaller lump sum. The difference between that and the lump sum award represents a saving to the defendant. This may be a notional or theoretical saving but it is important when considering budgets and funding requirements for the defendant.

In the same way if the cost of capital for the self-funding defendant is lower than the return available to a commercial provider there will be a saving in the overall cost. Such a situation may arise because currently most structures are offered at the rates quoted by commercial providers. These are based on the return available to those providers. The lower cost to the defendant with access to a cheaper source of capital (such as a government body) effectively means they obtain a higher "return" on their money (in the saving of the cost). This generates a saving to the self-funding defendant.

Another potential major advantage for Health Authorities and other self-funding defendants is the cash flow advantage of a structure. It defers from the current budget the majority of the costs. This may be considered a short sighted view, if that is the only consideration, but it is a possible advantage of a structure.

Apart from cost there is the area of life expectancy. Sometimes a self-funding defendant believes a claimant may have a shorter life expectancy than that assumed by the experts considered by the commercial providers. In such a case, or where the claimant's advisors in assessing the lump sum have a different expectation, then a structure offers the opportunity to benefit if that view is eventually correct.

The converse, where a commercial structure provider's advisors assume a shorter life expectancy then the two sides would agree in assessing any lump sum can exist, but in practice this is unlikely. The commercial providers normally assume life expectancy somewhere in a range between those proposed by the two sets of expert and close to where courts tend to decide if agreement fails.

Publicity can also be considered as a contributing factor in the decision of a defendant. How they perceive a headline figure of damages paid by them is important. The press have a history of reporting structured settlements as a sum of the agreed payments for the expected life. This ignores the fact that a large part of these arise from income on the fund in the early years, so giving a higher headline figure.

The other side of the publicity coin is seen less often. A caring defendant could get the publicity value of providing an income for life. This advantage may however be harder to achieved for the defendant than the claimant.

For structures purchased commercially there is no difference in terms of finality. Both lump sum awards and structures allow defendant insurers to close their files on the case.

Conclusion

Structured settlements are a complicated area. There are however a discrete area that can be tacked on to many larger claims. They need not be limited to the traditional £million plus medical negligence case. They can, and I believe should, be considered in many more cases.

If you have a case where the costs are likely to be incurred for the rest of the claimants lifetime then think about a structure. A specialist in the field can quickly give you the pointers you need to decide whether to look at one further.

If you do decide to look at them be imaginative. Consider deferred structures, stepped ones or a mix of a lump sum and structure. There is no real need to stick to the traditional view point, and with still relatively low annuity rate one of these more modern approaches may well prove worthwhile.

 

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