Structured settlements in today's climate.
There is little doubt that structured settlements can be an effective and cost-efficient tool for resolving personal injury cases. However, m light of the concerns over Executive Life, it is more important than ever that risk managers understand the funding process associated with structured settlements and know how to select a stable insurer to issue the annuity.
Concerns about an insurer's ability to make annuity payments over the long-term are especially pertinent because the payments are usually made to people who have been traumatized in some way and who have ongoing needs. The benefits received from a settlement replace lost income, make housing payments, pay continuing medical and attendant care, fund college and other forms of education for their children, and generally provide the best quality of life possible to those injured. Thus, the investment risk should be minimized to the greatest extent possible while still generating a favorable rate of return. Overall, the structured settlement tool enables the defendant to settle the claim at a lower total cost than an all-cash setdement, and the claimant receives more benefits over the long run.
In reality, what has happened to Executive Life is an aberration in the industry. Executive Life was the first of a very small number of life companies to invest more than 60 percent of their assets in junk bonds. According to a New York Times article in the 1980s, "the life insurance industry as a whole limited its junk bond exposure to about 5 percent of assets." The American Council of Life Insurance reports that the industry has only about 20 percent of total assets allocated to real estate investment, and of this amount, only 3.25 percent - 0.6 percent of total assets - are non-performing (i.e., where the prindpal or interest payments are more than 90 days overdue). When one compares the relatively small junk bond and real estate exposure of the life insurance industry as a whole with the 60 percent of assets invested by Executive Life, it becomes obvious that the situation of Executive Life is the exception, not the rule.
Certainly these statistics put the condition of the life insurance industry in a much more favorable light. Given the fact that the asset base of the life insurance industry is so dramatically different from the savings and loan industry, no responsible observer could expect a repetition of the savings and loan debacle in the insurance industry, although there may be instances of insolvent companies as with any industry.
IT IS PARAMOUNT to remember that a structured settlement funded through an annuity, just like any other investment, is only as safe or as risky as the investment vehicle. Consider that the same problems hold true for all-cash settlements, especially when the lump sum settlement is received and invested to provide for the ongoing needs of the injured party. Therefore, the security of the funding vehicle is of vital importance.
The best approach for risk managers when assessing the stability, appropriateness and security of a life insurance company is to turn to the professional rating services. Among those resources are four independent, well-known services that monitor life companies active in the structured settlements business: A.M. Best Co., Moody's Investors Service, Standard & Poor's Corp. and Duff& Phelps Co. These services review and assess the strength of each life company's management, operations and investments and have an investment grade level of ratings at the top end of their respective spectrums. As a general rule, investment grade is probably a reasonable minimum standard in selecting an appropriate life market.
In the case of Best's, the investment grades are generally considered to be the first two, A++ and A+. For the others, it is the first four ratings groups: Moody's, Aaa, Aa, A and Baaa; and Standard & Poor's and Duff & Phelps, AAA, AA, A and BBB. There are also sub-categories within these groups. Moody's uses numerical values with the smaller number denoting a higher rating: e.g., Aal is better than Aa2. Standard & Poor's and Duff& Phelps use pluses and minuses; AA+ is better than AA, which is better than AA-. In addition, Best's Insurance Reports also assigns a financial size category denoted by a Roman numeral. These financial size categories reflect the current adjusted amount of company surplus and securities valuation reserves.
According to Section 18 of the Model Periodic Payments of Judgment Act by the National Conference of Commissioners on Uniform State Laws, the following conditions should be met for a life company to be designated a "qualified insurer" for funding structured settlements. Under Section 18, a life company should "have a minimum of $100,000,000 of capital and surplus, exclusive of any mandatory security valuation reserve," which would generally equate to a Best's financial size category of VIII. The company also should have one of the following ratings from two of the following rating organizations: A.M. Best Co., A44, A+, A+g, A+p, A+r or A+s; Moody's Investors Service Claims Paying Rating, Aa3, Aa2, Aal orAaa; Standard & Poor's Corp. Insurer Claims-Paying Ability Rating, AA-, AA, AA+ or AAA; Duff & Phelps Credit Rating Co. Insurance Company ClaimsPaying Ability Rating, AA-, AA, AA+ or AAA. As of May of this year, Best's gives its A44 or A+ rating to 258 life companies, Moody's gives an Aaa or Aa to 49 companies and Standard and Poor's gives AAA or AA to 80 companies.
Following the criteria set forth in this model act would be a more conservative approach than the "minimum standard of investment grade" mentioned earlier. However, one must note that following the findings of rating services is not without its difficulties. For example, there may be a lag between the time a company starts having problems and when the rating service revises its ratings. Executive Life was rated A+ by Best's and AAA by Standard & Poor's, though it is important to remember that in the mid-l980s, junk bonds were viewed much more positively than they are today. In light of such miscalculations as the ones on Executive Life's financial situation, however, it is very important to note that most of the major rating services are now issuing changes on a monthly, rather than a yearly, basis.
Given this caveat, one can further ensure an insurer's strength and solvency by comparing the percentage of non-performing assets to the surplus of the company. In a basic accounting course, one learns that assets minus liabilities equals net worth. In the case of life companies, the assets are the money that they have invested in bonds, stocks and real estate. The liabilities are the present values or reserve of their policyholder obligations. Thus, the net worth is the surplus, which is meant to act as a cushion so that life companies are able to withstand adversity to their assets.
The important factor to consider is whether the surplus cushion is large enough in relation to the quality of assets. For example, a representative life company active in the structured settlement market has 5.1 percent of its assets in high yield, non-investment grade bonds commonly referred to as junk bonds. Of these bonds, 6.5 percent are non-performing. Another 4.5 percent of assets are invested in mortgages, of which 1.6 percent are non-performing. This means that 0.4 percent of assets are non-performing. If the company has a reasonable surplus equal to 6.3 percent of its assets, then the surplus would cover the non-performing assets by a ratio of 15.6-to-1. The surplus also would cover all junk bond investments by a ratio of 1.24-to-l. These ratios reflect a substantial cushion of protection for the policyholders. Thus, ascerraining that the percentage of non-performing assets is relatively low compared to the surplus of the company provides added assurance with respect to the stability and safety of an insurer.
QUALIFIED assignment under Section 130 of the Internal Revenue Code allows the defendant entering into a structured settlement to transfer/assign its obligation for the ongoing payments to a third party. Without an assignment under Section 130, the tax deductibility for the purchase of the annuity would be limited to the actual payments made to the claimant over the course of the year - not for the cost of funding the annuity. Where a transfer of obligation is used, however, it is felt that the annuity premium paid by a self-insured defendant to an assignee under Section 130 allows the full deduction. Thus, it is vital that the risk manager make use of the Section 130 transfer of the self-insured's structured settlement whereby the person receiving the payments under the structure may look only to the assignee (the party accepting the obligation) for performance. Therefore the assignee is an important party to both the plaintiff and the self-insured defendant.
The assignee is generally an affiliate, subsidiary or parent of the life company issuing the annuity to fund the structured settlement, and the assignment is accomplished at a very nominal cost. Often, the strength of the life company will carry over to the assignee due to the close relationship. In some cases, the assignee is a "shell corporation" whose only purpose is to act as the assignee and may have its performance guaranteed by the parent. This may be the case with companies such as Allstate, where the parent company issues a bond, and with those such as Transamerica and SAFECO, where the parent issues a guarantee letter.
In some cases, the assignee maybe a stronger-rated entity than the life company, making the life market more acceptable. For example, American International Life of New York is rated A, size VII ($50 million to $100 million) by Best's and AAA by Standard & Poor's; but its assignee is American Home Insurance, a sister company, which is rated A+, size XV ($2 billion or more) by Best's and also AAA by Standard & Poor's.
The situation with Integrity Life, a relatively new company that is non-rated by Best's, size VII ($50 million to $100 million) and rated AAby both Standard & Poor's and Duff & Phelps, presents a slight variation on the assignee relationship. Integrity Life has made an arrangement whereby General American Life, a much larger, older and non-affiliated company acts as Integrity Life's assignee for a nominal cost. General American Life is rated A+, size VIII ($100 million to $250 million) by Best's and AA by Standard & Poor's.
In a unique approach, Lincoln National Structured Settlements Co. (LNSSC), a subsidiary of the large insurance holding company Lincoln National Corp., accepts transfers of obligation under Section 130 from a number of non-affiliated life markets. LNSSC charges a premium - typically 2 percent to 5 percent of the annuity premium - based on their assessment of the quality of the life market. This approach raises questions as to who will be left paying this additional cost, the defendant or the plaintiff, and whether it is necessary to have a company like LNSSC guaranteeing the performance of such stronger companies as Prudential or Metropolitan. However, the availability of this alternative is valuable and may be important in putting together a structure that might otherwise not succeed due to security concerns.
THERE WILL ALWAYS BE a vast number of objections that a plaintiff attorney may advance. The two most common objections are that the annuity is not safe enough and that claimants could do better in the long run by investing an all-cash settlement on their own.
Concerning the contention that structured settlements are not safe enough, one can always look at the alternatives. When compared with the problems of savings and loans and other financial institutions, it is clear that although the insurance industry has problems that may impose risk, they are much smaller than those of the major financial institutions. Real estate is plagued with the traditional problems of cycles, lack of liquidity and the need for hands-on management in many situations, while the stock market is troubled by its volatile nature and low-yielding securities. And banks and savings and loans are replete with low yields and severe security problems. Only government bonds, which offer lower effective returns and lack flexibility and adaptability in providing life income, afford greater security.
To counter plaintiff attorneys' objections about how structures compare to investing an all-cash settlement, one may note that a structured settlement funded through an annuity by a stable insurance company can provide the claimant with a long-term payout, without jeopardizing the principal, with an after-tax return that is comparable to or better than other investments.
Quite often, the purchase of tax-free municipal bonds after an all-cash settlement is suggested as an alternative to a structured settlement since both types of investments are tax-free in nature. However, a Tampa Tribune article reported last year that during the 1980s more than 7,000 "municipals" worth more than $10 billion went into default. This rate of default, which has not been generally publicized, is significant. It's a reminder that no investment is risk-free.
It is interesting to note that Municipal GICs (municipal bonds backed by Guaranteed Investment Contracts issued by Executive Life) are the least protected product in the Executive Life of California disaster. Many who thought they were investing in local, stable municipal bonds were, in fact, investing in junk bonds through GICs issued by Executive Life of California. However, an annuity purchased through a strong life company with significant quality assets and surplus is a viable option when looking to minimize investment risk.
Secured Creditor Status THE SAFETY FACTOR of structured settlements has been further strengthened thanks to the Tax Reform Act of 1988, which amended Section 130 to grant the structured settlements recipient a status greater (i.e., a secured creditor status) than a general creditor. Prior to this change, the recipient of the payments could be no greater than a general creditor of the entity having the obligation for future payments.
However, the appropriate language and mechanics of perfecting the "secured creditor" status for the recipient of the payments is a little unclear. The industry is awaiting the issuance of guidelines from the IRS on exactly how a company becomes a secured creditor. In the interim, most life companies active in the market have been using different types of "bridge" language in assignment agreements to afford the recipient the same protection that a secured creditor status affords.
In order to ensure that a case is settled in the most beneficial way possible and that all parties to a claim are fully aware of the benefits available through structures, hiring a specialist can prove invaluable. When utilizing a structured settlement specialist, the risk manager should compile a list of "approved" life markets that answers the question of security and, at the same time, affords the necessary flexibility to assure competitively underwritten and priced annuity funding vehicles. The structured settlement professional can also provide the risk manager with up-to-date information regarding release language, assignment agreements, taxation questions, and other technical support, as well as legislative developments, both federal and state, and court decisions affecting structured settlements.
After the smoke of the Executive Life seizure clears and reason once again rules the day, the fact will remain that structured settlements funded through life insurance company annuities are a safe solution to the problems facing today's claimants. While there is no sure way to predict how a life company will invest its monies 10 or 20 years from now, there are many high quality life markets active in the structured settlement industry with proven, long-term performance in investing prudently to meet then future obligations. Structures have continually proved that they fulfill the needs of the injured parties and at the same time, are an efficient and cost-effective method in the handling of cases for the selfinsured defendant.
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|Author:||White, Allan; Klingler, Peter|
|Date:||Aug 1, 1992|
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