Legal structure of structured settlements, in layman’s terms
Most structured settlements follow a similar process, and are generally structured according to the following guidelines: To begin with, the claimant (the injury victim) and the defendant (or possibly the defendant’s insurance provider) settle a tort suit. Such a settlement agreement stipulates that the injured party will drop the lawsuit against the defendant, in exchange for a series of periodic payments, made over time from either the defendant or, as is usually the case, the defendant’s insurer. This means that the defendant, or the property/casualty insurer, now has a very lengthy financial obligation to the successful claimant.
In order to meet these payment obligations, the insurance company will usually proceed along one of two paths. The first option is for the insurer to buy an annuity from a life insurance company. This arrangement is known as a ‘buy and hold’ case. The other option is an ‘assigned case’, where the insurance company chooses to delegate its periodic payment obligation to a third-party company. In order to fund the assigned periodic payments, the third party now purchases what is known as a ‘qualified funding asset’. According to IRC 130(d), the qualified funding asset may be either an annuity (by far the most common choice) or else an obligation of the United States government, i.e. United States Treasuries.
In unassigned cases, it is the defendant (or their insurer) who buys a life insurance annuity, retaining the periodic payment obligation, and paying out the claimant themselves over time. The annuity becomes an asset that matches the periodic payment obligation, and therefore offsets it. This matching process means that the payment stream purchased by the annuity matches the original agreement in every respect, so that the claimant receives payments strictly according to the timing and amounts that were agreed in the structured settlement.
The annuity is owned by the defendant (or the insurer), and the victim is named as the payee under the annuity. The annuity issuer is directed to send all payments directly to the claimant. If the structured settlement is linked to the lifetime of the claimant, then the claimant (or anyone else who may have been designated the measuring life) is pronounced to be the measuring life (the annuitant) under the annuity.
On the other hand, we have the assigned case. Here, the defendant or insurer doesn’t want to keep the periodic payment obligation on its books. In this instance, they then transfer the obligation to a third party, achieving this result by means of a legal device called a ‘qualified assignment’. This third party (or assignment company) requires that the defendant or his insurer must hand over enough money to cover the purchase of an annuity, in order for it to be able to meet the newly transferred periodic payment obligation. This is something cannot proceed without the claimant’s agreement, which may be given as part of the settlement agreement, or otherwise in a type of special qualified assignment, the ‘qualified assignment and release’. Once the claimant has agreed to this transfer, the defendant and/or the defendant’s property/casualty insurer, are free of any continued liability, and are no longer required to make periodic payments to the claimant.
For those companies that prefer not to carry a periodic payment obligation on their books, this is obviously advantageous. The claimant also benefits from the qualified assignment, as he is now no longer reliant on the defendant’s continued good standing, credit-wise. In general, assignment companies tend to be affiliated to the same life insurance company that the annuity was bought from.
There are particular criteria that must be satisfied, if an assignment is to be designated as ‘qualified’, and these are defined in Internal Code Section 130. This qualification is vital for the assignment companies. Without it, they would incur federal income tax, as they are paid a percentage to take over responsibility for the periodic payment obligation, and that would be seen as income. An assignment that DOES qualify under the terms of Section 130 automatically receives an exclusion from the income of the company, and is therefore not taxable.
It was in order to encourage assigned cases, that this tax code provision was enacted. Were this not the case, assignment companies would be in the impossible position of owing federal income taxes, without being able to generate the necessary revenue to pay them.