Saturday, November 10, 2007
STRUCTURED SETTLEMENT
A structured settlement is a financial or insurance arrangement, including periodic payments, that a claimant accepts to resolve a personal injury tort claim or to compromise a statutory periodic payment obligation. Structured settlements were first utilized in Canada and the United States during the 1970s as an alternative to lump sum settlements. Structured settlements are now part of the statutory tort law of several common law countries including: Australia, Canada, England and the United States. Although some uniformity exists, each of these countries has its own definitions, rules and standards for structured settlement. Structured settlements may include income tax and spendthrift requirements as well as benefits. Structured settlement payments are sometimes called “periodic payments”. A structured settlement incorporated into a trial judgment is called a “periodic payment judgment”.
Structured Settlements in the United StatesThe United States has enacted structured settlement laws and regulations at both the federal and state levels. Federal structured settlement laws include sections of the Federal Internal Revenue Code. State structured settlement laws include structured settlement protection statutes and periodic payment of judgment statutes. Medicaid and Medicare laws and regulations impact structured settlements. To preserve a claimant’s Medicare and Medicaid benefits, structured settlement payments may be incorporated into “Medicare Set Aside Arrangements” the “Special Needs Trusts”.
Injury victims should know that structured settlements are endorsed by many of the nation's largest disability rights organizations, including the American Association of People with Disabilities [1] and the National Organization on Disability [2].
Definitions:The United States definition of “structured settlement” for Federal income taxation purposes, found in Internal Revenue Code Section 5891(c)(1), is an "arrangement" that meets the following requirements:
A structured settlement must be established by: A suit or agreement for periodic payment of damages excludable from gross income under Internal Revenue Code Section 104(a)(2); or An agreement for the periodic payment of compensation under any workers’ compensation law excludable under Internal Revenue Code Section 104(a)(1); and The periodic payments must be of the character described in subparagraphs (A) and (B) of Internal Revenue Code Section 130(c)(2) and must be payable by a person who: Is a party to the suit or agreement or to a workers' compensation claim; or By a person who has assumed the liability for such periodic payments under a Qualified Assignment in accordance with Internal Revenue Code Section 130.
Legal StructureThe typical structured settlement arises and is structured as follows: An injured party (the claimant) settles a tort suit with the defendant (or its insurance carrier) pursuant to a settlement agreement that provides that, in exchange for the claimant's securing the dismissal of the lawsuit, the defendant (or, more commonly, its insurer) agrees to make a series of periodic payments over time. The insurer, a property/casualty insurance company, thus finds itself with a long-term payment obligation to the claimant. To fund this obligation, the property/casualty insurer generally takes one of two typical approaches: It either purchases an annuity from a life insurance company (an arrangement called a "buy and hold" case) or it assigns (or, more properly, delegates) its periodic payment obligation to a third party which in turn purchases an annuity (which arrangement is called an "assigned case").
In an unassigned case, the property/casualty insurer retains the periodic payment obligation and funds it by purchasing an annuity from a life insurance company, thereby offsetting its obligation with a matching asset. The payment stream purchased under the annuity matches exactly, in timing and amounts, the periodic payments agreed to in the settlement agreement. The property/casualty company owns the annuity and names the claimant as the payee under the annuity, thereby directing the annuity issuer to send payments directly to the claimant. If any of the periodic payments are life-contingent (i.e., the obligation to make a payment is contingent on someone continuing to be alive), then the claimant (or whoever is determined to be the measuring life) is named as the annuitant or measuring life under the annuity.
In an assigned case, the property/casualty company does not wish to retain the long-term periodic payment obligation on its books. Accordingly, the property/casualty insurer transfers the obligation, through a legal device called a qualified assignment, to a third party. The third party, called an assignment company, will require the property/casualty company to pay it an amount sufficient to enable it to buy an annuity that will fund its newly accepted periodic payment obligation. If the claimant consents to the transfer of the periodic payment obligation (either in the settlement agreement or, failing that, in a special form of qualified assignment known as a qualified assignment and release), the defendant and/or its property/casualty company has no further liability to make the periodic payments. This method of substituting the obliger is desirable for property/casualty companies that do not want to retain the periodic payment obligation on their books. Typically, an assignment company is an affiliate of the life insurance company from which the annuity is purchased.
An assignment is said to be "qualified" if it satisfies the criteria set forth in Internal Revenue Code Section 130 [3]. Qualification of the assignment is important to assignment companies because without it the amount they receive to induce them to accept periodic payment obligations would be considered income for federal income tax purposes. If an assignment qualifies under Section 130, however, the amount received is excluded from the income of the assignment company. This provision of the tax code was enacted to encourage assigned cases; without it, assignment companies would owe federal income taxes but would typically have no source from which to make the payments
Tuesday, November 6, 2007
Steps in a Transaction
1. Policyowner consults with an advisor, decides to sell his or her policy.
2. Policy owner and advisor decide whether to work with broker or to go directly to providers.
3. Client & advisor submit policy for valuation. Client releases medical information.
4. If policy meets criteria for a life settlement, providers send offers directly or through a
broker.
5. Client and advisor review offers and client accepts his preferred offer.
6. Client and advisor complete the provider's closing package, and return essential documents.
7. Provider places cash payment in escrow and submits change of ownership forms to the insurance
carrier.
8. Paperwork is verified and funds are transferred to the policy seller.
Life Settlement History
Although the secondary market for life insurance is relatively new, the market was more the 100 years in
the making. The life settlement market would not have originated without a number of events, judicial
rulings, and key individuals.
The Policy as Transferable Property
The Supreme Court case of Grigsby v. Russell (1911) established the policyowner’s right to transfer an
insurance policy. Justice Oliver Wendell Holmes noted in his opinion that life insurance possessed all
the ordinary characteristics of property, and therefore represented an asset that a policyowner could
transfer without limitation. Wrote Holmes, “Life insurance has become in our days one of the best
recognized forms of investment and self-compelled saving.” This opinion placed the ownership rights in a
life insurance policy on the same legal footing as more traditional investment property such as stocks
and bonds. As with these other types of property, a life insurance policy could be transferred to
another person at the discretion of the policyowner.
This decision established a life insurance policy as transferable property that contains specific legal
rights, including the right to:
* Name the policy beneficiary
* Change the beneficiary designation (unless subject to restrictions)
* Assign the policy as collateral for a loan
* Borrow against the policy
* Sell the policy to another party
A second milestone occurred in 2001 when The National Association of Insurance Commissioners (NAIC) took
a crucial step by releasing the Viatical Settlements Model Act defining guidelines for avoiding fraud
and ensuring sound business practices. Around this time, many of the life settlement providers that are
prominent today began purchasing policies for their investment portfolio using institutional capital.
The arrival of well-funded corporate entities transformed the settlement concept into a regulated wealth
management tool for high-net-worth policyowners who no longer needed a given policy. Strong demand for
life settlements policies is driving a rapid market expansion that continues today.
Major Study Findings
One major study that showed some of the potential of the life settlement market was conducted by the
University of Pennsylvania business school, the Wharton School. The research papers, credited to Neil
Doherty and Hal Singer, were released under the title "The Benefits of a Secondary Market For Life
Insurance." ([1]) This study found, among other things, that life settlement providers paid
approximately $340 million to consumers for their underperforming life insurance policies, an
opportunity that was not available to them just a few years before.
"We estimate that life settlements, alone, generate surplus benefits in excess of $240 million
annually for life insurance policyholders who have exercised their option to sell their policies at a
competitive rate." - Wharton Study, pg 6
Another study, perhaps even more influential, was the Conning & Co. Research study "Life Settlements:
Additional Pressure on Life Profits." This study found that senior citizens owned approximately $500
billion worth of life insurance in 2003, of which $100 billion was owned by seniors eligible for life
settlements. Since 2003, more and more of these eligible senior clients have sold their policies and
helped the market increase.
Other Life Settlement Fast Fent Providers - 34
o Estimated Amount of life policies to be purchased by providers in 2005 - $10-15 billion
- From the Maple Life Financial Industry Outlook 2005
2. Policy owner and advisor decide whether to work with broker or to go directly to providers.
3. Client & advisor submit policy for valuation. Client releases medical information.
4. If policy meets criteria for a life settlement, providers send offers directly or through a
broker.
5. Client and advisor review offers and client accepts his preferred offer.
6. Client and advisor complete the provider's closing package, and return essential documents.
7. Provider places cash payment in escrow and submits change of ownership forms to the insurance
carrier.
8. Paperwork is verified and funds are transferred to the policy seller.
Life Settlement History
Although the secondary market for life insurance is relatively new, the market was more the 100 years in
the making. The life settlement market would not have originated without a number of events, judicial
rulings, and key individuals.
The Policy as Transferable Property
The Supreme Court case of Grigsby v. Russell (1911) established the policyowner’s right to transfer an
insurance policy. Justice Oliver Wendell Holmes noted in his opinion that life insurance possessed all
the ordinary characteristics of property, and therefore represented an asset that a policyowner could
transfer without limitation. Wrote Holmes, “Life insurance has become in our days one of the best
recognized forms of investment and self-compelled saving.” This opinion placed the ownership rights in a
life insurance policy on the same legal footing as more traditional investment property such as stocks
and bonds. As with these other types of property, a life insurance policy could be transferred to
another person at the discretion of the policyowner.
This decision established a life insurance policy as transferable property that contains specific legal
rights, including the right to:
* Name the policy beneficiary
* Change the beneficiary designation (unless subject to restrictions)
* Assign the policy as collateral for a loan
* Borrow against the policy
* Sell the policy to another party
A second milestone occurred in 2001 when The National Association of Insurance Commissioners (NAIC) took
a crucial step by releasing the Viatical Settlements Model Act defining guidelines for avoiding fraud
and ensuring sound business practices. Around this time, many of the life settlement providers that are
prominent today began purchasing policies for their investment portfolio using institutional capital.
The arrival of well-funded corporate entities transformed the settlement concept into a regulated wealth
management tool for high-net-worth policyowners who no longer needed a given policy. Strong demand for
life settlements policies is driving a rapid market expansion that continues today.
Major Study Findings
One major study that showed some of the potential of the life settlement market was conducted by the
University of Pennsylvania business school, the Wharton School. The research papers, credited to Neil
Doherty and Hal Singer, were released under the title "The Benefits of a Secondary Market For Life
Insurance." ([1]) This study found, among other things, that life settlement providers paid
approximately $340 million to consumers for their underperforming life insurance policies, an
opportunity that was not available to them just a few years before.
"We estimate that life settlements, alone, generate surplus benefits in excess of $240 million
annually for life insurance policyholders who have exercised their option to sell their policies at a
competitive rate." - Wharton Study, pg 6
Another study, perhaps even more influential, was the Conning & Co. Research study "Life Settlements:
Additional Pressure on Life Profits." This study found that senior citizens owned approximately $500
billion worth of life insurance in 2003, of which $100 billion was owned by seniors eligible for life
settlements. Since 2003, more and more of these eligible senior clients have sold their policies and
helped the market increase.
Other Life Settlement Fast Fent Providers - 34
o Estimated Amount of life policies to be purchased by providers in 2005 - $10-15 billion
- From the Maple Life Financial Industry Outlook 2005
Brokers
Financial advisors who choose not to submit cases directly to a settlement provider may opt to work
through a life settlement broker. Life settlement brokers are intermediaries who bring together
policyowners who wish to sell a policy and providers seeking to purchase them. Brokers, in exchange for
a fee, will shop a policy to multiple providers, much as a real estate broker solicits multiple offers
for one’s home. While it is the broker's duty to collect bids, it is still incumbent on the advisor to
help the client evaluate the offers against a number of criteria including offer price, stability of
funding, privacy provisions, net yield after commissions, and more. Compensation arrangements vary
significantly and should be fully disclosed and understood to determine if engaging a broker will
benefit the client. In many states, brokers must be licensed to do business in that state.
Investors / Risk takers
Life settlement investors are known as financing entities because they are providing the capital or
financing for life settlement transactions (the purchase of a life insurance policy). Life settlement
investors may use their own capital to purchase the policies or may raise the capital from a wide range
of investors through a variety of structures. The life settlement provider is the entity that enters
into the transaction with the policyowner and pays the policyowner when the life settlement transaction
closes. In most cases, the life settlement provider has a written agreement with the life settlement
investor to provide the life settlement provider with the funds needed to acquire the policy. In this
scenario, the life settlement investor is effectively the ultimate funder of the secondary market
transaction. However, in some life settlement transactions, the life settlement provider is also the
investor; the provider uses its own capital to purchase the policy for its own portfolio.
Life settlement investments are not typically suitable for individual investors. Risks are associated
with life settlement investments that individual investors may not recognize and that unscrupulous
promoters may misrepresent or fail to disclose. For example, funds invested in life settlement
investments are usually not accessible on the demand of the investor, as are investments in many other
types of securities, such as mutual funds. These factors and others render this type of investment
unsuitable for the financial needs and interests of the average individual investor. For this reason,
the norm today, especially among reputable life settlement providers, is to obtain capital only from
life settlement investors who are established and credible institutional sources of capital rather than
individual sources of capital.
In most cases, a life settlement investor must be a qualified institutional buyer as defined in the
federal Securities Act of 1933. A qualified institutional buyer (QIB) is defined under Regulation D,
Rule 144A as an entity owning and investing large amounts of securities, with the threshold ranging from
$10 million to $100 million of securities not affiliated with the entity and dependent on the type of
entity. QIBs are eligible to participate in a restricted investment market known as the "Rule 144A
market" that is not available to the public because the issuer of the securities has chosen not to make
the required public disclosures or to register the securities. The purpose of the qualified
institutional buyer requirement in life settlements is to prevent unsophisticated or undercapitalized
investors from participating in—and potentially being harmed by—complicated life settlement
transactions.
Financial institutions meet the qualified institutional buyer test and are therefore suitable life
settlement purchasers. In addition, institutions have teams of experienced investment analysts and are
experts at managing investment risk; they can impose a “corporate governance” discipline on the life
settlement transaction process intended to minimize questionable market practices; and institutional
funding provides a high degree of consumer protection with regard to privacy and confidentiality (a
policyowner’s or insured’s personal information should never be in the hands of an individual investor.)
Other Involved Parties
Underwriters/Life Expectancy Providers - Provide life expectancy estimates on the insured for pricing
purposes. There are four major life expectancy providers, namely 21st Services, AVS, Fasano, and ISC
Services.
Some underwriters provide unreasonably short life expectancies by using base tables that are 5 years out
of date, ignoring future mortality improvements & current treatments Eg Statins and basing life
expectancies on life manuals which are conservative for mortality and not longevity risk. Others apply
actuarial analysis to the most recent available data as well as their own experience to develop their
base tables and underwriting manuals.
Providers who do not provide short life expectancies are shunned by originators whom are primarily
remunerated for volume. Providing more reasonable life expectancies does not inflate the apparent value
in these insurance policies. This results in fewer cases being written and less support from
originators.
There are no experience studies publically available which support the accuracy of any of the major life
settlements underwriters
through a life settlement broker. Life settlement brokers are intermediaries who bring together
policyowners who wish to sell a policy and providers seeking to purchase them. Brokers, in exchange for
a fee, will shop a policy to multiple providers, much as a real estate broker solicits multiple offers
for one’s home. While it is the broker's duty to collect bids, it is still incumbent on the advisor to
help the client evaluate the offers against a number of criteria including offer price, stability of
funding, privacy provisions, net yield after commissions, and more. Compensation arrangements vary
significantly and should be fully disclosed and understood to determine if engaging a broker will
benefit the client. In many states, brokers must be licensed to do business in that state.
Investors / Risk takers
Life settlement investors are known as financing entities because they are providing the capital or
financing for life settlement transactions (the purchase of a life insurance policy). Life settlement
investors may use their own capital to purchase the policies or may raise the capital from a wide range
of investors through a variety of structures. The life settlement provider is the entity that enters
into the transaction with the policyowner and pays the policyowner when the life settlement transaction
closes. In most cases, the life settlement provider has a written agreement with the life settlement
investor to provide the life settlement provider with the funds needed to acquire the policy. In this
scenario, the life settlement investor is effectively the ultimate funder of the secondary market
transaction. However, in some life settlement transactions, the life settlement provider is also the
investor; the provider uses its own capital to purchase the policy for its own portfolio.
Life settlement investments are not typically suitable for individual investors. Risks are associated
with life settlement investments that individual investors may not recognize and that unscrupulous
promoters may misrepresent or fail to disclose. For example, funds invested in life settlement
investments are usually not accessible on the demand of the investor, as are investments in many other
types of securities, such as mutual funds. These factors and others render this type of investment
unsuitable for the financial needs and interests of the average individual investor. For this reason,
the norm today, especially among reputable life settlement providers, is to obtain capital only from
life settlement investors who are established and credible institutional sources of capital rather than
individual sources of capital.
In most cases, a life settlement investor must be a qualified institutional buyer as defined in the
federal Securities Act of 1933. A qualified institutional buyer (QIB) is defined under Regulation D,
Rule 144A as an entity owning and investing large amounts of securities, with the threshold ranging from
$10 million to $100 million of securities not affiliated with the entity and dependent on the type of
entity. QIBs are eligible to participate in a restricted investment market known as the "Rule 144A
market" that is not available to the public because the issuer of the securities has chosen not to make
the required public disclosures or to register the securities. The purpose of the qualified
institutional buyer requirement in life settlements is to prevent unsophisticated or undercapitalized
investors from participating in—and potentially being harmed by—complicated life settlement
transactions.
Financial institutions meet the qualified institutional buyer test and are therefore suitable life
settlement purchasers. In addition, institutions have teams of experienced investment analysts and are
experts at managing investment risk; they can impose a “corporate governance” discipline on the life
settlement transaction process intended to minimize questionable market practices; and institutional
funding provides a high degree of consumer protection with regard to privacy and confidentiality (a
policyowner’s or insured’s personal information should never be in the hands of an individual investor.)
Other Involved Parties
Underwriters/Life Expectancy Providers - Provide life expectancy estimates on the insured for pricing
purposes. There are four major life expectancy providers, namely 21st Services, AVS, Fasano, and ISC
Services.
Some underwriters provide unreasonably short life expectancies by using base tables that are 5 years out
of date, ignoring future mortality improvements & current treatments Eg Statins and basing life
expectancies on life manuals which are conservative for mortality and not longevity risk. Others apply
actuarial analysis to the most recent available data as well as their own experience to develop their
base tables and underwriting manuals.
Providers who do not provide short life expectancies are shunned by originators whom are primarily
remunerated for volume. Providing more reasonable life expectancies does not inflate the apparent value
in these insurance policies. This results in fewer cases being written and less support from
originators.
There are no experience studies publically available which support the accuracy of any of the major life
settlements underwriters
Life settlement
A life settlement is a financial transaction in which a policyowner possessing an unneeded or unwanted
life insurance policy sells the policy to a third party for more than the cash value offered by the life
insurance company. The purchaser becomes the new beneficiary of the policy at maturation and is
responsible for all subsequent premium payments.
Life settlements are an important development in that they have opened a secondary market for life
insurance in which policyowners can access fair market value for their policies, rather than accepting
the lower cash surrender value from the issuing life insurance company.
Generally speaking, life settlements are an option for high-net-worth policyowners age 65 or older.
Independent estimates report that among this group, 20% of policies have a market value that exceeds the
cash value offered by the carrier. And while many policyowners are unfamiliar with life settlements
until a financial professional mentions the option to them, the concept has gained attention from high-
profile proponents such as Warren Buffett, former U.S. Representative Bill Gradison, and numerous media
sources including The Wall Street Journal, Time Magazine, Business Week and The Economist. A growing
number of experts now believe that informing clients about offering life settlements should fall under
the fiduciary duty of a financial advisor.
How It Works
In a life settlement transaction, there is a chain leading from the seller of the policy to the end
buyer of the policy (known as a life settlement provider). Each link in the chain has a different
responsibility in facilitating the transaction and ensuring that it runs smoothly, while outside vendors
typically assist the provider with specialized functions.
Policy Sellers
Candidates for life settlements are policyowners over the age of 65 who no longer want or need a
particular life insurance policy. Life settlement candidates generally have a life expectancy between 2
and 20 years. There are certain restrictions for their policies as well - policies must be valued at
$50,000 or more, and depending on the life expectancy determination of the seller, any and all types of
policies can be sold, ie; universal life, whole life, or convertible term contracts.
Financial Advisors
Life settlements are complex financial transactions that are generally conducted on behalf of clients by
experienced professional advisors. Some examples of advisors that are becoming increasingly involved in
the life settlement arena are:
* Accountants/CPAs
* Attorneys
* Financial Planners/CFPs/ChFCs/CFCs
* Insurance Advisors
* Estate Planners/CEPs
* Certified Senior Advisors/CSAs
* Charitable Trust Officers
Providers
Life settlement providers serve as the purchaser in a life settlement transaction and are responsible
for paying the client a cash sum greater than the policy's cash surrender value. The top providers in
the industry fund many transactions each year and hold the seller's policy as a confidential portfolio
asset. They are experienced in the analysis and valuation of large-face-amount policies and work
directly with advisors to develop transactions that are customized to a client's particular situation.
They have in-house compliance departments to carefully review transactions and, most importantly, they
are backed by institutional funds.
Life Settlement providers must be licensed in the state where the policy owner resides. Approximately 41
states have regulations in place regarding the sale of life insurance policies to third parties.
life insurance policy sells the policy to a third party for more than the cash value offered by the life
insurance company. The purchaser becomes the new beneficiary of the policy at maturation and is
responsible for all subsequent premium payments.
Life settlements are an important development in that they have opened a secondary market for life
insurance in which policyowners can access fair market value for their policies, rather than accepting
the lower cash surrender value from the issuing life insurance company.
Generally speaking, life settlements are an option for high-net-worth policyowners age 65 or older.
Independent estimates report that among this group, 20% of policies have a market value that exceeds the
cash value offered by the carrier. And while many policyowners are unfamiliar with life settlements
until a financial professional mentions the option to them, the concept has gained attention from high-
profile proponents such as Warren Buffett, former U.S. Representative Bill Gradison, and numerous media
sources including The Wall Street Journal, Time Magazine, Business Week and The Economist. A growing
number of experts now believe that informing clients about offering life settlements should fall under
the fiduciary duty of a financial advisor.
How It Works
In a life settlement transaction, there is a chain leading from the seller of the policy to the end
buyer of the policy (known as a life settlement provider). Each link in the chain has a different
responsibility in facilitating the transaction and ensuring that it runs smoothly, while outside vendors
typically assist the provider with specialized functions.
Policy Sellers
Candidates for life settlements are policyowners over the age of 65 who no longer want or need a
particular life insurance policy. Life settlement candidates generally have a life expectancy between 2
and 20 years. There are certain restrictions for their policies as well - policies must be valued at
$50,000 or more, and depending on the life expectancy determination of the seller, any and all types of
policies can be sold, ie; universal life, whole life, or convertible term contracts.
Financial Advisors
Life settlements are complex financial transactions that are generally conducted on behalf of clients by
experienced professional advisors. Some examples of advisors that are becoming increasingly involved in
the life settlement arena are:
* Accountants/CPAs
* Attorneys
* Financial Planners/CFPs/ChFCs/CFCs
* Insurance Advisors
* Estate Planners/CEPs
* Certified Senior Advisors/CSAs
* Charitable Trust Officers
Providers
Life settlement providers serve as the purchaser in a life settlement transaction and are responsible
for paying the client a cash sum greater than the policy's cash surrender value. The top providers in
the industry fund many transactions each year and hold the seller's policy as a confidential portfolio
asset. They are experienced in the analysis and valuation of large-face-amount policies and work
directly with advisors to develop transactions that are customized to a client's particular situation.
They have in-house compliance departments to carefully review transactions and, most importantly, they
are backed by institutional funds.
Life Settlement providers must be licensed in the state where the policy owner resides. Approximately 41
states have regulations in place regarding the sale of life insurance policies to third parties.
Reverse convertibles securities
What are Reverse Convertible Securities?
* Short-term coupon bearing notes, structured to provide enhanced yield while participating in
certain equity-like risks.
* Investment value is derived from underlying equity exposure, which is paid in the form of fixed
coupons.
* Investors receive full principal back at maturity if the Knock-in Level is not breached (which is
typically 70-80% of the initial reference price).
* The underlying stock, index or basket of equities is defined as Reference Shares. However, in most
cases, Reverse convertibles are linked to a single stock.
Reference Shares
* Underlying stocks or basket of equities can include names such as:
o Dell Computers
o Wal Mart
o Exxon Mobil
o Cisco
o Best Buy
o Corning
* Broad market indices may include names such as:
o Nasdaq-100 Index
How do Reverse Convertibles work?
* Short-term investments, typically with one year maturity.
* At maturity, investors receive either 100% of their original investment or a predetermined number
of shares of the underlying stock, in addition to the stated coupon payment.
* The investors’ earning potential is limited to the security’s stated coupon, because investors
receive coupon payments regardless of the performance of the underlying reference shares.
* Coupon payments are the obligation of the Issuer and are paid quarterly.
* Sold by prospectus or offering circular and pricing term sheet.
* General rule of thumb:
The higher your coupon payment, the greater likelihood of receiving stock at maturity.
* NOTE: Whether or not the Knock-in Level is breached, the investor will receive fixed periodic
coupons through the term of the notes.
Delivery at Maturity
At maturity, there are 2 possible outcomes:
* Cash Delivery
o Stock closes at or above the Initial Share Price upon valuation date, regardless of whether
the stock closed below the Knock-in Level during the holding period. OR stock closes below the Initial
Share Price, but has never closed below the Knock-in Level.
* Physical Delivery
o Underlying shares closed below the Knock-in Level at any time during the holding period and
does not trade back up above the Initial Share Price on valuation date (4 days prior to maturity).
Physical Delivery
* Initial Share Price is determined on Trade Date.
* The final valuation of the shares is based on the closing price of the Reference Shares determined
4 days prior to maturity.
* If the investor is delivered physical shares, their value will be less than the Initial Share
Price, however, investors are not required to sell their shares at prevailing market prices.
Secenario 1 - Cash Delivery
Cash Delivery
Reference share closing price is above the Initial Share Price of the note on Valuation Date (4
days prior to maturity), regardless of whether the stock closed below the Knock-in Level. Investor
receives Cash Delivery Amount (Par), at maturity.
Secenario 2 - Cash Delivery
Cash Delivery
Reference share closing price is below the Initial Share Price of the note on Valuation Date (4
days prior to maturity), but never closed below the Knock-in Level. Investor receives Cash Delivery
Amount (Par) at maturity.
Secenario 3 - Physical Delivery
Physical Delivery
Reference share closing price is below the initial price of the note at valuation date (4 days
prior to maturity), and has closed below the downside Knock-in Level during the holding period.
Investors receive Physical Delivery Amount, or shares of stock, at maturity. Predetermined number of
shares delivered to the investor if closing price of reference shares below initial price.
Physical Delivery Amount = (Original Investment Amount / Initial Price of Underlying Asset),
Liquidity
* Generally created as a buy and hold investment.
* Issuers typically provide liquidity in the secondary market.
* The secondary market price may not immediately reflect changes in the underlying security.
* Liquidations prior to maturity may be less than the initial principal amount invested.
Trading
* Trade flat and accrue on a 30/360 basis.
* End of day pricing posted on Bloomberg and/or the internet.
* Pricing will fluctuate intraday.
* Reverse Convertibles are notes that are registered with the SEC
Ratings
* These are an unsecured debt obligation of the issuer, not the reference company thus it carries
the rating of the issuer.
* The creditworthiness of the issuer does not affect or enhance the likely performance of the
investment other than the ability of the issuer to meet its obligations.
Taxes
* For tax purposes Reverse Convertibles Notes are considered to have two components:
o A debt portion.
o A put option.
* At maturity, the option component is taxed as a short-term capital gain if the investor receives
the cash settlement. In the case of physical delivery, the option component will reduce the tax basis of
the Reference Shares delivered to their accounts.
* Investors should consult their own tax advisor prior to investing. Refer to the Note’s prospectus
for more detailed information.
Investor Benefits
* Enhanced yield.
* Current income
* Downside protection, typically up to 10-30% on most Reverse Convertible offerings.
* The bid-ask spread is typically 1%.
* $1,000 minimum investment.
Risk to Consider
* Owners of the Reverse Convertible Notes may be exposed to the risk of the decline in the price of
the reference shares during the term of the note.
* Investments in equity-linked notes may not be suitable for all investors.
* Investors selling notes prior to maturity may receive a market price which is at a premium or a
discount to par and may not necessarily reflect any increase or decrease in the market price of the
underlying equity to the date of such sale.
* Reverse Convertibles do NOT guarantee return of principal at maturity.
* In addition, Reverse Convertibles do not have the same price appreciation potential as the
reference shares because at maturity the value of the note may not appreciate above the initial
principal amount.
* The market price of the Reverse Convertibles may be influenced by unpredictable market factors.
Investor Suitability Profile
* High net worth clients seeking current income.
* Traditional Equity Customers.
o Trust accounts
o Money managers
o Qualified accounts
o Non-profit organizations
* Investors that believe the markets will be relatively flat.
* Current equity linked notes investors.
* Investors who own the underlying stock.
* Notes purchased at original issue will not subject to wash sale rules on the underlying stock
* Short-term coupon bearing notes, structured to provide enhanced yield while participating in
certain equity-like risks.
* Investment value is derived from underlying equity exposure, which is paid in the form of fixed
coupons.
* Investors receive full principal back at maturity if the Knock-in Level is not breached (which is
typically 70-80% of the initial reference price).
* The underlying stock, index or basket of equities is defined as Reference Shares. However, in most
cases, Reverse convertibles are linked to a single stock.
Reference Shares
* Underlying stocks or basket of equities can include names such as:
o Dell Computers
o Wal Mart
o Exxon Mobil
o Cisco
o Best Buy
o Corning
* Broad market indices may include names such as:
o Nasdaq-100 Index
How do Reverse Convertibles work?
* Short-term investments, typically with one year maturity.
* At maturity, investors receive either 100% of their original investment or a predetermined number
of shares of the underlying stock, in addition to the stated coupon payment.
* The investors’ earning potential is limited to the security’s stated coupon, because investors
receive coupon payments regardless of the performance of the underlying reference shares.
* Coupon payments are the obligation of the Issuer and are paid quarterly.
* Sold by prospectus or offering circular and pricing term sheet.
* General rule of thumb:
The higher your coupon payment, the greater likelihood of receiving stock at maturity.
* NOTE: Whether or not the Knock-in Level is breached, the investor will receive fixed periodic
coupons through the term of the notes.
Delivery at Maturity
At maturity, there are 2 possible outcomes:
* Cash Delivery
o Stock closes at or above the Initial Share Price upon valuation date, regardless of whether
the stock closed below the Knock-in Level during the holding period. OR stock closes below the Initial
Share Price, but has never closed below the Knock-in Level.
* Physical Delivery
o Underlying shares closed below the Knock-in Level at any time during the holding period and
does not trade back up above the Initial Share Price on valuation date (4 days prior to maturity).
Physical Delivery
* Initial Share Price is determined on Trade Date.
* The final valuation of the shares is based on the closing price of the Reference Shares determined
4 days prior to maturity.
* If the investor is delivered physical shares, their value will be less than the Initial Share
Price, however, investors are not required to sell their shares at prevailing market prices.
Secenario 1 - Cash Delivery
Cash Delivery
Reference share closing price is above the Initial Share Price of the note on Valuation Date (4
days prior to maturity), regardless of whether the stock closed below the Knock-in Level. Investor
receives Cash Delivery Amount (Par), at maturity.
Secenario 2 - Cash Delivery
Cash Delivery
Reference share closing price is below the Initial Share Price of the note on Valuation Date (4
days prior to maturity), but never closed below the Knock-in Level. Investor receives Cash Delivery
Amount (Par) at maturity.
Secenario 3 - Physical Delivery
Physical Delivery
Reference share closing price is below the initial price of the note at valuation date (4 days
prior to maturity), and has closed below the downside Knock-in Level during the holding period.
Investors receive Physical Delivery Amount, or shares of stock, at maturity. Predetermined number of
shares delivered to the investor if closing price of reference shares below initial price.
Physical Delivery Amount = (Original Investment Amount / Initial Price of Underlying Asset),
Liquidity
* Generally created as a buy and hold investment.
* Issuers typically provide liquidity in the secondary market.
* The secondary market price may not immediately reflect changes in the underlying security.
* Liquidations prior to maturity may be less than the initial principal amount invested.
Trading
* Trade flat and accrue on a 30/360 basis.
* End of day pricing posted on Bloomberg and/or the internet.
* Pricing will fluctuate intraday.
* Reverse Convertibles are notes that are registered with the SEC
Ratings
* These are an unsecured debt obligation of the issuer, not the reference company thus it carries
the rating of the issuer.
* The creditworthiness of the issuer does not affect or enhance the likely performance of the
investment other than the ability of the issuer to meet its obligations.
Taxes
* For tax purposes Reverse Convertibles Notes are considered to have two components:
o A debt portion.
o A put option.
* At maturity, the option component is taxed as a short-term capital gain if the investor receives
the cash settlement. In the case of physical delivery, the option component will reduce the tax basis of
the Reference Shares delivered to their accounts.
* Investors should consult their own tax advisor prior to investing. Refer to the Note’s prospectus
for more detailed information.
Investor Benefits
* Enhanced yield.
* Current income
* Downside protection, typically up to 10-30% on most Reverse Convertible offerings.
* The bid-ask spread is typically 1%.
* $1,000 minimum investment.
Risk to Consider
* Owners of the Reverse Convertible Notes may be exposed to the risk of the decline in the price of
the reference shares during the term of the note.
* Investments in equity-linked notes may not be suitable for all investors.
* Investors selling notes prior to maturity may receive a market price which is at a premium or a
discount to par and may not necessarily reflect any increase or decrease in the market price of the
underlying equity to the date of such sale.
* Reverse Convertibles do NOT guarantee return of principal at maturity.
* In addition, Reverse Convertibles do not have the same price appreciation potential as the
reference shares because at maturity the value of the note may not appreciate above the initial
principal amount.
* The market price of the Reverse Convertibles may be influenced by unpredictable market factors.
Investor Suitability Profile
* High net worth clients seeking current income.
* Traditional Equity Customers.
o Trust accounts
o Money managers
o Qualified accounts
o Non-profit organizations
* Investors that believe the markets will be relatively flat.
* Current equity linked notes investors.
* Investors who own the underlying stock.
* Notes purchased at original issue will not subject to wash sale rules on the underlying stock
A structured sale
A structured sale is a special type of installment sale pursuant to the Internal Revenue Code.[1]
Installment sales permit sellers to defer recognition of gains on the sale of a business or real estate
to the tax year in which the related sale proceeds are received. Structured sales allow the seller of an
asset to pay taxes over time while having the payments guaranteed by a high credit quality alternate
obligor, who accepts assignment of the buyers periodic payment obligation. Transactions can currently be
done as small as $100,000.
In a structured sale, rather than the buyer paying the installments, the buyer pays cash, some of which
is used as consideration for a third party assignment company to accept the payment obligation. The
assignment company then purchases an annuity from a life insurance company with high financial ratings
from A. M. Best. Case law and administrative precedents supporting substitution of obligors.[2] In
addition, a properly handled transaction will avoid issues with constructive receipt and economic
benefit.
While negotiating the installment payments, the seller is free to design payment streams with a great
deal of flexibility. The seller recognizes capital gain in each year an installment payment is received.
Interest is imputed and taxed annually, even in years d-ring the contract where no installment payments
are received. Taxation is the same as if the buyer were making installment payments directly.
Structured sales are an alternative to a section 1031 exchange, which defers recognition of capital
gain, but forces the seller to continue holding some form of property. Structured sales work well for
sellers who want to create a continuing stream of income without management worries. Retiring business
owners and downsizing homeowners are examples of sellers who can benefit.
The structured sale must be documented, and money must be handled in such a way that the ultimate
recipient is not treated as having constructive received the payment prior to the time it is act-ally
paid. For the buyer, there is no difference from a traditional cash-and-title-now deal, except for
additional paperwork. Because of tax advantages to the seller, structuring the sale might, however, make
the buyer's offer more attractive. Because the buyer has paid in full, the buyer gets full title at time
of closing.
There are no direct fees to the b-yer or seller to employ the structured sale strategy. The structured
settlement specialist who implements the transaction is paid directly by the life insurance company that
writes the annuity.
The internal rate of return is comparable to long term high quality debt instruments.
Allstate Life was the originator of the structured sale concept and until recently was the only
structured settlement annuity company whose product was available for the structured sale transaction.
Prudential has begun to use its non-qualified assignment product on a limited basis. By mid 2007, Aviva
Life may be in the market as well.
Installment sales permit sellers to defer recognition of gains on the sale of a business or real estate
to the tax year in which the related sale proceeds are received. Structured sales allow the seller of an
asset to pay taxes over time while having the payments guaranteed by a high credit quality alternate
obligor, who accepts assignment of the buyers periodic payment obligation. Transactions can currently be
done as small as $100,000.
In a structured sale, rather than the buyer paying the installments, the buyer pays cash, some of which
is used as consideration for a third party assignment company to accept the payment obligation. The
assignment company then purchases an annuity from a life insurance company with high financial ratings
from A. M. Best. Case law and administrative precedents supporting substitution of obligors.[2] In
addition, a properly handled transaction will avoid issues with constructive receipt and economic
benefit.
While negotiating the installment payments, the seller is free to design payment streams with a great
deal of flexibility. The seller recognizes capital gain in each year an installment payment is received.
Interest is imputed and taxed annually, even in years d-ring the contract where no installment payments
are received. Taxation is the same as if the buyer were making installment payments directly.
Structured sales are an alternative to a section 1031 exchange, which defers recognition of capital
gain, but forces the seller to continue holding some form of property. Structured sales work well for
sellers who want to create a continuing stream of income without management worries. Retiring business
owners and downsizing homeowners are examples of sellers who can benefit.
The structured sale must be documented, and money must be handled in such a way that the ultimate
recipient is not treated as having constructive received the payment prior to the time it is act-ally
paid. For the buyer, there is no difference from a traditional cash-and-title-now deal, except for
additional paperwork. Because of tax advantages to the seller, structuring the sale might, however, make
the buyer's offer more attractive. Because the buyer has paid in full, the buyer gets full title at time
of closing.
There are no direct fees to the b-yer or seller to employ the structured sale strategy. The structured
settlement specialist who implements the transaction is paid directly by the life insurance company that
writes the annuity.
The internal rate of return is comparable to long term high quality debt instruments.
Allstate Life was the originator of the structured sale concept and until recently was the only
structured settlement annuity company whose product was available for the structured sale transaction.
Prudential has begun to use its non-qualified assignment product on a limited basis. By mid 2007, Aviva
Life may be in the market as well.
Settlement (structural)
For settlement of the ground, see subsidence.
Timber frame building showing considerable, but tolerable settlement
Timber frame building showing considerable, but tolerable settlement
Settlement in a structure refers to the distortion or disruption of parts of a building due to either;
unequal compression of its foundations, shrinkage such as that which occurs in timber framed buildings
as the frame adjusts its moisture content, or by undue loads being applied to the building after its
initial construction.[1] Settlement should not be confused with subsidence which results from the load
bearing ground upon which a building sits reducing in level, for instance in areas of mine workings
where shafts collapse underground.
Some settlement is quite normal after construction has been completed, but unequal settlement may cause
significant problems for buildings. Traditional green oak framed buildings are designed to settle with
time as the oak seasons and warps, lime mortar rather than Portland cement is used for its elastic
properties and glazing will often employ small leaded lights which can accept movement more readily than
larger panes.
Timber frame building showing considerable, but tolerable settlement
Timber frame building showing considerable, but tolerable settlement
Settlement in a structure refers to the distortion or disruption of parts of a building due to either;
unequal compression of its foundations, shrinkage such as that which occurs in timber framed buildings
as the frame adjusts its moisture content, or by undue loads being applied to the building after its
initial construction.[1] Settlement should not be confused with subsidence which results from the load
bearing ground upon which a building sits reducing in level, for instance in areas of mine workings
where shafts collapse underground.
Some settlement is quite normal after construction has been completed, but unequal settlement may cause
significant problems for buildings. Traditional green oak framed buildings are designed to settle with
time as the oak seasons and warps, lime mortar rather than Portland cement is used for its elastic
properties and glazing will often employ small leaded lights which can accept movement more readily than
larger panes.
Structured settlement factoring transaction
A structured settlement factoring transaction describes the selling of future structured settlement
payments (or, more accurately, rights to receive the future structured settlement payments). People who
receive structured settlement payments (for example, the payment of personal injury damages over time
instead of in a lump sum at settlement) may decide at some point that they need more money in the short
term than the periodic payment provides over time. People's reasons are varied but can include
unforeseen medical expenses for oneself or a dependent, the need for improved housing or transportation,
education expenses and the like. To meet this need, the structured settlement recipient can sell (or,
less commonly, encumber) all or part of their future periodic payments for a present lump sum.
History
Structured settlements experienced an explosion in use beginning in the 1980s.[1] The growth is most
likely attributable to the favorable federal income tax treatment such settlements receive as a result
of the 1982 amendment of the tax code to add § 130.[2] [3] Internal Revenue Code § 130 provides, inter
alia, substantial tax incentives to insurance companies that establish “qualified” structured
settlements.[4] There are other advantages for the original tort defendant (or casualty insurer) in
settling for payments over time, in that they benefit from the time value of money (most demonstrable in
the fact that an annuity can be purchased to fund the payment of future periodic payments, and the cost
of such annuity is far less than the sum total of all payments to be made over time). Finally, the tort
plaintiff also benefits in several ways from a structured settlement, notably in the ability to receive
the periodic payments from an annuity that gains investment value over the life of the payments, and the
settling plaintiff receives the total payments, including that “inside build-up” value, tax-free.[5]
However, a substantial downside to structured settlements comes from their inherent inflexibility.[6] To
take advantage of the tax benefits allotted to defendants who choose to settle cases using structured
settlements, the periodic payments must be set up to meet basic requirements [set forth in IRC 130(c)].
Among other things, the payments must be fixed and determinable, and cannot be accelerated, deferred,
increased or decreased by the recipient.[7] For many structured settlement recipients, the periodic
payment stream is their only asset. Therefore, over time and as recipients’ personal situations change
in ways unpredicted at the settlement table, demand for liquidity options rises. To offset the liquidity
issue, most structured settlement recipients, as a part of their total settlement, will receive an
immediate sum to be invested to meet the needs not best addressed through the use of a structured
settlement. Beginning in the late 1980s, a few small financial institutions started to meet this demand
and offer new flexibility for structured settlement payees.[8]
Process
Pre-2002
Before the enactment of IRC 5891, which became effective on July 1, 2002, some states regulated the
transfer of structured settlement payment rights, while others did not. Most states that regulated
transfers at this time followed a general pattern, substantially similar to the present day process
which is mandated in IRC 5891 (see below for more details of the post-2002 process). However, the
majority of the transfers processed from 1988 to 2002 were not court ordered.[9] After negotiating the
terms of the transaction (including the payments to be sold and the price to be paid for those
payments), a formal purchase contract was executed, effecting an assignment of the subject payments upon
closing. Part of this assignment process also included the grant of a security interest in the
structured settlement payments, to secure performance of the seller’s obligations. Filing a public lien
based on that security agreement created notice of this assignment and interest. The insurance company
issuing the structured settlement annuity checks was typically not given actual notice of the transfer,
due to antagonism by the insurance industry against factoring and transfer companies. Many annuity
issuers were concerned that factoring transactions, which were not contemplated when Congress enacted
IRC 130, might upset the tax treatment of qualified assignments. HR 2884 (discussed below) resolved this
question for annuity issuers.
Federal legislation
In 2001, Congress passed HR 2884, signed into law by the President in 2002 and effective July 1, 2002,
codified at Internal Revenue Code § 5891.[10] Through a punitive excise tax penalty, this has created
the de facto regulatory paradigm for the factoring industry. In essence, to avoid the excise tax
penalty, IRC 5891 requires that all structured settlement factoring transactions be approved by a state
court, in accordance with a qualified state statute. Qualified state statues must make certain baseline
findings, including that the transfer is in the best interest of the seller, taking into account the
welfare and support of any dependents. In response, many states enacted statutes regulating structured
settlement transfers in accord with this mandate.
Post-2002
Today, all transfers are completed through a court order process. As of September 6, 2006, 46 states
have transfer laws in place regulating the transfer process. Of these, 41 are based in whole or in part
on the model state law enacted by NCOIL, the National Conference of Insurance Legislators (or, in cases
when the state law predates the model act, they are substantially similar).
Most state transfer laws contain similar provisions, as follows: (1) pre-contract disclosures to be made
to the seller concerning the essentials of the transaction; (2) notice to certain interested parties;
(3) an admonition to seek professional advice concerning the proposed transfer; and (4) court approval
of the transfer, including a finding that it is in the best interest of seller, taking into account the
welfare and support of any dependents.
States with Transfer Laws in Place
Factoring Terminology
Best Interest Standard
Internal Revenue Code Sec. 5891 and most state laws require that a court find that a proposed settlement
factoring transaction be in the best interest of the seller, taking into account the welfare and support
of any dependents. [11] “Best interest” is generally not defined, which gives judges flexibility to make
a subjective determination on a case-by-case basis. Some state laws may require that the judge look at
factors such as the “purpose of the intended use of the funds,” the payee’s mental and physical
capacity, and the seller’s potential need for future medical treatment. [12] [13]. One Minnesota court
described the “best interest standard” as a determination involving “a global consideration of the
facts, circumstances, and means of support available to the payee and his or her dependents.” [14]
Courts have consistently found that the “best interest standard” is not limited to financial hardship
cases. [15] Hence, a transfer may be in a seller’s best interest because it allows him to take advantage
of an opportunity (i.e., buy a new home, start a business, attend college, etc.) or to avoid disaster
(i.e., pay for a family member’s unexpected medical care, pay off mounting debt, etc.). For example, a
New Jersey court found that a transaction was in a seller’s best interest where the funds were used to
“pay off bills…and to buy a home and get married.” [16]
Although sometimes criticized for being vague, the best interest standard’s lack of precise definition
allows considerable latitude in judicial review. Courts can consider on a case-by-case basis the
totality of the circumstances surrounding the transfer to determine whether it should be approved.
Discount Rate
In the beginning, the factoring industry had some relatively high discount rates due to heavy expenses
caused by costly litigation battles and limited access to traditional investors. However, once state and
federal legislation was enacted, the industry’s interest rates decreased dramatically. There is much
confusion with the terminology “discount rate” because the term is used in different ways. The discount
rate referred to in a factoring transaction is similar to an interest rate associated with home loans,
credit cards and car loans where the interest rate is applied to the payment stream itself. In a
factoring transaction, the factoring company knows the payment stream they are going to purchase and
applies an interest rate to the payment stream itself and solves for the funding amount, as though it
was a loan. Discount rates from factoring companies to consumers can range anywhere between under 9% up
to over 18% but usually average somewhere in the middle. Factoring discount rates can be a bit higher
when compared to home loan interest rates, due to the fact the factoring transactions are more of a
boutique product for investors opposed to the mainstream collateralized mortgage transactions. One
common mistake in calculating the discount rate is to use “elementary school math” where you take the
funding/loan amount and divide it by the total price of all the payments being purchased. Because this
method disregards the concept of time (and the time value of money), the resulting percentage is
useless. For example, the court in In Re Henderson Receivables Origination v. Campos noted an annual
discount rate of 16.8% where the annuitant received $36,500 for the assignment of payments totaling
$63,364.94 over 84 months (two monthly payments of $672.32 each, beginning September 30, 2006 and ending
on October 31, 2006; eighty-two monthly payments of $692.49 each, increasing 3% every twelve months,
beginning on November 30, 2006 and ending on August 31, 2013). However, had the court in Henderson
Receivables Origination applied the illogical formula of discounting from “elementary school math”
($36,500/ $63,364.94), the discount rate would have been an astronomical (and nonsensical) 61%. [17]
Discounted Present Value
Another term commonly used in factoring transactions is “discounted present value,” which is defined in
the NCOIL model transfer act as “the present value of future payments determined by discounting such
payments to the present using the most recently published Applicable Federal Rate for determining the
present value of an annuity, as issued by the United States Internal Revenue Service.” [18] The IRS
discount rate, also known as the Applicable Federal Rate (AFR), is used to determine the charitable
deduction for many types of planned gifts, such as charitable remainder trusts and gift annuities. The
rate is the annual rate of return that the IRS assumes the gift assets will earn during the gift term.
The IRS discount rate is published monthly (link to current rate may be found here). In Henderson
Receivables Origination (above), the court calculated the discounted present value of the $63,364.94 to
be transferred as $50,933.18 based on the applicable federal rate of 6.00%. [18] The “discounted present
value” is a measuring stick for determining what the value of a future payment (i.e., a payment that is
due in the year 2057) is today. Hence, the discounted present value of a payment corrects for inflation
and the principle that money available today is worth more than money not accessible for 50 years (or
some future time). However, the discounted present value is not the same thing as market value (what
someone is willing to pay). Basically, a calculation that discounts a future payment based on IRS rates
is an artificial number since it has no bearing on the payment’s actual selling price. For example, in
Henderson Receivables Origination, it is somewhat confusing for the court to evaluate future payments
totaling $63,364,94 based the discounted present value of $50,933.18 because that is not the market
value of the payments. In other words, the annuitant couldn’t go out and get $50,933.18 for his future
payments because no person or company would be willing to pay that much. Some states will require a
quotient to be listed on the disclosure that is sent to the customer prior to entering into a contract
with a factoring company. The quotient is calculated by dividing the purchase price by the discounted
present value. The quotient (like the discounted present value) provides no relevance in the pricing of
a settlement factoring transaction. In Henderson Receivables Origination (above), the court did consider
this quotient which was calculated as 71.70% ($36,500/ $50,933.18). [19]
payments (or, more accurately, rights to receive the future structured settlement payments). People who
receive structured settlement payments (for example, the payment of personal injury damages over time
instead of in a lump sum at settlement) may decide at some point that they need more money in the short
term than the periodic payment provides over time. People's reasons are varied but can include
unforeseen medical expenses for oneself or a dependent, the need for improved housing or transportation,
education expenses and the like. To meet this need, the structured settlement recipient can sell (or,
less commonly, encumber) all or part of their future periodic payments for a present lump sum.
History
Structured settlements experienced an explosion in use beginning in the 1980s.[1] The growth is most
likely attributable to the favorable federal income tax treatment such settlements receive as a result
of the 1982 amendment of the tax code to add § 130.[2] [3] Internal Revenue Code § 130 provides, inter
alia, substantial tax incentives to insurance companies that establish “qualified” structured
settlements.[4] There are other advantages for the original tort defendant (or casualty insurer) in
settling for payments over time, in that they benefit from the time value of money (most demonstrable in
the fact that an annuity can be purchased to fund the payment of future periodic payments, and the cost
of such annuity is far less than the sum total of all payments to be made over time). Finally, the tort
plaintiff also benefits in several ways from a structured settlement, notably in the ability to receive
the periodic payments from an annuity that gains investment value over the life of the payments, and the
settling plaintiff receives the total payments, including that “inside build-up” value, tax-free.[5]
However, a substantial downside to structured settlements comes from their inherent inflexibility.[6] To
take advantage of the tax benefits allotted to defendants who choose to settle cases using structured
settlements, the periodic payments must be set up to meet basic requirements [set forth in IRC 130(c)].
Among other things, the payments must be fixed and determinable, and cannot be accelerated, deferred,
increased or decreased by the recipient.[7] For many structured settlement recipients, the periodic
payment stream is their only asset. Therefore, over time and as recipients’ personal situations change
in ways unpredicted at the settlement table, demand for liquidity options rises. To offset the liquidity
issue, most structured settlement recipients, as a part of their total settlement, will receive an
immediate sum to be invested to meet the needs not best addressed through the use of a structured
settlement. Beginning in the late 1980s, a few small financial institutions started to meet this demand
and offer new flexibility for structured settlement payees.[8]
Process
Pre-2002
Before the enactment of IRC 5891, which became effective on July 1, 2002, some states regulated the
transfer of structured settlement payment rights, while others did not. Most states that regulated
transfers at this time followed a general pattern, substantially similar to the present day process
which is mandated in IRC 5891 (see below for more details of the post-2002 process). However, the
majority of the transfers processed from 1988 to 2002 were not court ordered.[9] After negotiating the
terms of the transaction (including the payments to be sold and the price to be paid for those
payments), a formal purchase contract was executed, effecting an assignment of the subject payments upon
closing. Part of this assignment process also included the grant of a security interest in the
structured settlement payments, to secure performance of the seller’s obligations. Filing a public lien
based on that security agreement created notice of this assignment and interest. The insurance company
issuing the structured settlement annuity checks was typically not given actual notice of the transfer,
due to antagonism by the insurance industry against factoring and transfer companies. Many annuity
issuers were concerned that factoring transactions, which were not contemplated when Congress enacted
IRC 130, might upset the tax treatment of qualified assignments. HR 2884 (discussed below) resolved this
question for annuity issuers.
Federal legislation
In 2001, Congress passed HR 2884, signed into law by the President in 2002 and effective July 1, 2002,
codified at Internal Revenue Code § 5891.[10] Through a punitive excise tax penalty, this has created
the de facto regulatory paradigm for the factoring industry. In essence, to avoid the excise tax
penalty, IRC 5891 requires that all structured settlement factoring transactions be approved by a state
court, in accordance with a qualified state statute. Qualified state statues must make certain baseline
findings, including that the transfer is in the best interest of the seller, taking into account the
welfare and support of any dependents. In response, many states enacted statutes regulating structured
settlement transfers in accord with this mandate.
Post-2002
Today, all transfers are completed through a court order process. As of September 6, 2006, 46 states
have transfer laws in place regulating the transfer process. Of these, 41 are based in whole or in part
on the model state law enacted by NCOIL, the National Conference of Insurance Legislators (or, in cases
when the state law predates the model act, they are substantially similar).
Most state transfer laws contain similar provisions, as follows: (1) pre-contract disclosures to be made
to the seller concerning the essentials of the transaction; (2) notice to certain interested parties;
(3) an admonition to seek professional advice concerning the proposed transfer; and (4) court approval
of the transfer, including a finding that it is in the best interest of seller, taking into account the
welfare and support of any dependents.
States with Transfer Laws in Place
Factoring Terminology
Best Interest Standard
Internal Revenue Code Sec. 5891 and most state laws require that a court find that a proposed settlement
factoring transaction be in the best interest of the seller, taking into account the welfare and support
of any dependents. [11] “Best interest” is generally not defined, which gives judges flexibility to make
a subjective determination on a case-by-case basis. Some state laws may require that the judge look at
factors such as the “purpose of the intended use of the funds,” the payee’s mental and physical
capacity, and the seller’s potential need for future medical treatment. [12] [13]. One Minnesota court
described the “best interest standard” as a determination involving “a global consideration of the
facts, circumstances, and means of support available to the payee and his or her dependents.” [14]
Courts have consistently found that the “best interest standard” is not limited to financial hardship
cases. [15] Hence, a transfer may be in a seller’s best interest because it allows him to take advantage
of an opportunity (i.e., buy a new home, start a business, attend college, etc.) or to avoid disaster
(i.e., pay for a family member’s unexpected medical care, pay off mounting debt, etc.). For example, a
New Jersey court found that a transaction was in a seller’s best interest where the funds were used to
“pay off bills…and to buy a home and get married.” [16]
Although sometimes criticized for being vague, the best interest standard’s lack of precise definition
allows considerable latitude in judicial review. Courts can consider on a case-by-case basis the
totality of the circumstances surrounding the transfer to determine whether it should be approved.
Discount Rate
In the beginning, the factoring industry had some relatively high discount rates due to heavy expenses
caused by costly litigation battles and limited access to traditional investors. However, once state and
federal legislation was enacted, the industry’s interest rates decreased dramatically. There is much
confusion with the terminology “discount rate” because the term is used in different ways. The discount
rate referred to in a factoring transaction is similar to an interest rate associated with home loans,
credit cards and car loans where the interest rate is applied to the payment stream itself. In a
factoring transaction, the factoring company knows the payment stream they are going to purchase and
applies an interest rate to the payment stream itself and solves for the funding amount, as though it
was a loan. Discount rates from factoring companies to consumers can range anywhere between under 9% up
to over 18% but usually average somewhere in the middle. Factoring discount rates can be a bit higher
when compared to home loan interest rates, due to the fact the factoring transactions are more of a
boutique product for investors opposed to the mainstream collateralized mortgage transactions. One
common mistake in calculating the discount rate is to use “elementary school math” where you take the
funding/loan amount and divide it by the total price of all the payments being purchased. Because this
method disregards the concept of time (and the time value of money), the resulting percentage is
useless. For example, the court in In Re Henderson Receivables Origination v. Campos noted an annual
discount rate of 16.8% where the annuitant received $36,500 for the assignment of payments totaling
$63,364.94 over 84 months (two monthly payments of $672.32 each, beginning September 30, 2006 and ending
on October 31, 2006; eighty-two monthly payments of $692.49 each, increasing 3% every twelve months,
beginning on November 30, 2006 and ending on August 31, 2013). However, had the court in Henderson
Receivables Origination applied the illogical formula of discounting from “elementary school math”
($36,500/ $63,364.94), the discount rate would have been an astronomical (and nonsensical) 61%. [17]
Discounted Present Value
Another term commonly used in factoring transactions is “discounted present value,” which is defined in
the NCOIL model transfer act as “the present value of future payments determined by discounting such
payments to the present using the most recently published Applicable Federal Rate for determining the
present value of an annuity, as issued by the United States Internal Revenue Service.” [18] The IRS
discount rate, also known as the Applicable Federal Rate (AFR), is used to determine the charitable
deduction for many types of planned gifts, such as charitable remainder trusts and gift annuities. The
rate is the annual rate of return that the IRS assumes the gift assets will earn during the gift term.
The IRS discount rate is published monthly (link to current rate may be found here). In Henderson
Receivables Origination (above), the court calculated the discounted present value of the $63,364.94 to
be transferred as $50,933.18 based on the applicable federal rate of 6.00%. [18] The “discounted present
value” is a measuring stick for determining what the value of a future payment (i.e., a payment that is
due in the year 2057) is today. Hence, the discounted present value of a payment corrects for inflation
and the principle that money available today is worth more than money not accessible for 50 years (or
some future time). However, the discounted present value is not the same thing as market value (what
someone is willing to pay). Basically, a calculation that discounts a future payment based on IRS rates
is an artificial number since it has no bearing on the payment’s actual selling price. For example, in
Henderson Receivables Origination, it is somewhat confusing for the court to evaluate future payments
totaling $63,364,94 based the discounted present value of $50,933.18 because that is not the market
value of the payments. In other words, the annuitant couldn’t go out and get $50,933.18 for his future
payments because no person or company would be willing to pay that much. Some states will require a
quotient to be listed on the disclosure that is sent to the customer prior to entering into a contract
with a factoring company. The quotient is calculated by dividing the purchase price by the discounted
present value. The quotient (like the discounted present value) provides no relevance in the pricing of
a settlement factoring transaction. In Henderson Receivables Origination (above), the court did consider
this quotient which was calculated as 71.70% ($36,500/ $50,933.18). [19]
Legal Structure
The typical structured settlement arises and is structured as follows: An injured party (the claimant)
settles a tort suit with the defendant (or its insurance carrier) pursuant to a settlement agreement
that provides that, in exchange for the claimant's securing the dismissal of the lawsuit, the defendant
(or, more commonly, its insurer) agrees to make a series of periodic payments over time. The insurer, a
property/casualty insurance company, thus finds itself with a long-term payment obligation to the
claimant. To fund this obligation, the property/casualty insurer generally takes one of two typical
approaches: It either purchases an annuity from a life insurance company (an arrangement called a "buy
and hold" case) or it assigns (or, more properly, delegates) its periodic payment obligation to a third
party which in turn purchases an annuity (which arrangement is called an "assigned case").
In an unassigned case, the property/casualty insurer retains the periodic payment obligation and funds
it by purchasing an annuity from a life insurance company, thereby offsetting its obligation with a
matching asset. The payment stream purchased under the annuity matches exactly, in timing and amounts,
the periodic payments agreed to in the settlement agreement. The property/casualty company owns the
annuity and names the claimant as the payee under the annuity, thereby directing the annuity issuer to
send payments directly to the claimant. If any of the periodic payments are life-contingent (i.e., the
obligation to make a payment is contingent on someone continuing to be alive), then the claimant (or
whoever is determined to be the measuring life) is named as the annuitant or measuring life under the
annuity.
In an assigned case, the property/casualty company does not wish to retain the long-term periodic
payment obligation on its books. Accordingly, the property/casualty insurer transfers the obligation,
through a legal device called a qualified assignment, to a third party. The third party, called an
assignment company, will require the property/casualty company to pay it an amount sufficient to enable
it to buy an annuity that will fund its newly accepted periodic payment obligation. If the claimant
consents to the transfer of the periodic payment obligation (either in the settlement agreement or,
failing that, in a special form of qualified assignment known as a qualified assignment and release),
the defendant and/or its property/casualty company has no further liability to make the periodic
payments. This method of substituting the obliger is desirable for property/casualty companies that do
not want to retain the periodic payment obligation on their books. Typically, an assignment company is
an affiliate of the life insurance company from which the annuity is purchased.
An assignment is said to be "qualified" if it satisfies the criteria set forth in Internal Revenue Code
Section 130 [3]. Qualification of the assignment is important to assignment companies because without it
the amount they receive to induce them to accept periodic payment obligations would be considered income
for federal income tax purposes. If an assignment qualifies under Section 130, however, the amount
received is excluded from the income of the assignment company. This provision of the tax code was
enacted to encourage assigned cases; without it, assignment companies would owe federal income taxes but
would typically have no source from which to make the payments
settles a tort suit with the defendant (or its insurance carrier) pursuant to a settlement agreement
that provides that, in exchange for the claimant's securing the dismissal of the lawsuit, the defendant
(or, more commonly, its insurer) agrees to make a series of periodic payments over time. The insurer, a
property/casualty insurance company, thus finds itself with a long-term payment obligation to the
claimant. To fund this obligation, the property/casualty insurer generally takes one of two typical
approaches: It either purchases an annuity from a life insurance company (an arrangement called a "buy
and hold" case) or it assigns (or, more properly, delegates) its periodic payment obligation to a third
party which in turn purchases an annuity (which arrangement is called an "assigned case").
In an unassigned case, the property/casualty insurer retains the periodic payment obligation and funds
it by purchasing an annuity from a life insurance company, thereby offsetting its obligation with a
matching asset. The payment stream purchased under the annuity matches exactly, in timing and amounts,
the periodic payments agreed to in the settlement agreement. The property/casualty company owns the
annuity and names the claimant as the payee under the annuity, thereby directing the annuity issuer to
send payments directly to the claimant. If any of the periodic payments are life-contingent (i.e., the
obligation to make a payment is contingent on someone continuing to be alive), then the claimant (or
whoever is determined to be the measuring life) is named as the annuitant or measuring life under the
annuity.
In an assigned case, the property/casualty company does not wish to retain the long-term periodic
payment obligation on its books. Accordingly, the property/casualty insurer transfers the obligation,
through a legal device called a qualified assignment, to a third party. The third party, called an
assignment company, will require the property/casualty company to pay it an amount sufficient to enable
it to buy an annuity that will fund its newly accepted periodic payment obligation. If the claimant
consents to the transfer of the periodic payment obligation (either in the settlement agreement or,
failing that, in a special form of qualified assignment known as a qualified assignment and release),
the defendant and/or its property/casualty company has no further liability to make the periodic
payments. This method of substituting the obliger is desirable for property/casualty companies that do
not want to retain the periodic payment obligation on their books. Typically, an assignment company is
an affiliate of the life insurance company from which the annuity is purchased.
An assignment is said to be "qualified" if it satisfies the criteria set forth in Internal Revenue Code
Section 130 [3]. Qualification of the assignment is important to assignment companies because without it
the amount they receive to induce them to accept periodic payment obligations would be considered income
for federal income tax purposes. If an assignment qualifies under Section 130, however, the amount
received is excluded from the income of the assignment company. This provision of the tax code was
enacted to encourage assigned cases; without it, assignment companies would owe federal income taxes but
would typically have no source from which to make the payments
Structured Settlements in the United States
A structured settlement is a financial or insurance arrangement, including periodic payments, that a
claimant accepts to resolve a personal injury tort claim or to compromise a statutory periodic payment
obligation. Structured settlements were first utilized in Canada and the United States during the 1970s
as an alternative to lump sum settlements. Structured settlements are now part of the statutory tort law
of several common law countries including: Australia, Canada, England and the United States. Although
some uniformity exists, each of these countries has its own definitions, rules and standards for
structured settlement. Structured settlements may include income tax and spendthrift requirements as
well as benefits. Structured settlement payments are sometimes called “periodic payments”. A structured
settlement incorporated into a trial judgment is called a “periodic payment judgment”.
Structured Settlements in the United States
The United States has enacted structured settlement laws and regulations at both the federal and state
levels. Federal structured settlement laws include sections of the Federal Internal Revenue Code. State
structured settlement laws include structured settlement protection statutes and periodic payment of
judgment statutes. Medicaid and Medicare laws and regulations impact structured settlements. To preserve
a claimant’s Medicare and Medicaid benefits, structured settlement payments may be incorporated into
“Medicare Set Aside Arrangements” the “Special Needs Trusts”.
Injury victims should know that structured settlements are endorsed by many of the nation's largest
disability rights organizations, including the American Association of People with Disabilities [1] and
the National Organization on Disability [2].
Definitions
The United States definition of “structured settlement” for Federal income taxation purposes, found in
Internal Revenue Code Section 5891(c)(1), is an "arrangement" that meets the following requirements:
A structured settlement must be established by:
A suit or agreement for periodic payment of damages excludable from gross income under Internal Revenue
Code Section 104(a)(2); or
An agreement for the periodic payment of compensation under any workers’ compensation law excludable
under Internal Revenue Code Section 104(a)(1); and
The periodic payments must be of the character described in subparagraphs (A) and (B) of Internal
Revenue Code Section 130(c)(2) and must be payable by a person who:
Is a party to the suit or agreement or to a workers' compensation claim; or
By a person who has assumed the liability for such periodic payments under a Qualified Assignment in
accordance with Internal Revenue Code Section 130.
claimant accepts to resolve a personal injury tort claim or to compromise a statutory periodic payment
obligation. Structured settlements were first utilized in Canada and the United States during the 1970s
as an alternative to lump sum settlements. Structured settlements are now part of the statutory tort law
of several common law countries including: Australia, Canada, England and the United States. Although
some uniformity exists, each of these countries has its own definitions, rules and standards for
structured settlement. Structured settlements may include income tax and spendthrift requirements as
well as benefits. Structured settlement payments are sometimes called “periodic payments”. A structured
settlement incorporated into a trial judgment is called a “periodic payment judgment”.
Structured Settlements in the United States
The United States has enacted structured settlement laws and regulations at both the federal and state
levels. Federal structured settlement laws include sections of the Federal Internal Revenue Code. State
structured settlement laws include structured settlement protection statutes and periodic payment of
judgment statutes. Medicaid and Medicare laws and regulations impact structured settlements. To preserve
a claimant’s Medicare and Medicaid benefits, structured settlement payments may be incorporated into
“Medicare Set Aside Arrangements” the “Special Needs Trusts”.
Injury victims should know that structured settlements are endorsed by many of the nation's largest
disability rights organizations, including the American Association of People with Disabilities [1] and
the National Organization on Disability [2].
Definitions
The United States definition of “structured settlement” for Federal income taxation purposes, found in
Internal Revenue Code Section 5891(c)(1), is an "arrangement" that meets the following requirements:
A structured settlement must be established by:
A suit or agreement for periodic payment of damages excludable from gross income under Internal Revenue
Code Section 104(a)(2); or
An agreement for the periodic payment of compensation under any workers’ compensation law excludable
under Internal Revenue Code Section 104(a)(1); and
The periodic payments must be of the character described in subparagraphs (A) and (B) of Internal
Revenue Code Section 130(c)(2) and must be payable by a person who:
Is a party to the suit or agreement or to a workers' compensation claim; or
By a person who has assumed the liability for such periodic payments under a Qualified Assignment in
accordance with Internal Revenue Code Section 130.
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