Factoring Structured Settlement Life - Contingent Payment Annuities What Judges Should Know

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1 Factoring Structured Settlement Life - Contingent Payment Annuities What Judges Should Know By: Andrew S. Hillman, Esq., President and CEO, Specialty Asset Advisors, Inc. for Seneca One Finance, LLC May 2015 Scope of this White Paper Judges are increasingly being asked by people who are entitled to receive life- contingent structured settlement payments for approval to sell those payments. Life- contingent payments are those that last for only so long as the recipient lives. With a view to assist these judges to better understand the cost associated with these transactions, this article will: Describe a structured settlement factoring transaction; Describe the nature of life- contingent annuities and guaranteed payment annuities; Explain what a discount rate is and how it is calculated; Explain the concept of time value of money and how this principle impacts the calculation of a discount rate; and Explain why discount rates in structured settlement factoring transactions tend to be higher when purchasing life- contingent payments What Is a Structured Settlement and a Structured Settlement Factoring Transaction? A structured settlement is an agreement between a personal injury plaintiff (claimant) and a defendant liability insurance company in which the claimant agrees to settle a lawsuit in exchange for payments to be made over time by the liability insurance company. The liability insurance carrier then buys an annuity policy from a highly rated insurance company to make those payments on behalf of that liability insurance company. The payments are structured in the sense that they are to be paid periodically over time to assist a claimant to plan for their financial future and to ensure that a claimant does not squander a one- time lump sum payment. Structured settlements contain prohibitions against selling, assigning or otherwise alienating the payments to be made thereunder. Structured settlements are a popular method for settling personal injury lawsuits and wrongful death cases. A structured settlement factoring transaction is the selling of future structured settlement payments. People who receive structured settlement payments may decide at some point that they need money immediately rather than wait until future payments are made. The reasons for this need vary but can 1

2 include unforeseen medical expenses for themselves or a loved one, the need for improved housing, for education costs, or to start a new business. To meet this need, a claimant can, notwithstanding the anti- alienation provisions described above, sell all or part of its future payments for a present lump sum. In order to do this, a claimant must seek approval from a judge to sell these payments. This process is more fully discussed later in this article. Types of Annuity Payments that are Purchased by Structured Settlement Factoring Companies In general, there are two (2) types of annuities used in structured settlements: (a) payments that are guaranteed to be made over a certain period of time; and (b) life- contingent annuities in which payments are made only until a claimant dies. These annuities are also referred to as non- guaranteed annuities. The purpose of these annuities is to provide a claimant with an income for a set number of years, sometimes as many ae 30 years into the future. A disadvantage of a life- contingent annuity is that a claimant receives the payments for only so long as a he or she is alive. For example, a claimant currently receiving structured settlement payments that are life- contingent will receive the payments when they are due but if they were to pass away, their heirs/family members will not be entitled to any payments that may be due on the annuity and, for purposes of this discussion, neither will a factoring company that purchases those payments. The receipt of guaranteed payments, life- contingent payments or a combination of both is determined at the time the structured settlement is put into place. At this time, an analysis of a claimant s current need of payments, his or her age and other relevant factors is made to determine the nature and length of these payments. More times than not, if life- contingent payments are part of a settlement, those payments are typically scheduled to be paid relatively far into the future. Most factoring companies purchase from claimants both guaranteed and life- contingent payments and the purchase of the latter has increased over the last couple of years. This article will focus on aspects of life- contingent structured settlement annuities because they are more difficult than guaranteed payments to underwrite given mortality and other factors. Procedures to Purchase Structured Settlement Annuity Payments and Standards for Approval To date, forty- nine (49) states have passed laws regulating the transfer of structured settlement payments (SSPAs) that mandate that courts have hearings to determine whether the sale is in the best interest of a claimant and his or her dependents. If a judge determines that the transaction is in the best interest of a claimant and its dependents and that the sale complies with the requirements in the SSPA, the sale will be approved and the factoring company will purchase the payments from the claimant in return for a lump sum of cash. Included in whether a sale is in the best interest of a claimant and any dependents, a major factor is the cost of the transaction. This necessarily includes whether the discount rate (discussed later in this article) charged and the resulting purchase price is fair and reasonable. Among other requirements in the SSPAs a factoring company generally must provide to a claimant: A separate written Disclosure Statement in advance of the funding date showing: 2

3 o o An itemized list of how the factoring company has calculated the present value of payments and gross amounts payable to the claimant in exchange for the payments; and The net amount payable to the claimant after deducting all itemized commissions, fees, costs, expenses and other items that may be charged by the factoring company. Judges must analyze these Disclosure Statements, among other evidence, and understand the cost of a transaction including how the discount rate is calculated and why a claimant is sometimes receiving a certain amount of money in return for a disproportionately larger amount of money. Judges must then determine whether the discount rate is fair and reasonable and in a claimant s and its dependents best interest. The Discount Rate and Discounted Present Value Term in Disclosure Statements There is much confusion with the terminology discount rate because the term is used in different ways and for different purposes. The discount rate used in factoring transactions is similar to an interest rate associated with home loans, credit cards and car loans where the interest rate is applied to the payment itself. In a factoring transaction, the factoring company knows the payment stream it is going to purchase and applies an interest rate to the payment stream and solves for the funding amount (purchase price). One common mistake in calculating the discount rate is to use elementary school math where one takes the funding amount and divides it by the total price of all of the payments being purchased. Because this method disregards the time value of money (discussed below), the resulting percentage is useless, is always exorbitant and has no basis to the reality of the transaction. In the past, the structured settlement factoring industry had some very high discount rates due to heavy expenses caused by costly litigation battles and limited access to traditional investors. However, due to the enactment of the SSPAs and increased competition in the structured settlement factoring space discount rates have dropped dramatically. Another confusing term commonly used in factoring transactions is the discounted present value that is required to be disclosed in Disclosure Statements. The discounted present value is a measuring stick for determining the value of a future payment. The SSPAs require that the discounted present value rate be calculated (and calculated in Disclosure Statements) using the present value of future payments determined by discounting such payments using the applicable federal rate for valuing annuities which, for purposes of discounting structured settlement payments, is currently 1.8%. A federal appeals court has held that this is truly an arbitrary discount rate used by the IRS to value an annuity and has no bearing on the true present market value of the structured settlement payments being purchased. Moreover, that same court held that the true value of the payments being purchased should focus on what is fair and reasonable in the marketplace. As noted earlier, factoring companies are also required to disclose in the Disclosure Statements and how it calculated the present value of the payments. This is the true discount rate that is used, not the applicable federal rate. 3

4 The drafters of the SSPAs, including this writer, maintain that the applicable federal rate for computing the discounted present value was selected merely to provide a benchmark for illustrative purposes only and has no true bearing on the actual future value of structured settlement payments in a free and open market in any given transaction. Now, unfortunately, this unnecessary benchmark has proven to be misleading and confusing to many judges. Notwithstanding this, factoring companies need to comply with the SSPAs by including this concept in Disclosure Statements. So, when judges review Disclosure Statements to learn the actual cost to a claimant of a sale they need to understand and apply the concepts discussed in this article when determining whether the cost of the transaction is fair and reasonable. What is the Time Value of Money? Some of you may recall that the lovable character Wimpy of the Popeye cartoon series was fond of saying: I ll gladly pay you Tuesday for a hamburger today. This is the essence of the concept of the time value of money, the truth being that the price for the hamburger would be higher today than on Tuesday. So, in effect, Wimpy will pay less for the hamburger on Tuesday than he would today, when he receives his hamburger. Clearly, Wimpy understood the time value of money. One of the most difficult financial concepts that people grapple with is grasping the concept of the time value of money. As was noted earlier, many life- contingent payments are not scheduled to begin to be paid to a claimant until many years in the future. The optics of such a disparity between (a) the amount advanced by a factoring company and (b) the amount of payments purchased can be easily misunderstood. This is why it appears that a claimant receives disproportionately less money at the time of sale in return for a larger, total of amount of payments. It is a well- settled financial principle that a payment to be received in the future is worth less than if that payment were received today. Thus, the concept of time value of money means very basically that the value of money decreases over time. So factoring companies need to account for this concept when determining the amount of payments to buy given the amount it advances to a seller. By way of analogy, and very simply, this is why banks charge interest to borrowers because loans are to be repaid in the future when the principal is worth less than it was when the loan was made. The Inherent Risks in Purchasing Life- Contingent Payments As noted earlier, life- contingent payments are those that last for so only as long as a claimant lives; they stop upon the claimant s death. Thus, a factoring company, when determining how to structure a factoring transaction needs to determine, as best as it can, how long a claimant will live in order to make certain that the amount of money a factoring company advances to a claimant is appropriate to the risk of a claimant passing away before that date. This is not an exact science. Factoring companies do their best to determine this (with assistance from mortality risk experts) but since life- contingent payments are, by their name and nature contingent (and not guaranteed), this risk must be taken into account in pricing a transaction. If a claimant passes away before that date, a factoring company will 4

5 lose the benefit of its agreement with the claimant and could potentially lose some or all of its investment (i.e., some or all of the funds it advanced to the claimant) in the transaction. The Reasonableness of the Discount Rate As noted earlier, in a factoring transaction, the true value of payments being sold to a factoring company is most properly based on what a willing buyer agrees to pay a willing seller as long as that price is fair and reasonable. Judges should determine that the discount rate was negotiated in good faith and should ascertain that the factoring company has bested other competitors offers. It can be helpful if judges analogize a factoring transaction to a loan and understand that a traditional bank would not enter into a factoring transaction (for a number of legal and practical reasons not described here), even were a claimant able to qualify for a loan. Judges should also determine that the discount rate is within the average range for transactions of this type. In order to assist judges in making these determinations, an expert in structured settlement factoring transactions, such as Specialty Asset Advisors, Inc., can provide to the judge a rate affidavit that sets forth an expert opinion as to the factors that a judge needs to consider and whether a discount rate is fair and reasonable for transactions of this type in the marketplace. Conclusion This article has attempted to shed light on how and why factoring companies value and price the cost to claimants in the sale of their life- contingent annuity payments. Selling these payments will inure to the claimants benefit in achieving the certainty of receiving the money to which they (and, as importantly, their family members) are entitled that may not even be available to their family members after a claimant passes away. Expert testimony in the form of rate affidavits can provide judges an understanding of these issues that can help them rendered a judgment as to whether the transaction is in the best interest of a [seller and his or her] dependents. Andrew S. Hillman is President and CEO of Specialty Asset Advisors, Inc., (www.specialtyassetadvisors.com) a consulting firm that provides a full array of services to the advance funding industry. Seneca One Finance, LLC (www.sencaone.com) is one of the largest specialty finance companies in the U.S. that purchases structured settlement annuity payments, assignable annuities, lottery winnings and other prizes. Specialty Asset Advisors, Inc. All rights reserved. This publication does not purport to give legal or tax advice and may not be used to avoid penalties under the Internal Revenue Code. 5

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