Structured Settlement Annuities: A Compelling Investment Opportunity
An annuity is a financial product that involves a contract between a consumer and an insurer. Under the terms of an annuity contract, the consumer makes a lump sum payment or series of payments to the insurer. In exchange, the insurer is then obligated to pay the consumer a series of cash disbursements at regular intervals. An annuity that begins paying out immediately is referred to as an “immediate annuity,” while an annuity that begins disbursements at a preset date in the future is a “deferred annuity”. Annuities may be particularly attractive to retirees because they have the potential to provide a reliable, low-risk stream of income over decades or even a lifetime. They may also be attractive to investors as part of a diversified group of assets.
Payment for Structured Settlement Annuities
When a person suffers a serious injury or disability due to another person's fault (e.g., car accident, medical malpractice, workers’ compensation, etc.), the injured party may choose to file a claim in court to be “made whole” financially. If the injured party’s claim is successful, the court may enter a final judgment in which the at-fault party becomes legally obligated to pay damages to the aggrieved party. If the at-fault party has insurance to cover the casualty leading to the claim, the obligation to pay the injured party will fall upon the insurance carrier.
Sometimes, the injured party is presented with the option to receive financial compensation as either a 1. lump sum; or 2. a series of periodic, scheduled payments. The latter option is referred to as a “structured settlement.” Structured settlements are an important part of the United States legal system. During the 1980s, the government attempted to incentivize personal injury claimants to opt for structured settlements. The goal was to prevent recipients from burning through funds too quickly rather than solely relying upon public financial assistance. Structured settlements act as a safeguard for such claimants to eliminate the risk associated with managing a large sum of money.
Funding for Structured Settlement Annuities
When the claimant and the defendant agree on the payment schedule in a judicial proceeding, an annuity contract is purchased to fund the payments under the structured settlement. If the defendant is a property and casualty insurance carrier, the defendant may opt to maintain the periodic payment obligation and fund it by purchasing an annuity from a life insurance company that matches the payment schedule agreed to under the structured settlement.
However, the defendant will often enter into a "qualified assignment" with a third party. In a qualified assignment, the defendant purchases an annuity from a life insurance carrier. As part of the annuity purchase agreement, the defendant assigns the structured settlement liability to an affiliate of the life insurance carrier providing the annuity. Finally, the assignee purchases the annuity from the life insurance carrier to fund the structured settlement liability. Such an assignment is called a “qualified” assignment by the IRS because the settlement proceeds are excluded from federal income tax.
The figure below illustrates a typical structured settlement transaction.
The Secondary Market: Opportunity for Immediate Liquidity
Sometimes, an injured party’s settlement payment schedule may no longer fit their needs. Other times, certain life events may necessitate immediate liquidity. In such an instance, the claimant has the option to enter into a factoring transaction. Factoring transactions occur when recipients of structured settlement payments agree to transfer the right to receive future payments to a third party in return for an immediate, discounted lump sum payment. These transactions represent the secondary market of structured settlements.
The Structured Settlement Protection Act was passed by congress in 2001 to protect those seeking to sell their structured settlement on the secondary market by requiring disclosures and administrative approvals that ensure a transparent and fair transaction. A 40% excise tax penalizes purchasers of structured settlements that fail to comply with the appropriate standards.
In 2018, sales of structured settlements totaled over $6 billion. According to the National Association of Settlement Purchasers, less than 15% of structured settlements are transferred on the secondary, “factoring” market.
Potential for Higher Yields, Contractual Income, And Uncorrelated Returns
Professional financial institutions have identified the secondary purchase of these annuities as an attractive investment opportunity for several reasons. First, yields are often higher than the interest rates on the initial annuity due to the higher liquidity requirement of the current owner, who is willing to sell their income stream at a discount. Second, annuity payments are contractually promised income. And finally, the potential portfolio diversification benefits are particularly attractive since the is little to no correlation with the returns in traditional asset classes historically, such as public stocks and bonds.
AIR Asset Management is an SEC-registered investment advisor that specializes in life-contingent alternative assets. For more information about investing in life-contingent, structured settlement annuities, please contact AIR Asset Management at info@airassetmanagement.com.
DISCLOSURES
AIR Asset Management ("AIRAM”) is an investment adviser registered with the SEC. The information contained in this email is for general informational purposes only and should not be construed by any prospective or existing client (or investor) of AIRAM as a solicitation to effect transactions in securities. In addition, the information herein should not be construed by any prospective or existing client (or investor) of AIRAM as personalized investment advice. AIRAM’s personalized investment advice is given only within the context of its contractual agreements with each client. AIRAM’s investment advice may only be rendered after the delivery of its Form ADV-Part 2A/2B and the execution of an agreement by the client and AIRAM.
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RISK OVERVIEW
Management of Operational Risk- In the normal course of business, AIRAM life-settlement funds may be exposed to a variety of operational risks, including position pricing and Net Asset Value calculation procedures, client reporting procedures, compliance controls, and policy acquisition sources. Our managers seek to manage these risks by employing experienced service providers and management who report and manage in accordance with the investment objectives of each fund as outlined in its prospectus. Our approach is to hire the most experienced professionals and firms to add value and protection to our investors.
Longevity Risk- When evaluating the value of life settlements, each policy must be reviewed for multiple quantitative aspects of the insured and their health to get a firm handle on the probability of death over a given timeframe. Understanding the broader implications of these small details within a life settlement transaction is important. One of the key pieces of data used during the underwriting process is the medical underwriting report, which is performed by an independent medical underwriter. Utilizing the latest mortality information, premium data, mortality tables, and verification of coverage, an asset profile is developed and a valuation is produced by an independent valuation agent. A thorough review should then be conducted by a number of parties to create redundancy, and a detailed checklist utilized to ensure uniformity such that all criteria and regulatory requirements correspond to accurate underwriting and quality standards.
Liquidity Risk- Liquidity risk is the risk that a fund may not be able to settle or meet its obligations on time. Investment vehicles are traditionally exposed to quarterly and annual cash redemptions of units at specified amounts. Liquidity risk is managed by investing the majority of the Fund’s assets in investments that can be readily disposed of through various life settlement firms and exchanges. The Fund utilizes marked-to-market accounting practices within its assets that provide quotations to its fund managers on a regular basis ensuring proper valuations are maintained. Longevity risk is the biggest quantitative risk factor in the valuing of life settlements. In general, investment managers focus on reducing the economic impact of unexpectedly increased policyholder longevity. In order to ensure this, a fund must review actual versus expected results and stress test different scenarios of mortality expectations in order to determine the impact that these stressed scenarios have on the value of the life settlement. This stress testing is typically performed on the current portfolio as well as on policies available in the market that are being evaluated for purchase. The primary driver of a policy’s sensitivity to longevity risk is the cost of insurance (“COI”). COI increases every year until a mortality event because premiums must be paid to maintain the policy. A policy’s sensitivity to longevity can be found by reviewing how probable it is that mortality will occur when the COI would produce an unacceptable return.
Credit Risks- Credit risk is the risk that the counterparty to a financial instrument will fail to discharge an obligation or commitment that has entered into with a fund. Where the fund invests in only U.S. life insurance policies these represent the main concentration of credit risk. The fair value of life settlement policies include consideration of the creditworthiness of the life insurance issuer, and accordingly, represents the maximum credit risk exposure of the fund. Management considers a fund to have marginal credit risk to the U.S. life issuers as each insurer is required by law to maintain stringent reserve requirements. In addition, no U.S. life insurance carrier has ever failed to pay a legitimate death claim. The risk of default is considered minimal.
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