June 1, 2007 by Ralph Fenik and Phil R. Thorpe
If insurers, reinsurers and risk managers could have one wish granted, it might well be for a potion to control the cost of catastrophic injury claims. In spite of the implementation of caps on awards for whiplash-type cases in many jurisdictions, the increasing cost of bodily injury claims remains a major concern. Catastrophic injuries are driving severities to new heights, especially for reinsurers. While not a cure, structured settlements can be a soothing pain-reliever.
Structured settlements have saved the insurance industry millions of dollars. They can continue to do so, but only if everyone responsible for controlling claims costs fully understands and utilizes the concept.
A structured settlement is an alternative to a lump sum in settling personal injury claims; it is designed to meet a particular claimant’s needs. It does this through periodic payments, either for a fixed term or for the claimant’s lifetime. In addition, the structured settlement usually provides for upfront money for special damages such as medical expenses, lost wages, special equipment and the usual out-of-pocket expenses. The structured settlement can be tailored to meet most needs that an injured person might have. In that respect, it is more responsive to the individual’s needs than a conventional lump-sum payment alone.
The most obvious benefit of the structured settlement is that the injured person receives all of the payments tax-free. The premise behind this tax-free status is that each structure payment parallels the traditional treatment of a larger lump-sum payment. As we all know, damages for personal injury or death are not subject to income tax. In the structured settlement, one simply substitutes a series of periodic payments for the single lump-sum payment so that there is no logical reason why the tax treatment should be any different.
The funding vehicle for the structured settlement is an annuity, purchased from a life insurance company. This funding vehicle has been developed over a number of years and is useful because of its great degree of flexibility, which has allowed the design of structured settlements to become quite sophisticated. For example, payments can be indexed at a set rate to protect against inflation and can also be designed to provide tax-free lump-sum payments within the annuity to replace equipment such as wheelchairs and vans, etc.
Because it provides such benefits to an injured party, the structured settlement also provides substantial benefits to the casualty insurer and its reinsurers in the form of cost savings.
STRUCTURED SETTLEMENTS REDUCE COSTS
Structured settlements play an important role in helping insurers and their counsel resolve personal injury and wrongful death claims sooner and for less money.
The very fact that structured settlements cannot be implemented without the insurer’s consent provides significant impetus for cost savings.
The benefits to insurers of settling claims by way of structured settlements are:
Claims Cost Savings
* As a valuation vehicle for injury damages, structure costs are invariably lower than actuarial present values. Structure costs are based on real market rates. They take into account reduced life expectancy using the most competitive impairment ratings available from the various life insurers serving the structure market;
* Most plaintiff counsel recognize that the insurer’s consent is required to set up a structured settlement and quite often a reasonable discount can be negotiated;
* In accident benefit cases, structures allow insurers to create a potential recovery through a reversionary guarantee (i.e. insurer recovers money if the claimant dies prematurely);
* Structures designed to meet the plaintiff’s specific future needs (i.e. needs-based approach) eliminate the need for gross-up and management fees on tort claims–for example over $4-million combined in the case of Roberts et. al. v. Morana et. al. (2000), 49 O.R. (3d) 157 (Ont. C.A.);
* In recognizing the benefit of structures to injured plaintiffs and the cost savings to insurers (which results in reduced insurance premiums for consumers) there is an increasing trend for provinces to legislate court-ordered structures. The availability of court-ordered structures filters back into the settlement process and results in a greater willingness of the parties to negotiate on the basis of a structured settlement;
*An insurer indicating willingness to structure can act as a catalyst to early settlement, thus eliminating exposure to adverse claims development. Claims rarely, if ever, get better with time; they invariably deteriorate. The old adage that, “the best claim is a closed claim” has been proven over time;
* Because structures create a win-win outcome, whereby plain-tiffs receive more and insurers pay less, a valuable antidote is provided to insurers against claims for bad faith in excess limits cases;
* To satisfy reinsurance commutation requirements, structures can be used to crystallize the exposure.
* Accident benefit claims, particularly in Ontario, are extremely labour intensive. Structures offer an opportunity to transfer administrative handling, especially the costly and time-consuming issuance of future periodic payments to claimants, to a life insurer. One cannot ignore the administra-tive costs associated with maintaining open files. These costs are not static; they are subject to inflationary increases;
* Most structure brokers provide all their services for free and only receive a one-time commission from the life insurer if and when a structure is actually placed.
APPLYING STRUCTURES TO CATASTROPHIC CASES
The largest heads of damage in catastrophic injury cases, including fatal claims, relate to future economic loss–future care and future loss of income. The following are a few comments with respect to the benefits structures can provide in such cases:
Since awards are based on net or after-tax income in awarding a dependency allowance in fatal cases, and, further, since the case law suggests that a gross-up is appropriate in an amount sufficient to compensate for the payment of future income taxes, then a substantial savings can be realized through the use of a structured settlement. The reason for this is simply that no gross-up need be considered since the payments made by a structured settlement are tax free in the hands of the plaintiff.
The claim for future care is similar to that in the fatal case in the sense that the award or settlement is based on an amount net of income tax. There are some notable differences between the future care claim and the fatal claim insofar as a number of expenses for future care are deductible from taxable income. There is, however, a large group of items falling within the description of future care, which, in fact, are not deductible for tax purposes. Allocations in respect to those claims must be grossed-up for tax purposes.
Future Loss of Earnings
The claim for future wage loss can be readily distinguished from either the fatal claim or the future care claim. Whereas in the case of the fatal and future care claims, the award is made on a net, after-tax basis, the award with respect to future loss of earnings is made on a gross or pre-tax basis. It follows that since no deduction is made for future tax payable, then no gross-up need be made in this connection. Since the settlement is premised on a pre-tax amount, a substantial savings can be achieved with the use of a structured settlement given the tax-free nature of the structured settlement payments.
Structures on catastrophic cases typically pay for a claimant’s lifetime and invariably are based on shortened life expectancy assessments from the underwriting life companies. This results in significantly higher payments for the
claimant than would otherwise be the case, based on assumptions of normal mortality. Further, structure payments are completely tax-exempt. Therefore, the claimant is able to receive more than he or she would get from the conventional, taxable investment of an all-cash settlement. At the same time, the insurer pays less than it would have to in an all-cash settlement. This win-win scenario helps bridge the settlement divide, which frequently prevents an insurer and a claimant from reaching a mutually advantageous settlement.
The increasing frequency and severity of catastrophic injury claims presents a very real concern to the casualty industry. This is further compounded by the successful development of new heads of damage in such catastrophic cases by very resourceful plaintiff counsel. Although the industry is concerned, there is no need to panic.
Structured settlements are designed to address these very types of exposures. This can only be done successfully if:
1) the industry has been educated about the advantages that structured settlements offer as a means of controlling claims costs; and
2) casualty insurers, reinsurers, and risk managers are prepared to utilize the concept.
Ralph Fenik is the managing partner and Phil R. Thorpe is a principal at McKellar Structured Settlements Inc.. Established in 1979, McKellar is the oldest and largest structured settlement firm in Canada. Today, it is Canada’s largest provider of tax-free annuity income for personal injury and wrongful death settlements.