by John Darer® CLU ChFC MSSC RSP CLTC
What is a structured settlement commutation rider?
A structured settlement commutation rider is a provision in a structured settlement that provides for a conversion of some or all of the future structured settlement payments to a lump sum timed to a specific event and in accordance with a formula specified in the contract.
What is the purpose of a commutation rider?
The most common commutation rider is a commutation rider at death of the annuitant. The initial purpose of commutation was primarily to provide estate liquidity to (1) help pay federal and state estate or inheritance taxes*, (2) provide for post mortem planning cash needs of beneficiaries. and later (3) to settle/pay of Medicaid liens where the structured settlement was paying into a Supplemental Needs Trust or Special Needs Trust. Indeed it is generally a local mandate in New York City counties that a commutation rider be used when a structured settlement pays into an SNT.
*In 1995, the estate federal estate tax exemption was only $600,000 and a maximum federal rate of 55% could be applied at the top end!. By 2007, the maximum federal estate tax rate was 46% of taxable estates over $2,000,000, still a relatively small ramp up when considering the size of some recoveries.
What did people do before commutation riders?
For those structured settlement brokers that recognized the issue, life insurance was purchased on the life of the annuitant. The life insurance would typically be applied for and owned by a trust to keep the life insurance proceeds out of the annuitant's estate. The life insurance solution was not viable however, for large neurologically impaired infant medical malpractice cases where there was a high potential estate tax exposure and an uninsurable annuitant. In 1989, before I got into the structured settlement business full-time, I was contacted by a Brooklyn medical malpractice lawyer, whose infant client had recently died within a few years of the structured settlement's creation, leaving the parents saddled with the estate taxes on a $6 million structured settlement.
When were commutation riders introduced?
The structured settlement commutation rider triggered at the death of the annuitant, was introduced by Allstate Life Insurance Company in 1995. A favorable Private Letter Ruling on the commutation was issued by the IRS in conjunction with a medical malpractice case in New York City, paving the way for other life insurers issuing structured settlement annuities to follow with their own commutation riders. My colleague at the time Frank Sheerin, then of Sheerin Corp (now Starr Companies) ; a New York City personal injury attorney by the name of Frank P. Mangiatordi; Medical Liability Mutual Insurance Company, a New York medical malpractice insurer and their broker; and Larry Dahl, with the management team then at Allstate Life, collaborated on the resulting solution.
How is a structured settlement commutation rider established?
Whether or not to include a structured settlement commutation rider, including the percentage of payments to be commuted, must be determined up front and properly reflected in the Settlement Agreement and Release and qualified assignment documents when those documents are executed by the Plaintiff and the Defendant or Defendant's Insurer(s). Each life insurer that issues structured settlement annuities has its own preferred language to include in settlement documents.
Does a commutation rider cost anything?
A structured settlement commutation rider does not have any up front cost. The cost of the commutation is recovered by the annuity issuer if the annuitant dies during a period when there are remaining payments subject to commutation. Commutation riders can only be applied to guaranteed or certain payments, not life contingent payments.
When triggered, generally a commutation rider will provide a percentage of the present value of any guaranteed or certain payments remaining at the death of the annuitant. The percentage varies by structured settlement annuity issuer between the 90-95%. The means for determination of present value that the commutation percentage applies to, also varies by structured settlement annuity issuer. It is something that should be scrutinized carefully.
How do insurance companies determine present value when a structured settlement commutation is triggered?
One uses the purchase price of an annuity on the date of death of the original annuitant, that will provide the remaining payments to be commuted and if those rates are not available (e.g. because the company has discontinued that line of business), discounted using a rate from a recognized bond index.
Two companies uses the term "net cost" of an annuity in its commutation, where it has emerged in correspondence to an annuitant that "net cost" means net of the structured settlement broker's commission when the structure was created. I recently fielded a call from a widow from Florida, the former client of another industry colleague who was startled by this revelation after her husband died. This is the inspiration to write this post.
I've conducted further research, including speaking to the annuity departments at structured settlement annuity issuers. It has emerged that several are a less transparent. They do not expressly use the term "net cost" but appear to apply the same or similar methodology.
What is the potential downside of a "net cost" present value? When could it be a negative?
In cases in the New York City counties of Manhattan, Brooklyn, Bronx, Queens and Staten Island, or anywhere else that a structured settlement commutation rider is mandated where a structured settlements pays into a Supplemental Needs Trust, a net cost present value could result in less money commuted and with a Medicaid lien payoff at death could result in less money or no money paid to beneficiaries.
The most impact would be felt on a death within a few years of the structured settlement being created, where there are a substantial number of guaranteed or certain payment remaining. All other things being equal, on a minor's case, or other case where payments have a deferred start date and a large number of guaranteed and/or certain payments the present value could rise each year until the first payment is made. If the annuitant is 4 years old when the structured annuity is established and a lump sum at age 25 costs X$, at age 18 it might cost 2X$ at the insurer's then current rates
Depending on how payments are structured (in terms of guaranteed and life contingent payments) and when death occurs , on a $2 million structure that's a potential $80,000 impact; $160,000 on a $4 million structure and so on.
One representative of a structured settlement annuity issuer that I spoke to, is in the process of amending its structured settlement commutation rider to address this issue.
Is there an alternative to a structured settlement commutation?
The structured settlement secondary market offers an alternative to commutation.
Unfortunately the lack of regulation of structured settlement secondary market participants and the resulting mountain of documented bad business conduct from from top to bottom has impugned the credibility of the structured settlement secondary market. Until we can be sure that lawyers and paralegals for structured settlement buyers are not forging the signatures of judges on structured settlement transfer orders and whiting out the names of notaries, companies are not using unregistered LLCs with the life expectancy of a firefly, that operators in the space have the academic credentials they advertise and that Ponzi schemers or others owing financial restitution to victims of their crimes are not operating or associated in the space, how can this alternative to commutation be taken seriously?
If the structured settlement secondary market's participants were licensed and regulated and had a greater sense of legitimacy than they currently do, perhaps they could help provide a viable alternative to the liquidity that a commutation rider provides, at a more favorable market sensitive cost structure in certain circumstances.