Structured Life Settlements
What is a structured settlement?
A structured settlement is a way of settling a personal injury liability claim - it is important to remember that it has nothing to do with settlements meaning trusts. Briefly, it refers to settling a liability for a personal injury claim in the form of periodic payments rather than a lump sum. The purpose of such a structure is to provide permanent income which would replace the traditional lump sum award in all sorts of negligence cases. A structured settlement may provide tax free benefits - see "Tax implications of structured settlements" - and removes uncertainty and worry about how long the lump sum will last.
In a structured settlement, the defendant in the personal injury claim, typically the general insurer, will cover the liability incurred by purchasing an annuity from a life assurance company, which is then held for the benefit of the injured person. With the payment structured over a period of time, the amount of annuity may be variable, the payments may be confined to the plaintiff´s lifetime or may last longer if there are dependants to support. A structured settlement may also be inflation-proofed. If the plaintiff´s expenses or requirements are likely to increase in the future then it may allow larger sums to be released.
In most cases the structure will be achieved in such a way as to best meet the plaintiff´s needs according to the circumstances of each case. It is likely, for example, to include a lump sum that may be needed to convert a private residence or purchase a car etc. However, once the structured settlement is in place then it would generally not be possible to unlock the capital and the plaintiff will only be entitled to the income.
In view of the fact that structured settlements are afforded favourable tax treatment the result is that the plaintiff may get a higher income from damages whilst the insurer also saves money.
The main benefits of the structured settlement for the plaintiff are that:-
- the plaintiff does not need to worry about the investment of the lump sum received as damages
- there is no need to be concerned about inflation which can be provided for in the structure
- there is no worry that the money will run out if the plaintiff lives longer than expected
- the plaintiff is protected from bad advice and from their own extravagance
- the funds are safely locked away providing peace of mind as well as, in practice, more cash.
Structured settlements in the UK
Although structured settlements originated in the USA and Canada, they became more popular in the UK following the agreement between the ABI and Inland Revenue (now HM Revenue & Customs) in July 1987 as to the income tax treatment of the periodic payments. Although this has since changed, the model agreements provided by the ABI following the agreement with the Inland Revenue and the guidance notes have been extremely useful and are still being used - see below.
The advantages of structured settlements for all parties concerned were highlighted in a judgement given by Justice Potter in the case of Kelly and Another v Dawes in July 1989. Here the award for the plaintiff in the form of a structured settlement turned out to be some £17,500 less than the sum that would have been payable for a conventional lump sum award. Of the total amount of £410,000, £110,000 was paid as a lump sum and £300,000 used to buy an annuity. The judge commented that while normally the plaintiff should receive the highest possible payment on offer, in this case the differential was justified on the grounds that the plaintiff would benefit from a greater yield over the years than she would have received from a traditional lump sum, invested in the normal way, in a mixture of gilts and equities, the income from which would have been taxable. It was stated that the insurer should be permitted "to participate in the benefits resulting from the reduced levels of taxation" provided that the interests of the plaintiff were fully protected. In a more recent settlement an insurer achieved an even greater discount. Holdsure Motor Policies at Lloyd´s was reported to have saved £100,000 on a settlement valued at £900,000.
Arranging a structure in practice
The judgement in Kelly was also significant in that the judge made several important recommendations as to how structured settlement cases should be dealt with before Court. This has since been superseded by the Practice Note (Structured Settlements: Court´s Approval) issued by the Deputy Chief Justice in February 1992. The Practice Note was intended to establish a practice to overcome the difficulties caused by a short period over which life offices keep open offers of annuities at a given price. In the past it has proved difficult for the plaintiff´s solicitors to do all that was necessary to obtain the Court´s approval within the period in which the annuity offer remained open. The Practice Note sets up procedures for speedy dealing by the Court with applications for approval in structured settlement cases. It also lists the types of document which need to be lodged to enable the Court to consider the structure and these include:-
- copies of originating process or pleadings;
- an opinion of counsel assessing the value of the claim on a conventional basis and, if practicable, the opinion of counsel on the structured settlement proposed;
- a report of forensic accountants setting out the advantages and disadvantages, if any, of the structure, bearing in mind the plaintiff´s life expectancy and the anticipated cost of future care;
- a draft of the proposed agreement as approved by the Inland Revenue (this is where the ABI Model drafts become useful - see below);
- sufficient material to satisfy the Court that enough capital is available free of the structure to meet anticipated future capital needs, particularly with reference to accommodation and transport needs;
- proof that the structure involves secure arrangements backed by responsible insurers (it is understood that as long as one of the well known tariff companies or one of the syndicates operating under the Rules and protection of the Lloyd´s market is used, there should be no problem in satisfying the Court of the security of the arrangements);
- in cases where the plaintiff is under mental disability the consent of the Court of Protection;
- evidence of other assets available to the plaintiff.
In practice, a number of life offices specialise in this type of business and the plaintiff will need the advice of a solicitor and financial adviser specialising in this type of business.
The role of the financial adviser in arranging a structure
As indicated above, the starting point for consideration of a structured settlement will always be the counsel´s opinion assessing the value of the claim and its constituent elements on a conventional basis and the appropriate lump sum figure (for settlement on that basis). Careful consideration of the claimant´s life expectancy, based on medical opinions, would normally need to be obtained and taken into account.
In most, if not all, personal injuries cases there will usually be a need for a capital sum, or at least a cash fund, to meet immediate capital expenditure such as a new house or alteration to the existing property in order that it can be adapted to meet the claimant´s revised needs. In normal circumstances the remainder of the lump sum settlement would then be invested on the plaintiff´s behalf so to enable him or her to live off the interest/income generated as well as drawing on the capital sum invested so that in theory at the end of his or her life the lump sum is fully exhausted. Obviously, unless an investment is made which links the future payments to the life of the claimant, it would not be possible to precisely calculate how much capital to draw as there are too many unknowns and investment variables. If the claimant were to directly himself or herself invest in an annuity this would involve some of each payment being subject to income tax and therefore would not be tax efficient.
The general philosophy behind structured settlements is that once the claimant has been provided with a sum to meet immediate capital expenditure and also has a reasonable contingency cash fund, then the balance of the lump sum is normally used as a means to provide an annual income. Under a structured settlement such income will be provided by the defendant insurance company purchasing an annuity from a life office that would guarantee to achieve the certainty of the cash stream for as long as the claimant lives.
The financial adviser would normally be required to provide a report as to the fiscal and investment advantages to the claimant of the structured settlement proposed, with particular regard to the life expectancy of the claimant and the likely future costs of care. The purpose of the report would be to provide arguments in favour of a structured settlement for the particular claimant based on his or her life expectancy. Clearly to achieve this the financial adviser will have to be in possession of all the relevant medical information as well as the counsel´s opinion as to the appropriate sum that should be awarded on a conventional basis. In practice a comparison should be made between the investment of the lump sum (i.e., the sum awarded on a conventional basis) in the traditional manner with investment in a structure, i.e. via an annuity. For example, the position could be shown assuming that the lump sum were invested in the traditional manner with 70% invested in equities and 30% invested in gilts, this being the usual portfolio adopted by the Court of Protection. Obviously assumptions would have to be made as to annual income from gilts and equities, personal allowances and personal income tax rates, professional costs, dealing costs etc. A comparative table for investment in gilts only could also be included. The agreed level of annual sum that would be required for the claimant would be made up from income from the investments and supplemented from the capital sum, resulting in the capital sum being exhausted after a defined number of years, depending on mortality predictions.
Finally, comparison would be made with the net income available for the claimant based on a structured settlement that is based wholly or partly on an annuity. Obviously a number of annuity quotations will be required based on the health of the individual concerned. Generally speaking in personal injury cases, the life expectancy of the claimant would be reduced due to his or her injuries. In such a case, the life office should be able to agree a higher level of annuity than for an individual with a normal life expectancy. There are still comparatively few offices that specialise in underwriting impaired lives, but a number of such offices exist. Clearly, to provide a quotation, the life office would need more information than in the usual case, i.e. not just the date of birth and sex of the claimant but also up-to-date medical reports, size and frequency of the periodic payments required, level of inflation protection required and size and incidence of any future regular lump sum payments. Special application forms would be provided for this purpose.
Model agreements and HM Revenue & Customs approval
To ensure the desired tax treatment of a structured settlement is achieved, the agreement needs to be approved by the HM Revenue & Customs. Where the model agreement which has already been agreed by the ABI with the HM Revenue & Customs is used, the procedure is simplified. The ABI standard form provides four alternative forms of schedules to cater for the four main kinds of periodic payment arrangements likely to be required. These include basic terms, indexed terms, terms for life and indexed terms for life. Draft model agreements would normally be provided by the life office underwriting the annuity.
Further developments
In 1992 the Law Commission published a consultation paper on structured settlements and interim provisional damages, and the Commission reported on their findings in 1994. The Commission made several recommendations, in particular, on the rationalisation of the tax regime governing structured settlements. These have now been implemented.
However, generally speaking, the advantages of structured settlements notwithstanding, their popularity gradually reduced during the early 1990´s. An important factor in the decline of the popularity was the gradual reduction in interest rates and the corresponding increase in the cost of purchased life annuities. It is understandable that if a structure which cannot be "undone" is entered at the time of low interest rates, this may well disadvantage the claimant if in the future interest rates rise considerably. In the last couple of years though interest rates and inflation have been stable and as a result more plaintiffs and their lawyers have again started considering structured settlements, particularly following the exemption from tax in respect of annuity payments under a structure. Indeed, in many cases, particularly in respect of claimants who are under 18 years of age, mental patients and others requiring long-term care, the benefits of the certainty of a structure, the reduction in the need for investment management and the reduced risk of the funds being spent too early through unwise spending still outweigh the fixed nature of the arrangement and the low interest rates. However, the impact of future changes in interest rates needs to be considered by all parties, and in particular the financial adviser advising on the arrangement. The impact of future changes can be lessened by ensuring that an adequate contingency fund is kept outside the structure which is invested conventionally, in particular taking advantage of any tax-favoured investment vehicles. This will ensure that a degree of flexibility is retained. It is also important to ensure that an appropriate escalation rate is incorporated in the structured annuity.
The changes in taxation of structured settlements should also encourage the defendant insurers to opt for a structure, bearing in mind that the ongoing burdens of administration and the adverse cash flows arising because of the taxation in the past no longer apply. Of course this is also likely to mean that the traditional "discount to structure" previously sought by defendant insurers (to compensate for the burden of the ongoing administration of receiving in and paying out the annuity) will no longer be appropriate. There is also evidence that HM Revenue & Customs is more relaxed in considering structures for approval. For example, a practitioner may agree with the Revenue a standard settlement agreement which can be used in a number of cases with HM Revenue & Customs assurance that it will be acceptable to them.
Impact of Courts Act 2003
The Courts Act 2003 generally took effect for claims from 1 April 2004 although certain sections come into force through statutory instruments as set out in section 110. Unless stated otherwise the legislation extends only to England and Wales. Accompanying Explanatory Notes have been published. Judges have been given new powers under section 100 to unilaterally impose "periodic payment" awards on parties who have been at fault in an accident. Until now lump sum awards have been more usual. Where the parties have been insured e.g. motorists, the general insurance company (and / or the reinsurance company) will pay out.
Not all lawyers are happy with the new system. The problems were discussed in a House of Commons debate by Andrew Dismore M.P., a member of the Association of Personal Injury Lawyers. He said:
"It is important to point out that periodical payments have both advantages and disadvantages. Claimants would not have to fear running out of compensation, as they would if damages were ordered as a lump sum, but periodical payments create a lifetime relationship between the claimant and the defendant which the claimant may find extremely difficult. For that reason, the merits of imposing periodical payments must be assessed on an individual case-by-case basis, and I am concerned that, under clause 100, awards for future pecuniary loss - the lion´s share of any award - can be made irrespective of whether the claimant consents. That is particularly important if periodical payments are being linked to the retail prices index in respect of inflation because it would prevent the claimant from looking for a better rate of return. Under clause 100, it is possible for a court to order a periodical payment without the consent of either party, let alone just that of the claimant. That puts the claimant completely at the mercy of the court´s discretion and the defendant´s arguments. I believe that that is unfair because only the claimant is able to say how an award can best be used to place him in the position that he was in before the injury."
If the court decides that it is more appropriate to pay care costs to an accident victim on an annual basis this will mean that the burden for annual payment awards will fall on general insurers and reinsurers - the former may have less experience of taking on mortality risk (a major factor in periodic payment awards) than life insurers. As claimants will be able to return to court later to have their payments reviewed (in practice, increased), reinsurers will be exposed to a greater risk - this could run for many decades e.g. in the case of a child traffic victim who lives beyond one´s three score and ten years of life.
Although reinsurers could offer a lump sum to purchase an annuity from a life insurer, thereby commuting their risk back to the general insurer, concern has been expressed that annuities offer less value than they did some time ago. It has been reported in the press that the Financial Services Authority is aware of this problem and is considering whether to allow general insurers to take on mortality risk.
Historical background
Following the recommendations of the Law Commission on the tax treatment of structured settlements, the taxation of structured settlements has been considerably simplified in 1995 and 1996. However, it may be relevant, by way of background, to outline the previous tax treatment, particularly as it had a considerable bearing on the development of structures in the UK.
In a structured settlement three parties would be involved, the general (liability) insurer, the life office and the plaintiff (the injured party). As far as the general insurer was concerned, the insurer would normally treat the premium for the annuity as reinsurance of the liability to make the payments and such treatment would be approved by the ABI and DTI for regulatory purposes, (see reference to model agreements issued by the ABI mentioned in "Structured settlements in practice"). The reinsurance premium would be a trading expense for tax purposes. Although the general insurer would have been liable to tax on the receipt of the annuity, it would also be able to deduct an amount equal to the cost of the instalment payment and therefore the two payments would be tax neutral. The general insurer therefore suffered no tax costs.
As far as the life office underwriting the annuity was concerned, an argument would generally be put forward that since the payment was not pure income profit in the hands of the payee (general insurer) then there was no need for the life office to deduct tax on paying the annuity to the general insurer. Even where it was argued that the annuity should have been paid net, the general insurer could reclaim the tax at the end of the financial year, although this clearly would have created a cash flow problem for the general insurer. Also it would only allow for a tax reclaim where the general insurer had a tax liability in the first place. As far as the payment to the plaintiff was concerned, although strictly any payment should have been made from the life assurer to the defendant´s insurers and then to the plaintiff, in order to reduce administration the general insurer would normally arrange for the life office to act as his paying agent although a problem could arise where the general insurer and the life assurer were both separate departments of the same company on the basis that it is impossible for a person to contract with himself. In short, the administration of structured settlements provided a considerable burden on both insurance companies.
The payments received by the plaintiff were not subject to tax on the basis they were capital payments.
Current tax treatment
In 1995 the Government acted to remove tax on annuities received for injury damages. The Finance Act 1995 inserted additional section 329A in the Taxes Act 1988 headed "Annuities purchased for certain persons". This was replaced by ss329AA "Personal injury damages in the form of periodical payments" and 329AB "Compensation for personal injury under statutory or other schemes ICTA 1988 (now incorporated into sections 731-734 ITTIOA 2005) which provide that in a case where an agreement is made settling a claim or action for damages for personal injury and on agreement the damages are to consist wholly or partly of periodical payments and the person entitled to the payments is to receive them as the annuitant under one or more annuities purchased for him by the person against whom the claim was brought, or that person´s insurer, such agreement would be a qualifying agreement and where payments are made under such a qualifying agreement then they will not be treated as the annuitant´s income for any purposes of income tax and will be paid without deduction of tax.
In 1996 the scope of the exemption was widened to include damages in the form of regular payments awarded by the Court (now s731 ITTIOA 2005). While the 1995 changes allowed for damages in the form of an annuity payable to the victim to be exempted from tax if the annuity was purchased by the person responsible for the injury or that person´s insurers, where a personal injury claim was settled by an agreement there was a need to extend the same treatment to situations in which a third party may step in to discharge the damages, for instance the Motor Insurers´ Bureau in the case of a claim against an uninsured driver. The Damages Act 1996 affirms the power of a Court to award, by way of consent order, damages for personal injury not as a lump sum but as regular amounts over the life of the victim of the injury. Such payments will also be exempt from tax. The exemptions also apply where the damages are handled by trustees which will be necessary in some cases of injury or a child plaintiff (the trustees holding absolutely for the plaintiff during his lifetime).
Where an annuity continues after the death of the injured party HM Revenue & Customs make it clear that "the exemption from tax is personal to the victim of the injury and does not continue beyond his death. An annuity purchased as part of a structured settlement will often be payable for a guaranteed period even if the victim should die prematurely. Payments made after the death of the victim are chargeable to tax in the normal way and can be expected to represent a purchased life annuity with an exempt capital element".
It should also be noted that the Criminal Injuries Compensation Act 1995 similarly provided that a structured settlement of compensation payable by the Criminal Injuries Compensation Board should receive the same taxation treatment ie. such payments are also exempt from tax.
In conclusion, at present all the periodic payments made in respect of personal injuries are exempt from tax.
A structured settlement is a way of settling a personal injury liability claim - it is important to remember that it has nothing to do with settlements meaning trusts. Briefly, it refers to settling a liability for a personal injury claim in the form of periodic payments rather than a lump sum. The purpose of such a structure is to provide permanent income which would replace the traditional lump sum award in all sorts of negligence cases. A structured settlement may provide tax free benefits - see "Tax implications of structured settlements" - and removes uncertainty and worry about how long the lump sum will last.
In a structured settlement, the defendant in the personal injury claim, typically the general insurer, will cover the liability incurred by purchasing an annuity from a life assurance company, which is then held for the benefit of the injured person. With the payment structured over a period of time, the amount of annuity may be variable, the payments may be confined to the plaintiff´s lifetime or may last longer if there are dependants to support. A structured settlement may also be inflation-proofed. If the plaintiff´s expenses or requirements are likely to increase in the future then it may allow larger sums to be released.
In most cases the structure will be achieved in such a way as to best meet the plaintiff´s needs according to the circumstances of each case. It is likely, for example, to include a lump sum that may be needed to convert a private residence or purchase a car etc. However, once the structured settlement is in place then it would generally not be possible to unlock the capital and the plaintiff will only be entitled to the income.
In view of the fact that structured settlements are afforded favourable tax treatment the result is that the plaintiff may get a higher income from damages whilst the insurer also saves money.
The main benefits of the structured settlement for the plaintiff are that:-
- the plaintiff does not need to worry about the investment of the lump sum received as damages
- there is no need to be concerned about inflation which can be provided for in the structure
- there is no worry that the money will run out if the plaintiff lives longer than expected
- the plaintiff is protected from bad advice and from their own extravagance
- the funds are safely locked away providing peace of mind as well as, in practice, more cash.
Structured settlements in the UK
Although structured settlements originated in the USA and Canada, they became more popular in the UK following the agreement between the ABI and Inland Revenue (now HM Revenue & Customs) in July 1987 as to the income tax treatment of the periodic payments. Although this has since changed, the model agreements provided by the ABI following the agreement with the Inland Revenue and the guidance notes have been extremely useful and are still being used - see below.
The advantages of structured settlements for all parties concerned were highlighted in a judgement given by Justice Potter in the case of Kelly and Another v Dawes in July 1989. Here the award for the plaintiff in the form of a structured settlement turned out to be some £17,500 less than the sum that would have been payable for a conventional lump sum award. Of the total amount of £410,000, £110,000 was paid as a lump sum and £300,000 used to buy an annuity. The judge commented that while normally the plaintiff should receive the highest possible payment on offer, in this case the differential was justified on the grounds that the plaintiff would benefit from a greater yield over the years than she would have received from a traditional lump sum, invested in the normal way, in a mixture of gilts and equities, the income from which would have been taxable. It was stated that the insurer should be permitted "to participate in the benefits resulting from the reduced levels of taxation" provided that the interests of the plaintiff were fully protected. In a more recent settlement an insurer achieved an even greater discount. Holdsure Motor Policies at Lloyd´s was reported to have saved £100,000 on a settlement valued at £900,000.
Arranging a structure in practice
The judgement in Kelly was also significant in that the judge made several important recommendations as to how structured settlement cases should be dealt with before Court. This has since been superseded by the Practice Note (Structured Settlements: Court´s Approval) issued by the Deputy Chief Justice in February 1992. The Practice Note was intended to establish a practice to overcome the difficulties caused by a short period over which life offices keep open offers of annuities at a given price. In the past it has proved difficult for the plaintiff´s solicitors to do all that was necessary to obtain the Court´s approval within the period in which the annuity offer remained open. The Practice Note sets up procedures for speedy dealing by the Court with applications for approval in structured settlement cases. It also lists the types of document which need to be lodged to enable the Court to consider the structure and these include:-
- copies of originating process or pleadings;
- an opinion of counsel assessing the value of the claim on a conventional basis and, if practicable, the opinion of counsel on the structured settlement proposed;
- a report of forensic accountants setting out the advantages and disadvantages, if any, of the structure, bearing in mind the plaintiff´s life expectancy and the anticipated cost of future care;
- a draft of the proposed agreement as approved by the Inland Revenue (this is where the ABI Model drafts become useful - see below);
- sufficient material to satisfy the Court that enough capital is available free of the structure to meet anticipated future capital needs, particularly with reference to accommodation and transport needs;
- proof that the structure involves secure arrangements backed by responsible insurers (it is understood that as long as one of the well known tariff companies or one of the syndicates operating under the Rules and protection of the Lloyd´s market is used, there should be no problem in satisfying the Court of the security of the arrangements);
- in cases where the plaintiff is under mental disability the consent of the Court of Protection;
- evidence of other assets available to the plaintiff.
In practice, a number of life offices specialise in this type of business and the plaintiff will need the advice of a solicitor and financial adviser specialising in this type of business.
The role of the financial adviser in arranging a structure
As indicated above, the starting point for consideration of a structured settlement will always be the counsel´s opinion assessing the value of the claim and its constituent elements on a conventional basis and the appropriate lump sum figure (for settlement on that basis). Careful consideration of the claimant´s life expectancy, based on medical opinions, would normally need to be obtained and taken into account.
In most, if not all, personal injuries cases there will usually be a need for a capital sum, or at least a cash fund, to meet immediate capital expenditure such as a new house or alteration to the existing property in order that it can be adapted to meet the claimant´s revised needs. In normal circumstances the remainder of the lump sum settlement would then be invested on the plaintiff´s behalf so to enable him or her to live off the interest/income generated as well as drawing on the capital sum invested so that in theory at the end of his or her life the lump sum is fully exhausted. Obviously, unless an investment is made which links the future payments to the life of the claimant, it would not be possible to precisely calculate how much capital to draw as there are too many unknowns and investment variables. If the claimant were to directly himself or herself invest in an annuity this would involve some of each payment being subject to income tax and therefore would not be tax efficient.
The general philosophy behind structured settlements is that once the claimant has been provided with a sum to meet immediate capital expenditure and also has a reasonable contingency cash fund, then the balance of the lump sum is normally used as a means to provide an annual income. Under a structured settlement such income will be provided by the defendant insurance company purchasing an annuity from a life office that would guarantee to achieve the certainty of the cash stream for as long as the claimant lives.
The financial adviser would normally be required to provide a report as to the fiscal and investment advantages to the claimant of the structured settlement proposed, with particular regard to the life expectancy of the claimant and the likely future costs of care. The purpose of the report would be to provide arguments in favour of a structured settlement for the particular claimant based on his or her life expectancy. Clearly to achieve this the financial adviser will have to be in possession of all the relevant medical information as well as the counsel´s opinion as to the appropriate sum that should be awarded on a conventional basis. In practice a comparison should be made between the investment of the lump sum (i.e., the sum awarded on a conventional basis) in the traditional manner with investment in a structure, i.e. via an annuity. For example, the position could be shown assuming that the lump sum were invested in the traditional manner with 70% invested in equities and 30% invested in gilts, this being the usual portfolio adopted by the Court of Protection. Obviously assumptions would have to be made as to annual income from gilts and equities, personal allowances and personal income tax rates, professional costs, dealing costs etc. A comparative table for investment in gilts only could also be included. The agreed level of annual sum that would be required for the claimant would be made up from income from the investments and supplemented from the capital sum, resulting in the capital sum being exhausted after a defined number of years, depending on mortality predictions.
Finally, comparison would be made with the net income available for the claimant based on a structured settlement that is based wholly or partly on an annuity. Obviously a number of annuity quotations will be required based on the health of the individual concerned. Generally speaking in personal injury cases, the life expectancy of the claimant would be reduced due to his or her injuries. In such a case, the life office should be able to agree a higher level of annuity than for an individual with a normal life expectancy. There are still comparatively few offices that specialise in underwriting impaired lives, but a number of such offices exist. Clearly, to provide a quotation, the life office would need more information than in the usual case, i.e. not just the date of birth and sex of the claimant but also up-to-date medical reports, size and frequency of the periodic payments required, level of inflation protection required and size and incidence of any future regular lump sum payments. Special application forms would be provided for this purpose.
Model agreements and HM Revenue & Customs approval
To ensure the desired tax treatment of a structured settlement is achieved, the agreement needs to be approved by the HM Revenue & Customs. Where the model agreement which has already been agreed by the ABI with the HM Revenue & Customs is used, the procedure is simplified. The ABI standard form provides four alternative forms of schedules to cater for the four main kinds of periodic payment arrangements likely to be required. These include basic terms, indexed terms, terms for life and indexed terms for life. Draft model agreements would normally be provided by the life office underwriting the annuity.
Further developments
In 1992 the Law Commission published a consultation paper on structured settlements and interim provisional damages, and the Commission reported on their findings in 1994. The Commission made several recommendations, in particular, on the rationalisation of the tax regime governing structured settlements. These have now been implemented.
However, generally speaking, the advantages of structured settlements notwithstanding, their popularity gradually reduced during the early 1990´s. An important factor in the decline of the popularity was the gradual reduction in interest rates and the corresponding increase in the cost of purchased life annuities. It is understandable that if a structure which cannot be "undone" is entered at the time of low interest rates, this may well disadvantage the claimant if in the future interest rates rise considerably. In the last couple of years though interest rates and inflation have been stable and as a result more plaintiffs and their lawyers have again started considering structured settlements, particularly following the exemption from tax in respect of annuity payments under a structure. Indeed, in many cases, particularly in respect of claimants who are under 18 years of age, mental patients and others requiring long-term care, the benefits of the certainty of a structure, the reduction in the need for investment management and the reduced risk of the funds being spent too early through unwise spending still outweigh the fixed nature of the arrangement and the low interest rates. However, the impact of future changes in interest rates needs to be considered by all parties, and in particular the financial adviser advising on the arrangement. The impact of future changes can be lessened by ensuring that an adequate contingency fund is kept outside the structure which is invested conventionally, in particular taking advantage of any tax-favoured investment vehicles. This will ensure that a degree of flexibility is retained. It is also important to ensure that an appropriate escalation rate is incorporated in the structured annuity.
The changes in taxation of structured settlements should also encourage the defendant insurers to opt for a structure, bearing in mind that the ongoing burdens of administration and the adverse cash flows arising because of the taxation in the past no longer apply. Of course this is also likely to mean that the traditional "discount to structure" previously sought by defendant insurers (to compensate for the burden of the ongoing administration of receiving in and paying out the annuity) will no longer be appropriate. There is also evidence that HM Revenue & Customs is more relaxed in considering structures for approval. For example, a practitioner may agree with the Revenue a standard settlement agreement which can be used in a number of cases with HM Revenue & Customs assurance that it will be acceptable to them.
Impact of Courts Act 2003
The Courts Act 2003 generally took effect for claims from 1 April 2004 although certain sections come into force through statutory instruments as set out in section 110. Unless stated otherwise the legislation extends only to England and Wales. Accompanying Explanatory Notes have been published. Judges have been given new powers under section 100 to unilaterally impose "periodic payment" awards on parties who have been at fault in an accident. Until now lump sum awards have been more usual. Where the parties have been insured e.g. motorists, the general insurance company (and / or the reinsurance company) will pay out.
Not all lawyers are happy with the new system. The problems were discussed in a House of Commons debate by Andrew Dismore M.P., a member of the Association of Personal Injury Lawyers. He said:
"It is important to point out that periodical payments have both advantages and disadvantages. Claimants would not have to fear running out of compensation, as they would if damages were ordered as a lump sum, but periodical payments create a lifetime relationship between the claimant and the defendant which the claimant may find extremely difficult. For that reason, the merits of imposing periodical payments must be assessed on an individual case-by-case basis, and I am concerned that, under clause 100, awards for future pecuniary loss - the lion´s share of any award - can be made irrespective of whether the claimant consents. That is particularly important if periodical payments are being linked to the retail prices index in respect of inflation because it would prevent the claimant from looking for a better rate of return. Under clause 100, it is possible for a court to order a periodical payment without the consent of either party, let alone just that of the claimant. That puts the claimant completely at the mercy of the court´s discretion and the defendant´s arguments. I believe that that is unfair because only the claimant is able to say how an award can best be used to place him in the position that he was in before the injury."
If the court decides that it is more appropriate to pay care costs to an accident victim on an annual basis this will mean that the burden for annual payment awards will fall on general insurers and reinsurers - the former may have less experience of taking on mortality risk (a major factor in periodic payment awards) than life insurers. As claimants will be able to return to court later to have their payments reviewed (in practice, increased), reinsurers will be exposed to a greater risk - this could run for many decades e.g. in the case of a child traffic victim who lives beyond one´s three score and ten years of life.
Although reinsurers could offer a lump sum to purchase an annuity from a life insurer, thereby commuting their risk back to the general insurer, concern has been expressed that annuities offer less value than they did some time ago. It has been reported in the press that the Financial Services Authority is aware of this problem and is considering whether to allow general insurers to take on mortality risk.
Historical background
Following the recommendations of the Law Commission on the tax treatment of structured settlements, the taxation of structured settlements has been considerably simplified in 1995 and 1996. However, it may be relevant, by way of background, to outline the previous tax treatment, particularly as it had a considerable bearing on the development of structures in the UK.
In a structured settlement three parties would be involved, the general (liability) insurer, the life office and the plaintiff (the injured party). As far as the general insurer was concerned, the insurer would normally treat the premium for the annuity as reinsurance of the liability to make the payments and such treatment would be approved by the ABI and DTI for regulatory purposes, (see reference to model agreements issued by the ABI mentioned in "Structured settlements in practice"). The reinsurance premium would be a trading expense for tax purposes. Although the general insurer would have been liable to tax on the receipt of the annuity, it would also be able to deduct an amount equal to the cost of the instalment payment and therefore the two payments would be tax neutral. The general insurer therefore suffered no tax costs.
As far as the life office underwriting the annuity was concerned, an argument would generally be put forward that since the payment was not pure income profit in the hands of the payee (general insurer) then there was no need for the life office to deduct tax on paying the annuity to the general insurer. Even where it was argued that the annuity should have been paid net, the general insurer could reclaim the tax at the end of the financial year, although this clearly would have created a cash flow problem for the general insurer. Also it would only allow for a tax reclaim where the general insurer had a tax liability in the first place. As far as the payment to the plaintiff was concerned, although strictly any payment should have been made from the life assurer to the defendant´s insurers and then to the plaintiff, in order to reduce administration the general insurer would normally arrange for the life office to act as his paying agent although a problem could arise where the general insurer and the life assurer were both separate departments of the same company on the basis that it is impossible for a person to contract with himself. In short, the administration of structured settlements provided a considerable burden on both insurance companies.
The payments received by the plaintiff were not subject to tax on the basis they were capital payments.
Current tax treatment
In 1995 the Government acted to remove tax on annuities received for injury damages. The Finance Act 1995 inserted additional section 329A in the Taxes Act 1988 headed "Annuities purchased for certain persons". This was replaced by ss329AA "Personal injury damages in the form of periodical payments" and 329AB "Compensation for personal injury under statutory or other schemes ICTA 1988 (now incorporated into sections 731-734 ITTIOA 2005) which provide that in a case where an agreement is made settling a claim or action for damages for personal injury and on agreement the damages are to consist wholly or partly of periodical payments and the person entitled to the payments is to receive them as the annuitant under one or more annuities purchased for him by the person against whom the claim was brought, or that person´s insurer, such agreement would be a qualifying agreement and where payments are made under such a qualifying agreement then they will not be treated as the annuitant´s income for any purposes of income tax and will be paid without deduction of tax.
In 1996 the scope of the exemption was widened to include damages in the form of regular payments awarded by the Court (now s731 ITTIOA 2005). While the 1995 changes allowed for damages in the form of an annuity payable to the victim to be exempted from tax if the annuity was purchased by the person responsible for the injury or that person´s insurers, where a personal injury claim was settled by an agreement there was a need to extend the same treatment to situations in which a third party may step in to discharge the damages, for instance the Motor Insurers´ Bureau in the case of a claim against an uninsured driver. The Damages Act 1996 affirms the power of a Court to award, by way of consent order, damages for personal injury not as a lump sum but as regular amounts over the life of the victim of the injury. Such payments will also be exempt from tax. The exemptions also apply where the damages are handled by trustees which will be necessary in some cases of injury or a child plaintiff (the trustees holding absolutely for the plaintiff during his lifetime).
Where an annuity continues after the death of the injured party HM Revenue & Customs make it clear that "the exemption from tax is personal to the victim of the injury and does not continue beyond his death. An annuity purchased as part of a structured settlement will often be payable for a guaranteed period even if the victim should die prematurely. Payments made after the death of the victim are chargeable to tax in the normal way and can be expected to represent a purchased life annuity with an exempt capital element".
It should also be noted that the Criminal Injuries Compensation Act 1995 similarly provided that a structured settlement of compensation payable by the Criminal Injuries Compensation Board should receive the same taxation treatment ie. such payments are also exempt from tax.
In conclusion, at present all the periodic payments made in respect of personal injuries are exempt from tax.
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