While looking at ways to diversify your portfolio you may have come across brokers recommending you invest in structured settlements. Structured settlements can be controversial because people associate them with aggressive ads urging people to cash them in. But what are they exactly?
This article explains what structured settlements are, how they are traded, why you might want to consider investing in one and what to be careful about.
Disclaimer: This article is for information only. You should always speak to a financial advisor before making decisions about making investments.
What are Structured Settlements and how are they Traded?
Structured settlements are a type of financial arrangement agreed upon following a successful personal injury claim or similar tort lawsuit. It guarantees the plaintiff a series of payments over a defined term. Normally, the arrangement will be managed by the defendant’s insurance company.
Each structured settlement is unique due to the differing circumstances of plaintiffs. For example, there may be an initial lump sum, a further period of smaller payments to cover ongoing medical expenses followed by larger payments after a number of years to support the plaintiff through retirement.
To mitigate the risk, some insurance companies enter into reinsurance deals with reputable insurers (Warren Buffet’s Berkshire Hathaway is a prolific reinsurer of structured settlements). The reinsurer then takes responsibility for fulfilling all or part of the structured settlement contract in return for a share of the premiums.
An investment opportunity arises if the plaintiff decides they need access to a lump sum in lieu of the scheduled payments. The investor (or investors) stumps up the cash and the insurance company fulfils the scheduled payments to the investor instead of the original plaintiff (minus any broker fees).
The Benefits of Investing in Structured Settlements
Depending on the discount agreed with the seller, structured settlements generally offer a high rate of return, usually within the four to seven per cent range although some can come in even higher. With the current economical climate offering limited high yield opportunities, this is a strong reason why investors are initially drawn to structured settlements.
Another plus point with many structured settlements investments is that they tend to be held by highly rated and regulated insurance companies. This makes the risk profile very attractive too with investors feeling that their future payouts are in safe hands. Since the settlement payments are decided by court-ordered contractual agreements rather than projections, investors have the peace of mind of knowing what they are going to receive and when.
Unlike a life contingent annuity, structured settlements are also independent of the plaintiff surviving the term of the agreement. They are also usually tax-exempt providing all conditions of the investment comply with state and federal laws. Some types of structured settlement are taxable but usually at a reduced rate. It is advisable to obtain qualified tax advice prior to investing in this market.
It seems that what we are looking at here is a high return, low risk investment opportunity which, as many investors know, is rarely a valid combination. So what is the catch? Why are investors seemingly rewarded so handsomely for a virtually guaranteed return.
The truth is that structured settlements are subject to different types of risk when compared to, for example, investing in stocks and shares.
The Illiquidity Issue and Other Concerns
When people think about the risk of an investment, it is usually in terms of equity risk. Since the performance of shares is contingent on supply and demand, their market price is unpredictable and can lead to losses as well as gains.
The main source of risk with structured settlement investments is liquidity risk. Whereas stocks and shares can provide regular dividend payments and can be easily sold off, investors in structured settlements are dependent on the details of the payment schedule and have to manage that illiquidity accordingly. Illiquidity goes hand-in-hand with another type of risk: horizon risk. This is when an investor is forced by unforeseen financial circumstances (e.g. an unexpected job loss or emergency need for capital) to sell long-term holdings. Even if they are able to sell their investment before the end of the term it is usually only at a heavily discounted price.
Although the insurers which back structured settlements are usually among the most reputable and well-regulated, investors should do their due diligence. They should make sure that the company itself is in good standing and has a strong credit rating. Nevertheless, they should understand that it could still suffer losses during extreme market conditions. The AIG bailout is proof that even the biggest insurers can fail and so there is always the risk that investors will lose their money. This type of risk is termed credit risk.
Then there is the issue of inflation risk. Even structured settlements which are linked to inflation are rarely able to keep pace with inflation. This erodes the value of the investment over time, particularly if payments are extended over a very long term.
If you have invested a large proportion of your capital in any one asset type – including structured settlements – you are also exposing yourself to concentration risk.
So when people tell you that structured settlements are a risk-free investment, that is not strictly accurate as it all depends on what type of risk you are talking about.
Investing in structured settlements is a legitimate way to diversify your portfolio. Offering relatively high yields and the promise of secure payments spread over a long term, structured settlements can balance the modest returns from stocks and shares.
However, no investments are risk-free. Structured settlements are highly illiquid which can be a problem if you need to access the money quickly. In addition, no insurance companies are immune from financial crises. As a result, many investors choose to minimize their exposure by only investing a very small portion of their portfolio in structured settlements.
As with all investments, it is important that you build a portfolio that suits your own circumstances and with a risk profile that you are happy with.
Kathy Manson is a Finance Coach and Blogger. Currently, she is working on structured settlement payments at http://www.catalinastructuredfunding.com. She is very proactive and aware about each and every update of financial changes in the industry.