Credit: Structured settlements are usually associated with compensation to injured plaintiffs following a legal hearing. They are more than just a mere compensation package, however. One of their main characteristics is they are meant to cover any medical expenses the injured plaintiff may incur in relation to the injuries suffered.
Another characteristic is that if the plaintiff is no longer able to engage in gainful employment due to the injuries suffered, the dependents would need another source of income to rely on. As such, structured settlements are reasonably compared to a form of early retirement benefits. Awards following lawsuits are not the only types of compensation associated with structured settlements, however.
Lottery winners often find themselves needing the services of a structured settlement specialist. Typically, a good number of lottery winners end up poorer after a few years than they were before receiving the huge payment.
According to SettlementSpecialist.com, "approximately 80% of lottery winners are in a worse financial situation after five years than they were before the win." As such, it would be better for them to sell the lump sum to a third party in exchange for annuity payments over a given time. Therefore, there are more ways in which investors can get involved in the structured payments market, but the primary avenue is via lawsuit settlements.
How do you invest in structured settlements?
In a lawsuit, the plaintiff is normally guaranteed to receive the compensation awarded by the judge and, as mentioned, these payments can be made over an extended period. In fact, some of them are lifetime payments, which means the insurance service provider of the defendant takes the risk.
To guarantee these payments, the insurance company finds an investor who is willing to reinsure the insurance company in exchange for structured annuity payments. This means that the risk is transferred to or shared with a third party, who in this case becomes the investor.
Buffett likes structured annuities
This is what Warren Buffett ( Trades , Portfolio )'s Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) did in 2013 when it offered to reinsure Cigna Corp.'s ( CI ) Guaranteed Minimum Death Benefits and Guaranteed Minimum Income Benefits business, up to a tune of $4 billion.
In return, Cigna paid Berkshire Hathaway $2.2 billion. For Berkshire Hathaway, Cigna was just another addition to a list of reinsurance deals the company has sealed since 2010, including American International Group ( AIG ), UK's Lloyds ( LYG ) and Switzerland's Swiss Re (XSWX:SREN), among others.
In fact, reports suggest that in 2012, Berkshire Hathaway was already one of the biggest reinsurers of structured settlements, controlling at least 15% of the market through its insurance company.
This has prompted many to wonder why one of the smartest investors would opt to invest in what, according to events of the 2008-2009 financial crisis, could easily lead to catastrophic losses. When there is a financial crisis, insurance companies tend to suffer. For instance, consider the case of AIG.
What are the risks?
Holding the responsibility to pay certain amounts to policyholders regardless of the market situation can be catastrophic. This is the same reason why insurance companies reinsure guaranteed benefits in a bid to reduce exposure.
Therefore, it is clear that structured settlements have one major risk exposure, time. This opens the doors for more risks tied to liquidity, insolvency and economic crises. The longer the period, the higher the risk of a potential financial crisis. But then again, financial crises appear in cycles. This means that unless you are looking to take up positions that guarantee payments to death benefits claims, you could identify the best possible times to invest in structured settlements.
And just like Buffett's Berkshire Hathaway, a few years after a financial crisis sounds like a good time. Structured settlements are illiquid, which means that once your funds are tied to the product for the entire period, it is hard to retrieve them unless there are some agreed upon annuity payments along the way. The other option is to find a buyer, which again is not easy in an illiquid market.
As long as the insurance company remains financially healthy, structured settlements are considered to be low-risk, fixed-income products, which tend to pay unusually high rates of return compared to their counterparts. Any annuity payments offered are likely to be made irregular and the amounts also tend to vary.
Conclusion
In summary, while structured settlements are largely considered to be a minimal risk way of investing for the mere fact of being fixed income investments, liquidity is a key concern, especially when investing indefinitely.
Therefore, investors would be better off adding just a small fraction to their portfolio to balance their investments in high-risk assets.
Disclosure: I have no position in stocks mentioned in this article.
Start afree 7-day trial of Premium Membershipto GuruFocus.
This article first appeared on GuruFocus .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
