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A structured settlement is a type of financial settlement usually awarded to the victim of a personal injury accident. For example, assume a jury awards the victim damages in the sum of $4 million. Depending on the circumstances, the damages may be awarded as a structured settlement rather than as a lump sum.

The settlement is called "structured" because the initial award ($4,000,000 in this example) is divided up into equal payments that are paid to the victim at precisely defined time intervals.

If the settlement is structured to pay the victim $100,000 a year, the period of the settlement is 40 years. Therefore, the victim would receive a payment of $100,000 each year for the next 40 years. The total amount of cash received by the victim would be 40 years x $100,000 per year, which equals the original award amount of $4,000,000.

Many people think the paying party has to put $4 million into a bank account set up for the victim. They also think that $100,000 will be withdrawn from that bank account each year and paid to the victim. At the end of 40 years, the victim's special account would be empty and the victim would have received the full amount of the award.

That's one way of setting up a structured settlement. From the point of view of the paying party, there is a less costly financial tool for setting up a structured settlement. That tool is called an annuity.

An annuity is a large sum of money set up to pay the recipient a fixed amount of money at regularly-defined time intervals. But wait, you might say. That's the same as putting $4 million in the bank account and paying it out over the 40-year period!

That's almost true. The power of an annuity comes from the fact that it can be set up by depositing a much lesser amount into an interest-bearing or an interest-earning account.

Before continuing, you need to remember these important points. The court ordered the paying party to pay the victim $100,000 a year for 40 years. The paying party is not required to submit a lump sum of $4 million to be paid over the 40-year period. As long as the paying party pays the victim the specified amount at the specified time intervals, they are in full compliance with the law.

U.S. law specifies that annuities can only be set up by independent, neutral third-party insurance companies.

To set up the structured settlement, the paying party does have to have to submit a lump sum to the insurance company to be put into an interest earning account. But the power of annuities allows the paying party submit a lump sum that is much smaller than the total reward.

For example, if the structured settlement account consistently earns 5% interest per year, the paying party only needs to invest a one-time sum of $2,000,000. Each year, the $2 million would earn 5% interest. At the end of each year, the account total would be $2,100,000. The extra $100,000 would be paid to the victim, leaving the original $2 million in the account.

If the paying party can find an account that pays 10% interest, it would only have to invest a one-time sum of $1,000,000. At 10% annual interest, a sum of $1 million makes $100,000 per year, which would be paid to the victim.

At 15% interest, the paying party would have a one-time investment of $666,667 in order to pay the victim the required $100,000 per year.

As you can see, the more interest a structured settlement account earns, the smaller the sum the paying party has to invest in order to create the annual payments to the victim. The above examples use simple interest to avoid the complexities of real-world finance. However, the principle of the annuity works the same.

If it seems that the paying party is getting off easy, consider these points. First, the paying party is being deprived of a large chunk of money for 40 years. Second, they are complying with the terms of the structured settlement. And third, if your company was required to make these payments, wouldn't you do it in the most economical way possible?

The resource below has more free information about how structured settlements work.