A structured settlement factoring company allows an individual who is receiving structured settlement payments to cash out in exchange for a lump sum payment. In exchange for this service, the company collects a fee so as to earn a return on its capital. The company makes a determination as to how secure the future cash flows are, the time value of money and then provides the cash settlement to the recipient, discounting for its perceived level of risk and time.
Under a structured settlement annuity, the individual receiving the settlement has been awarded a cash settlement amount that is to be paid in installments over a set period of time at set intervals. For example, he or she may receive $1000 every month for a period of five years, for a total of $60,000. Cashing out structured settlement payments takes this future value and discounts it into a present value amount. The amount will be less than the future value, and the discount rate that the company will use will be based on the perceived risk of the future payments and the amount of profit that the company needs to earn. Following on the original example, the company may determine that the current payout it is worth $40,000. The difference between the payout amount and the future value, $20000 in this case, is the return earned by the company or the investor that is purchasing the payment rights. This practice is often referred to as factoring because it is the discount rate or factor that determines the profitability of the transaction to the company or investor.
There are several advantages for each party to the transaction, both the individual and the company. The individual benefits because he or she no longer has to wait for the payout period. Any risk associated with the future payments, the solvency of the annuity company for example, is transferred to the investor. The money may still be invested and a return earned on the money. This is an important consideration because the real cost of the transaction is the discount rate minus the risk-free rate - the amount the individual can earn with no risk, such as in U.S. treasuries. If the individual needs the cash immediately or believes that he or she can earn a more favorable rate in other investments, the transaction benefits the individual.
From the perspective of the company, the discount rate charged on this type of transaction is usually sufficiently high to lock in a very favorable rate of return for the company, even on a risk-adjusted basis. The company or investor can earn outsized annual returns because it capitalizes on two advantages. First, it has the resources to thoroughly understand the risks associated with the future payments. Secondly, the company diversifies its risks sufficiently so that should any given investment fail, it can still be successful overall. The company will figure a certain failure rate into its investment model that ensures the success of the overall program. When this type of transaction is conducted properly, each party will benefit.