What is 'Shortfall Cover'
A reinsurance agreement used to temporarily reduce gaps in an insurer’s treaty reinsurance coverage. A shortfall cover is a type of facultative reinsurance, and is designed to protect the insurer if a reinsurance contract is found to have been structured insufficiently.
BREAKING DOWN 'Shortfall Cover'
When an insurance company underwrites a new policy, it is accepting the risk that a claim will be made against the policy, and in return receives a premium from the insured. The insurer can reduce its exposure to the risks created from its underwriting activities and strengthen its balance sheet by entering into a reinsurance agreement. Reinsurance shifts some or all of a risk from an insurer to a reinsurer which serves as an insurance to insurance companies. In exchange for taking on the insurer’s risk the reinsurer receives a portion of the premiums.
There are two types of reinsurance: facultative and treaty. In treaty reinsurance, the insurer cedes a book of business, such as a particular line of risk, to a reinsurer. The reinsurer automatically accepts all of these risks rather than negotiating which risk it will accept. Facultative reinsurance agreements do not require automatic acceptance by a reinsurer, and are instead used to cover risks that might be excluded from reinsurance treaties. A shortfall cover is a type of facultative reinsurance.
Shortfall cover is used by insurers that have an existing treaty reinsurance contract, but who determine that the existing contract leaves them exposed to more losses than expected. For example, a casualty insurer wants to be able to underwrite $2,000,000 in policies, but only retain $500,000 in losses. It enters into a treaty reinsurance contract to cover the remaining $1,500,000. Upon further examination the insurer determines that the setup of the treaty left a coverage gap of $50,000. The insurer enters into a shortfall cover contract for the $50,000 gap, allowing it to remain at its $500,000 retention goal. This is a short-term fix, and the insurer would likely adjust the treaty reinsurance contract terms to remove the coverage gap when it is time to renew the contract.