What is 'Shortfall Cover'
A shortfall cover usually refers to a commercial reinsurance agreement used to temporarily reduce gaps in an insurer’s reinsurance coverage. A shortfall cover is a type of facultative reinsurance designed to protect the insurer if a reinsurance contract is structured insufficiently to cover expected losses.
The term also refers to consumer or individual insurance that covers a shortfall in coverage, such as when a car is totaled in an accident and the primary insurance only covers the book value of the car, as opposed to its replacement value.
BREAKING DOWN 'Shortfall Cover'
Insurance companies use shortfall covers when reinsuring policies. When an insurance company underwrites a new policy, it is accepting the risk for claims 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, also known as portfolio 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 Covers Fill in the Gap
A shortfall cover is used by an insurer with an existing treaty or portfolio reinsurance contract, but determines the existing contract leaves it 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 or portfolio 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.