Shortfall Cover

What Is a Shortfall Cover?

In the insurance industry, "shortfall cover" refers to a type of reinsurance arrangement in which one party agrees to cover a specific gap in the existing insurance coverage of the other party. 

The term can also refer to a type of consumer or individual insurance that covers a shortfall in coverage. For example, when a car is totaled in an accident, the owner's car insurance may only cover the car's book value as opposed to its replacement value. To protect against this risk, the owner might purchase shortfall coverage to ensure they receive the car's full replacement value in that scenario.

How Shortfall Covers Work

Shortfall covers are a useful way to manage risk through insurance. Realistically, any insurance contract is likely to include some gaps, since the cost of insuring against all possible risks can quickly become prohibitively expensive. Usually, insurance customers decide what gaps to tolerate based on their individual risk tolerance, the perceived risk of those events occurring, and the likely cost if those events do occur.

As circumstances change, however, a policyholder might change their opinion about whether a particular gap in coverage is worth tolerating. For instance, an individual who recently upgraded their car and increased its value might decide that they are no longer content with only receiving the book value of their vehicle if it gets destroyed. In that scenario, that individual might want to purchase shortfall coverage, either from their existing car insurance provider or from a new insurer. The same principle applies to commercial insurance customers.

In fact, even insurance companies themselves can purchase shortfall covers by using the reinsurance market. In this market, there are two basic types of insurance coverage: treaty reinsurance and facultative insurance.

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, on the other hand, do not require automatic acceptance by a reinsurer. Instead, they simply cover specific risks that might be excluded from reinsurance treaties. A shortfall cover is thus a type of facultative reinsurance.

Real-World Example of a Shortfall Cover

Michael is the owner of an insurance company specializing in condominium insurance. He has become very adept at underwriting common risks relating to his market, such as theft and water damage. Recently, however, he has noticed a disturbing increase in canine-related liabilities. Michael is unsure about what is driving this trend, and if left unchecked, it could undermine the profitability of his home insurance contracts.

To mitigate against this risk, Michael uses the reinsurance market to purchase shortfall coverage. To do so, he finds another insurance company that agrees to sell him facultative insurance to cover any losses associated with canine liabilities. In exchange, Michael agrees to pay his reinsurer a percentage of the premiums he collects on his condominium insurance.