Key Takeaways
- Shortfall cover addresses gaps in existing insurance coverage, protecting the insured against specific risks.
- Consumers use shortfall cover to ensure full replacement value for assets like totaled cars.
- Insurance companies purchase shortfall covers as a form of facultative reinsurance in the market.
- Shortfall covers enable policyholders to adjust coverage based on changing circumstances and risk tolerance.
- Facultative reinsurance covers specific risks excluded from broader treaty reinsurance agreements.
What Is a Shortfall Cover?
Shortfall cover is insurance designed to fill a specific gap in existing coverage, used by consumers and in commercial or reinsurance markets. It strengthens protection from a primary policy, for example, covering the difference between a totaled car’s book value and its replacement value, or supplementing an insurer’s own coverage through reinsurance. As financial needs shift, shortfall cover can be tailored to match new risks.
Understanding How Shortfall Coverage Functions
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.
Practical Illustration: Shortfall Cover in Action
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.
The Botton Line
Shortfall cover fills a defined gap in existing insurance, adding protection where a primary policy leaves exposure. It can be used by individual consumers or by insurers, with company use resembling facultative reinsurance because it targets a specific risk.
