What is Risk Shifting?
Risk shifting refers to transferring the risk by a party to another party and is usually done in the financial sector, wherein ownership of risk is transferred by the organization to another organization in exchange for fees. It also happens in those companies which are overly burdened with debt wherein the stake of equity shareholders declines, and the debtholders increases.
- First is the standard type of risk shifting, wherein a party shifts the risk to another party instead of fees.
- Second is the type of risk-shifting undertaken by financially stressed companies that are burdened with debt and whose shareholders equityShareholders EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period. reduces.
Forms of Risk Shifting
- Outsourcing – By outsourcing, one party can transfer the risk covered in a particular project to some other party. Companies tend to outsource those functions in which they lack and instead concentrate on the functions that are their strengths. Such functions are outsourced to some outside parties capable of performing the same, and along with that, risks also get shifted.
- Derivative – As we all know, derivativeDerivativeDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. refers to a financial instrument that derives its value from an underlying asset. It is also a form of risk-sharing wherein one party shifts the underlying risk to another party. There are different types of derivativesTypes Of DerivativesA derivative is a financial instrument whose structure of payoff is derived from the value of the underlying assets. The three types of derivatives are forward contract, futures contract, and options., such as futures, forwards, and optionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date..
Risk Shifting Alternatives
#1 – Risk Sharing
Risks are sharing deals with risk on a positive side that represents opportunities available with the company. In risk-sharing, the companies who are encountered by favorable risk contracts with other parties to share the risks so that due to the combined energies of all the parties, the probability of the positive risk increases.
The company contracts to share the benefits that are to accrue from the risk along with the loss that may arise, with such other parties. For example, a company may contract with other parties to pool resources to place a bid for a high amount of bid contract.
#2 – Risk Transfer
The strategy of risk transfer involves intentionally transferring the risk to another party. A classic example of the same is an insurance contract, wherein the risk of loss is transferred deliberately by the policyholder to the insurer.
Risk Shifting vs. Risk Sharing
- Risk shifting means a strategy wherein risk is transferred by one party in favor of some other party. The responsibility related to the risk may either be transferred fully or maybe partially. It is done to ensure that the third party will take care of the consequences in case the risk materializes.
- On the contrary, risk-sharing refers to a strategy in which positive risks, known as opportunities, are shared upon with other parties to increase the chances of benefits be accruing to the parties when the risk materializes. Risk sharing is not concerned with adverse risk, and only positive risks can be shared.
- The burden of bearing possible significant loss by the company is reduced as the company transfers the same to another party.
- The companies can focus on their key areas and strengths by shifting the risk relating to the functions of another party.
- When positive risks are shared by involving other parties, it brings the advantage of synergies with all parties making contributions towards making the risk happen.
- There is a cost associated with the risk-shifting which the company needs to bear in terms of expense.
- When you transfer the risks associated with any function or asset, you might also lose control.
- When risks are shared, the company will also be compelled to share its expertise with other parties.
Risk shifting strategy helps organizations transfer the burden of risks to other parties, either as a whole or in part. The organizations incur expenses in the form of fees to shift the risks. It helps the company focus on major vital areas and relax about possible risks that may happen.
This has been a guide to What is Risk Shifting & its Definition. Here we discuss the types of risk shifting and its forms along with its advantages and disadvantages. You can learn more about from the following articles –