Risk Shifting

Updated on January 5, 2024
Article byNiti Gupta
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

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 the organization transfers ownership of risk 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.

Risk Shifting

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Key Takeaways

  • Risk shifting is moving risk from one party to another. It is most common in the financial industry when one organization transfers risk ownership to another in return for payments. It also occurs in firms still loaded with debt when equity owners’ stake diminishes, and the debtholders’ stake grows.
  • The most common risk-shifting occurs when one party transfers risk to another in exchange for money. The second type of risk-shifting is practiced by financially distressed firms that are heavily in debt and have declining shareholder equity.
  • Outsourcing and derivatives are forms of risk shifting.

Types

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Forms of Risk Shifting

Risk Shifting Forms

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  1. Outsourcing – By outsourcing, one party can transfer the riskTransfer The RiskRisk transfer is a risk-management mechanism that involves the transfer of future risks from one person to another. One of the most common examples of risk management is the purchase of insurance, which transfers an individual's or a company's risk to a third party (insurance company).read more covered in a particular project to another party. Companies tend to outsource those 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 risks also get shifted.
  2. Derivative – As we all know, a 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. read more refers to a financial instrumentFinancial InstrumentFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more 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.read more, 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.read more.

Risk Shifting Alternatives

#1 – Risk Sharing

Risks are sharing deals with risk on a positive side, representing opportunities available to the company. In risk-sharing, the companies encountering 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 policyholder deliberately transfers the risk of loss 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. It is done to ensure that the third party will take care of the consequences if the risk materializes. The responsibility related to the risk may either be transferred fully or partially.
  • On the contrary, risk-sharing refers to a strategy in which positive risks, known as opportunities, are shared with other parties to increase the chances of benefits accruing to the parties when the risk materializes. Risk sharing is not concerned with adverse risks; only positive risks can be shared.

Advantages

  • 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 contributing to making the risk happen

Disadvantages

  • There is a cost associated with the risk-shifting, which the company needs to bear in terms of expense.
  • You might also lose control when transferring the risks associated with any function or asset.
  • When risks are shared, the company will also be compelled to share its expertise with other parties.

Conclusion

Risk shifting strategy helps organizations transfer the burden of risks to other parties, either as a whole or in part. It helps the company focus on major vital areas and relax about possible risks that may happen. The organizations incur expenses in the form of fees to shift the risks.

Frequently Asked Questions (FAQs)

What does risk shifting imply?

Risk-shifting indicates a divergence between equity and debt prices when payout constraints alter.

What is the problem of risk shifting?

The main asset substitution issue is risk-shifting, which occurs when managers make risky investment decisions that maximize equity shareholder wealth at the expense of debtholders’ interests. The asset substitution dilemma underlines the tensions between investors and creditors.

What is the difference between risk transfer and risk shifting?

The risk can be transferred entirely or partially, and it assures that the third party will deal with the risk when it arises. At the same time, risk shifting is typical in the financial sector, where an organization turns risk responsibility to another party for a price.

How does risk shifting impact overall risk management strategy?

Risk shifting is one of several strategies within a comprehensive risk management plan. It allows organizations to diversify and distribute risks among different parties, reducing the potential impact of a single risk event.

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