Risk Shifting
Transferring the responsibility for risk or liability to another party
What is Risk Shifting?
Risk shifting is a risk strategy that involves transferring the responsibility for risk or liability to another party. The risk can be transferred in full or partially, and it ensures that the third party will deal with the risk as and when it materializes.
Risk shifting is a popular practice in the finance industry, where an organization transfers the responsibility of risk to another party at a fee. It also occurs when a company facing financial distress takes in additional risks.
By taking excessive risk, the company aims to generate additional income for its shareholders, who stand to gain significant returns if the outcome turns out favorably. The company can transfer the additional risks from the shareholders to the debtholders to reduce the impact of an unsuccessful business venture on the equity owners.
Summary
- Risk shifting is a risk management strategy that transfers the risk of loss or liability from one party to another.
- Risk shifting is designed to reduce the impact of the risk by transferring the responsibility of the risk to a third party.
- Unlike risk sharing, risk shifting adjusts the risk impact on the organization.
Understanding Risk Shifting
Risk shifting is a risk response strategy that is carried out as part of a company’s risk management process. It helps the company manage possible risks that may prevent a project from delivering its expected outcome. Usually, risk shifting is applicable to negative risks that may derail a project from delivering its objective, and are, therefore, transferred to a third party.
For example, a company with significant debt may engage in risk shifting as a way of protecting the shareholders from the impact of the downside risks. When the company takes more risks (borrowing additional debt) to stay afloat, it increases the stake of debtholders in the company.
At the same time, it decreases the shareholder’s equity in the company. By taking additional risks, any potential gains that the company makes will accrue to the shareholders, whereas the downside risks will be transferred from the shareholders to the debt holders.
Forms of Risk Shifting
Risk shifting can take the following forms:
1. Outsourcing
Outsourcing involves shifting the risks involved in a project to another party. Most businesses engage in outsourcing as a way of transferring the risks to a more competent entity and then focusing on the functions that they are more competent in.
For example, an online e-commerce store may decide to shift the production of its main products to a contract manufacturer who owns the infrastructure and resources required to manufacture the product at a lower cost.
Such a practice allows the e-commerce store to focus its attention and energy on areas such as design, customer service, and marketing where it is more competent. All the risks associated with the manufacturing process are shifted to the contract manufacturer.
2. Derivative
A derivative is a financial asset that derives its value from the value of an underlying asset, such as stocks, bonds, and currencies. It is a contract between two or more parties, where one party shifts the financial risk to another party.
Businesses purchase derivatives as a way of hedging potential financial risks, such as exchange rate risk. Investors use derivatives to speculate on the movement in the price of the underlying asset or hedge against the financial risk of loss. The main types of derivatives include futures, forwards, and options.
Alternatives to Risk Shifting
The following are the main alternatives to risk shifting as a risk strategy:
1. Risk Sharing
While risk shifting is applicable to negative risks, risk sharing relates to positive risks that present an opportunity to the company. Risk sharing involves increasing the probability of the positive risk happening by distributing the risk to other organizations or departments.
When the company is faced with a positive risk, it agrees to partner with other parties to increase the odds of the risk happening. The company also agrees to share the benefits and burden of loss that arise from the opportunity when the risk occurs.
When undertaking a large project, a company can share the risk with other participants in a mutually beneficial partnership. For example, let’s say ABC Limited specializes in road construction, but it lacks the capacity to carry out large projects.
To address the insufficiency, ABC collaborates with its competitor XYZ Corp. to pool their resources to bid for a large road construction contract. If awarded the contract, both companies stand to benefit from the proceeds of the contract.
2. Risk Transfer
Risk transfer is often confused with risk shifting. Risk transfer is a risk management strategy that deliberately passes on risk to another party. An example of risk transfer is purchasing an insurance policy, where the policyholder transfers the risk of loss to an insurer.
An insurance contract passes the responsibility for the insured risk to another party who is capable of handling the risk. In the healthcare industry, doctors purchase malpractice insurance to protect themselves from the risk of loss due to patient lawsuits.
In the event that the doctor is sued by a patient, the insurer shoulders the cost of the lawsuit, as well as any damages awarded by the court. The insurer charges an insurance premium for accepting the risk.
More Resources
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In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:
