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 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.

• 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 burdened with debt, and whose shareholder's equity reduces.

1. Outsourcing - By outsourcing, one party can transfer the risk 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 derivative 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 derivatives, such as futures, forwards, and options.

#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 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.

• 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

• 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.

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.

This has been a guide to What risk shifting is & its definition. Here we discuss the types of risk shifting, their forms and their advantages & disadvantages. You can learn more about it from the following articles –

• Default Risk
• Risk Parity
• Risk Exposure
• Risk Control