Risk Shifting

What Is Risk Shifting?

Risk shifting is a strategy individuals, businesses, and investors employ to transfer or distribute risks from one party to another. Risk can be entirely or partially shifted, guaranteeing that a third party will manage the risk if it arises.

This process is also apparent in companies with significant debt, where the influence of equity shareholders diminishes, and debtholders gain more prominence. Risk shifting can occur through actions like buying insurance, using investment hedges, or companies changing pension plans.

For instance, when businesses switch from traditional pensions to 401(k)s, they move the investment and payout risks from the company to the employees. While risk shifting can provide benefits such as increased stability and improved financial performance, it also carries inherent challenges and ethical considerations.

In finance, this is a widely adopted practice where an entity transfers the responsibility for risks to another party for a fee. During financial instability, a company may choose to take on extra risks to address its financial circumstances.

By assuming higher levels of risk, the company seeks to create extra revenue for its shareholders, which may lead to substantial returns if the venture proves successful.

To mitigate the potential negative consequences of an unsuccessful business endeavor on equity owners, the company can shift the supplementary risks from shareholders to debtholders.

How does Risk Shifting Work?

Risk shifting is a method used in a company's risk management to handle potential issues that could hinder a project's success.

It involves passing on potential problems that could slow a project from achieving its goals to someone else, usually a third party. This is mainly done to minimize the impact of these negative risks.

Consider a company grappling with a substantial debt. To shield its shareholders from potential financial setbacks, the company may opt to take on additional risks, such as acquiring more debt. This strategic move shifts a greater share of the associated risks to the company's creditors.

This also diminishes the company's shareholders' equity. Assuming additional risks allows any profits generated by the company to benefit shareholders, while the potential downsides are shifted from shareholders to those holding the company's debt.

As management is typically not held responsible for losses suffered, financial institutions facing or experiencing distress often engage in risky lending during potential or actual distress periods.

This behavior can adversely affect an economy by contributing to the emergence of asset bubbles and banking crises. Distressed companies and institutions might find risk management more favorable than risk shifting.

The risk management approach prioritizes maintaining a balance between risks and returns to generate adequate cash flow for meeting financial obligations instead of adopting the high-risk strategy of "shooting for the stars" associated with risk shifting.

Forms of Risk Shifting

This can occur through various mechanisms and in different contexts. Below are some common forms of risk shifting.

Outsourcing

Through outsourcing, one party can shift the risk associated with a specific project to another party. Businesses often outsource tasks they are not proficient in and focus on activities where they excel.

Suppose a company decides to hire an outside IT services provider instead of having its own IT team. In that case, this external firm takes on tasks like software development and system maintenance on behalf of the hiring company.

This decision allows the company to shift certain operational and technical risks to the outsourcing partner, letting the company focus on what it's best at and reducing potential problems in unfamiliar areas.

Derivatives

Financial derivatives are contractual agreements between parties, and their worth is linked to an underlying asset, a collection of assets, or a benchmark.

It represents a form of risk-shifting where one party transfers the associated risk to another.

They are employed for risk mitigation and help guard against financial uncertainties like changes in interest rates, currency exchange rates, commodity values, or stock prices.

For instance, a company can use futures contracts to hedge against adverse movements in commodity prices or interest rates.

Some derivatives are designed to transfer operational risks. For example, weather derivatives can be used to hedge against the operational risk associated with weather-dependent businesses like agriculture or tourism.

Moral Hazard

Moral hazard arises when individuals or companies take excessive risks due to improper incentives or financial troubles.

This risky behavior is usually done to create big profits for shareholders. They take on little extra risk but can potentially earn substantial additional returns. The consequence is that the risk is transferred from shareholders to those who hold the company's debt.

In insurance, moral hazard arises when those who are insured engage in riskier behavior, confident that their insurers will cover any resulting losses.

Banks, deemed “too big to fail,” tend to engage in additional financial risks, relying on the expectation that government support will come to their rescue through bailouts.

Alternatives to Risk Shifting

The following are the main alternatives to risk shifting.

Risk Sharing

Risk shifting is about managing and reducing negative risks. In contrast, risk sharing involves capitalizing on positive risks that can bring opportunities and benefits to the company.

In risk-sharing, companies engage in favorable risk agreements with other parties to collectively share risks, thereby enhancing the likelihood of positive outcomes through the combined efforts of all involved parties.

Risk sharing involves raising the probability of a positive risk occurrence by spreading the risk across different organizations or departments. 

Imagine LMN Services excels in small-scale event management but lacks the capability for larger events. To address this, LMN partners with its competitor OPQ Events to combine their strengths and jointly bid for a major event contract.

If they win the contract, both companies share in the rewards and prosper from the successful execution of the larger event.

Risk Transfer

A risk transfer strategy involves purposefully transferring the risk to another party. The person or organization typically offers regular payments to the third party to repay the third party for the risk.

For example, in an insurance contract, the person buying the policy hands the risk of loss to the insurance company. Someone taking car insurance obtains financial security against the financial consequences of physical damage or bodily injury from traffic accidents.

In doing so, the person transfers the burden of potential substantial financial losses resulting from a traffic incident to an insurance company. In return for these risks, the insurance company usually demands regular payments from the individual.

Contracts help manage risk by including an indemnification clause. This means that if there are any losses, both parties agree to cover each other's costs, damages, or losses resulting from the contract.

Advantages of Risk Shifting

The following are some of the advantages of risk shifting:

1. Specialization: Risk shifting allows parties to specialize in their core competencies. For example, a company may be an expert in manufacturing products but may lack expertise in managing certain risks, such as natural disasters. The manufacturing firm can focus on its core activities by transferring the risk to an insurance company.
2. Access to Capital: Shifting risks can unlock capital that would otherwise be set aside for risk management. This liberated capital can then be redirected towards activities like expanding the business, conducting research and development, or pursuing other strategic initiatives.
3. Expertise: Insurance companies and other risk-bearing entities often have specialized knowledge and expertise in assessing and managing risks. By transferring risk, businesses can leverage the expertise of professionals specializing in risk analysis and mitigation.
4. Budgeting and Planning: Knowing that certain risks are shifted to external parties can make it easier for businesses to budget and plan for the future. It provides a level of predictability and stability as the impact of certain risks is transferred to others.
5. Regulatory Compliance: Some industries have regulatory requirements related to risk management. Risk-shifting mechanisms, such as insurance, can help businesses meet these regulatory requirements and demonstrate their ability to handle potential risks.

Disadvantages of Risk Shifting

Here are some of the drawbacks associated with risk shifting:

1. Moral Hazard: When one party passes the risk to another, the party receiving the risk may not be as motivated to handle or reduce that risk. This can create a moral hazard, where the party taking on the risk might engage in riskier behavior because they are not fully responsible for the outcomes.
2. Lack of Control: The party shifting the risk may lose control over how the risk is managed and mitigated. This lack of control can result in inadequate risk management strategies or decisions not aligned with the original risk profile.
3. Costs of Transfer: There are often costs associated with transferring risk, such as insurance premiums or fees for financial instruments. These costs can diminish the overall financial benefit of shifting risks and impact the cost-effectiveness of the strategy.
4. Uncertain Outcomes: The outcomes of risk-shifting strategies can be uncertain. For example, relying on insurance may not guarantee full coverage or compensation, and financial markets can be unpredictable. This uncertainty can create financial volatility and impact the stability of the organization.
5. Counterparty Risk: When passing on risk to another party, there's always the possibility that the other party might not meet their commitments. This could be because of insolvency, default, or unexpected situations, potentially leaving the organization vulnerable to the initial risk.
6. Complexity and Overreliance: Using complex financial instruments and strategies to shift risks can be challenging to comprehend and control. Relying too heavily on these approaches without a deep understanding of the potential risks involved may result in unintended and adverse outcomes.
7. Legal and Regulatory Risks: Shifting risks may involve legal and regulatory complexities. Changes in laws or regulations can affect the validity or effectiveness of risk-shifting mechanisms, exposing the organization to legal and compliance risks.

Examples of Risk Shifting

The following are some examples of risk shifting.

Example 1

In real estate, a business property owner might look for ways to shift risk to the tenants. For instance, when small shops rent space in commercial buildings, landlords often have them sign an extra agreement apart from the lease.

This agreement typically states that the shop owner is obligated to keep the storefront and the sidewalk outside tidy and safe during winter by clearing away snow and ice.

If a customer slips and falls on ice outside a store, the contract would say that the store owner has to pay for the customer's medical bills and the costs of the lawsuit if the customer decides to sue.

The inclusion of a "Hold Harmless Agreement" further absolves the property owner from consequences related to the store owner's actions.

Example 2

In an office building scenario, the property owner may hire a janitorial service to ensure cleanliness and safety. 

The janitorial service might be required to agree to a contract that shifts some of the associated risks.

Suppose a janitor fails to address a wet entrance during a rainy day, leading to an employee slipping and breaking a leg. In that case, this contract ensures that the janitorial service company is responsible for the employee's injury and medical expenses.

Example 3 

Pharmaceutical companies often form joint ventures to share the expenses and risks linked to costly research and development projects.

By entering into partnerships, companies can collectively invest in the development of new drugs or therapies.

This arrangement allows them to share the financial burden and risks of the research process, including the uncertainties related to regulatory approvals and market acceptance.

Joint ventures in pharmaceutical research exemplify a strategic approach to risk sharing in an industry where the outcomes of research and development efforts are uncertain and costly.

Risk Shifting vs Risk Management

Let's understand the differences between Risk Shifting and Risk Management:

Authored and researched by Rani Thakur⎮LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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