Updated July 17, 2023
Definition of Risk Shifting
Risk shifting is the transfer of risk or liability to another person. The term is generally associated with the financial sector. It transfers the risk and the returns or rewards associated with the liability.
This can be between two corporate as well. There are certain companies that, by charging some considerations, take all the risk associated with the company. These companies hedge all the possibilities of the risk in advance.
Explanation
It is transferring the risk to another person or company. Financial professionals commonly utilize this strategy in various scenarios. The companies are willing to take risks in exchange for certain fees. This strategy can be used when there is a huge possibility of financial distress. In any company, if the risk shifting occurs, then, in that case, the shareholders’ equity stake will also decrease, and the companies’ debt will increase. The risk shifts either partially or fully, depending on the specific circumstances. These are discussed and contracted upon by the two parties. It can help the company eliminate possible burdens arising from future transactions. By following the process of risk shifting, the company can focus on its key areas and work accordingly. They will be free from the risk factors like damages etc.
How Does It Work?
This is one of the best risk management techniques applied so far. It involves a third party’s consent. The risk transfers to the third party for certain compensation in this process.
Example of Risk Shifting
The best example of risk shifting is buying an insurance policy.
Mr. N is planning to purchase a car and wants to get it insured by an insurance company. The insurance company and Mr. N will sign a contract of insurance policy wherein the customer must pay the premium every year to the insurance company. This payment is in the form of compensation to hedge the risk of the asset. In the future, if the Car gets damaged, then Mr. N can retain the money from the insurance company. In this case, the insurance company will repay the sum insured during the contract.
Thus this is one of the best examples of risk shifting. The risk has been shifted from Mr. N to the Insurance Company by paying a yearly premium.
Forms of Risk Shifting
In finance, risk shifting can be of two forms, i.e., Outsourcing the task and Investment in derivatives.
- Outsourcing the Task: The task being outsourced by the company to another person or company is one of the classic forms of risk shifting. The risk is being transferred to another party which will ensure that the task gets completed on time, and they are liable to solve all queries related to the undergoing projects.
- Investment in Derivatives: Derivatives are financial instrument that hedges the risk associated with the currency and inventory. An individual also uses derivatives or speculation for yield enhancement. These are one of the best methods of risk shifting or risk management.
Alternatives of Risk Shifting
- Risk Management: Risk management is one of the important aspects used to manage the company’s risk in many ways. Shifting is usually associated with negative risk, but risk management is positive. Risk management also provides a better alignment of resources with no extra risk associated with the process. That is why many companies are focusing on this concept to manage their risk so that they can focus on their key areas of operation and thus can help themselves from the downside.
- Risk Transfer: Risk transfer is another alternative to risk shifting. In this method, the risk is transferred to another party in exchange for some compensation. The best example of risk transfer is an insurance policy. The risk is transferred to the Insurance Company, and the insured is liable to pay the premium amount, and then the risk is transferred.
Advantage
Some of the advantages are given below:
- This helps the company to get rid of some extra burden.
- In this process, the risk is transferred to the third party, ultimately benefiting the company.
- It can be very helpful in the case of companies that are suffering from financial loss.
- In many companies, the significant risk is shifting from the equity shareholders to the debt holders because of some financial arrangements, which helps the company overcome the downside.
- From this method, the risk can be managed properly during the crisis, and the company members can focus on the key areas of operation.
Disadvantages
Some of the advantages are given below:
- This involves another party; therefore, the company’s data is transferred to another party, which can be a risk factor.
- The cost of compensation is also associated with the risk-shifting process because it is like working for another company to take the burden of the risk from the company.
- Sometimes it is also seen that the risk-shifting process can be a bit time taking, and lots of legal complications are also present while doing the settlement.
- If the company chooses risk shifting, it can lose control over its financial assets, which is also a challenge.
Conclusion
It is a process that helps the company eliminate a certain burden. The company then appoints another company to shift the portion of the risk in return for some compensation. The process is a bit costly, but if it is used very efficiently, it can help the company deal with the financial crisis. The company’s management should be prudent enough to select the best methods of risk shifting to get the maximum benefit out of the same.
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