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Risk Shifting

Definition of Risk Shifting

Risk shifting is the transfer of risk or any type of liability to another person. The term risk shifting is generally associated with the financial sector. The risk shifting not only transfers the risk but it also transfers the returns or rewards associated with the liability. The risk shifting can be between two corporate as well. There are certain companies which by charging some considerations takes all the risk associated with the company. These companies hedge all the possibilities of the risk in advance.

Explanation

Risk shifting is the process of transferring the risk to another person or company. In finance, this strategy is very commonly used. The companies are willing to take risk in exchange of certain fees. Where there is a huge possibility of financial distress then this strategy can be used. In any company, if the risk shifting occurs then in that case the equity stake of the shareholders will also decrease and the debt of the companies will increase. The risk shifting can be done on a partial basis or full these are discussed and contracted upon by the two parties. Risk shifting can help the company to get rid of 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.

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How does It Work?

Risk shifting is one of the best risk management techniques applied so far. The risk shifting involves a third party’s consent. In this process, the risk is transferred to the third party in exchange of certain compensation.

Example of Risk Shifting

The best example of risk shifting is buying an insurance policy.

Mr N is planning to purchase a car and he also wants to get it insured from an insurance company. The insurance company and Mr N will sign a contract of insurance policy wherein the customer is required to pay the premium every year to the insurance company this payment is in a form of compensation to hedge the risk of the asset. In future if the Car gets damaged then Mr N can retain the money from the insurance company. In this case, the insurance company will pay back 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 premium every year.

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 which is 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 make sure that the task gets completed on time and also they are liable to solve all queries related to the undergoing projects.
  • Investment in Derivatives: Derivatives is a financial instrument which hedges the risk associated with the currency and inventory. An individual also use 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 which are used to manage the risk of the company in many ways. The risk shifting is usually associated with negative risk but risk management is a positive aspect. Risk management also provides 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 form the downside.
  • Risk Transfer: Risk transfer is another alternative of risk shifting. In this method, the risk is transferred to another party in exchange of 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:

  • The risk shifting helps the company to get rid of some extra burden.
  • In this process, the risk is transferred to the third party that is ultimately beneficial for the company.
  • The risk shifting can be very helpful in the case of companies who are suffering from financial loss.
  • In many companies the significant risk is shifting form the equity shareholders to the debt holders because of some financial arrangements and this process of risk shifting helps the company to get over with the downside.
  • From this method, the risk can be managed properly at the time of crisis and the company members will be able to focus on the key areas of operation.

Disadvantages

Some of the advantages are given below:

  • The risk shifting involves another party and therefore the data of the company is transferred to another party which can be a risk factor.
  • The cost or compensation is also associated with the risk shifting process because it is like work 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 there while doing the settlement.
  • If the company choses risk shifting then the company can lose control over their financial assets which is also a challenge for the company.

Conclusion

Risk shifting is a process that helps the company to get rid of a certain type of burden. The company then appoints another company to shift the portion of the risk in return of some compensation. The process is a little bit costly but if it is used very efficiently then it can help the company to deal with the financial crisis. The management of the company should be prudent enough to select the best methods of risk shifting so that they can get the maximum benefit out of the same.

Recommended Articles

This is a guide to Risk Shifting. Here we also discuss the definition and alternatives of risk shifting along with advantages and disadvantages. You may also have a look at the following articles to learn more –

  1. Outsourcing vs Offshoring
  2. Asset Management vs Wealth Management
  3. Mistakes in Discounted Cash Flow
  4. Cash Investment
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