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Risk Shifting Definition

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What Is Risk Shifting?

Risk shifting is the transfer of risk to another party. Risk shifting has many connotations, the most common being the tendency of a company or financial institution facing financial distress to take on excessive risk. This high-risk behavior is typically undertaken with the objective of generating high rewards for equity owners—who face little additional downside risk, but may garner significant extra return—and has the effect of shifting risk from shareholders to debt holders.

Risk shifting also occurs when a company changes from offering employees a defined benefit plan to offering a defined contribution plan. In this case, the risk associated with pensions has shifted from the company to its employees.

Key Takeaways

  • Risk shifting transfers risk or liability from one party to another.
  • Risk shifting is common in the financial world, where certain parties are willing to take on others’ risk for a fee.
  • Insurance, for instance, transfers the risk of a loss from the policyholder to the insurer.

How Risk Shifting Works

Risk shifting for a troubled company with significant debt occurs because, as its shareholders’ equity decreases, the stake of debt holders in the enterprise increases. Thus, if the company takes on more risk, the potential extra profits accrue to the shareholders, while the downside risk falls to the debt holders, which means that risk has shifted from the former to the latter.

Since management is not liable for losses incurred, financial institutions in potential or actual distress often engage in risky lending, which can negatively impact an economy by fueling asset bubbles and banking crises.

Risk management may be preferable to risk shifting by distressed companies and institutions. The risk management strategy focuses on balancing risk and returns to generate cash flow that is sufficient to meet financial obligations, rather than taking the “shoot the lights out” approach of risk shifting. Companies have faced stricter regulation since the Great Recession to encourage a more prudent approach to managing risk.

Examples of Risk Shifting

In the world of real estate, a commercial property owner may find ways to transfer risk to its tenants. For example, many commercial property owners require their boutique tenants to sign a contract, in addition to a lease. This contract may ensure that the boutique owner keeps the storefront and the sidewalk immediately outside the shop clean and free of snow or ice in the winter months. In the event that a customer sues because they slipped and fell outside on the. ice, the contract would specify that the store owner would be responsible for the injured customer’s medical bills and the legal costs of the lawsuit. This type of contract may also include a “Hold Harmless Agreement,” which releases the commercial property owner from any consequences or liabilities due to the actions of the boutique owner.

Another example of risk shifting is an office building that hires a janitorial. service to keep the premises clean and safe. These janitorial services may be asked to sign a contract that transfers some of the risks involved. For example, if a janitor neglects to mop up a wet entrance on a rainy day, and a guest in the building falls and breaks a leg. This contract would ensure that the janitorial service company would be liable for the employee’s injuries and medical costs.

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