Risk Shifting

What Is Risk Shifting?

Risk shifting is the transfer of risk(s) from one party to another party.

Risk shifting can take on many forms, from purchasing an insurance policy to hedging investment positions to corporations moving from defined-benefit pensions to defined-contribution retirement plans like 401(k)s. In the latter case, the investment and payout risk associated with pensions has shifted from the company to its employees.

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. In other words, risk shifts 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.

Moral Hazard

One type of risk shifting is known as moral hazard, which occurs when an individual or firm takes on excessive risk, either in response to perverse incentives or to try to remediate financial stress. 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.

A moral hazard is an idea that a party protected from risk in some way will act differently than if they didn't have that protection. In the insurance industry, moral hazard occurs when insured parties take more risks, knowing their insurers will protect them against losses. Or, considered to be too big to fail, banks often take additional financial risks, knowing they'll be bailed out by the government.

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.