Chapter 3Risk Distribution and Risk shifting
- 1. 3.3 Risk Distribution and Risk shifting
- 3. The Basics of Risk Distribution • Risk distribution is a fundamental concept in the world of finance and insurance. • It involves the spreading of risk across different individuals or entities, aiming to mitigate the potential negative impact that a single party would bear. • By sharing the risk among multiple participants, the burden becomes more manageable, and the likelihood of catastrophic losses is reduced.
- 4. 1. Understanding Risk Distribution: •Risk distribution operates on the principle of sharing the potential consequences of an uncertain event. •Instead of one individual or organization bearing the full brunt of the risk, it is divided among multiple stakeholders. •This division can occur through various mechanisms, such as insurance contracts, investment portfolios, or even partnerships. •The underlying objective is to ensure that no single entity faces excessive exposure to a particular risk, thereby safeguarding against significant financial losses.
- 5. 2. Benefits of Risk Distribution: •A) Reduced Financial Impact: By distributing risk, the potential financial impact of an adverse event is shared among multiple parties. This can prevent a single individual or organization from suffering severe financial setbacks, as the losses are spread across a broader group. •B) Enhanced Stability: Risk distribution contributes to the stability of financial systems. When risks are concentrated in one place, a single event can trigger a cascading effect, leading to systemic failures. By dispersing risks, the overall system becomes more resilient and less susceptible to large-scale disruptions. •C) Increased Access to Capital: Risk distribution facilitates access to capital for businesses and individuals. Lenders and investors are more willing to
- 6. 3. Methods of Risk Distribution: A) Insurance: Insurance is perhaps the most common method of risk distribution. Policyholders pay premiums to an insurance company, which then assumes the financial responsibility for potential losses. Examples include health insurance, property insurance, and liability insurance. Through pooling premiums from many policyholders, insurers are able to spread the risk and compensate those who suffer losses. •B) Diversification: Diversifying investments is another effective way to distribute risk. By investing in a variety of assets across different sectors, industries, and geographic regions, individuals or organizations can reduce their exposure to any single investment. This strategy helps to mitigate the impact of losses in one area by balancing it with gains in others. •C) Partnerships and Joint Ventures: In business, partnerships and joint ventures allow firms to distribute risks associated with new ventures or projects. By sharing resources, expertise, and financial commitments, the risks and rewards are divided among multiple parties. This approach not only spreads the load but also brings additional knowledge and capabilities to the table.
- 7. 4. Perspectives on Risk Distribution •A) Individual Perspective: From an individual standpoint, risk distribution provides a sense of security and peace of mind. By transferring risk to insurance companies or diversifying investments, individuals can protect themselves against unexpected events that could otherwise have a devastating financial impact. •B) Business Perspective: For businesses, risk distribution is crucial for survival and growth. By spreading risks through insurance coverage, partnerships, or diversification, companies can mitigate potential losses and ensure continuity of operations. It also enables them to pursue new opportunities that would otherwise be too risky to undertake alone. •C) Societal Perspective: From a societal perspective, risk distribution promotes stability and economic resilience. By sharing risks, the burden on public resources can be reduced, as individuals and businesses become more self-reliant. This, in turn, contributes to the overall well-being of society.
- 8. • Risk distribution plays a vital role in managing uncertainties and minimizing potential losses. • By sharing risks among multiple parties, the financial impact of adverse events can be mitigated, stability can be enhanced, and access to capital can be facilitated. • Whether through insurance, diversification, or partnerships, risk distribution provides individuals, businesses, and society as a whole with a safety net in an unpredictable world
- 9. Risk shifting • Risk shifting is a popular practice in the finance industry, where an organization transfers the responsibility of risk to another party at a fee. • It also occurs when a company facing financial distress takes in additional risks. • Risk shifting is designed to reduce the impact of the risk by transferring the responsibility of the risk to a third party.
- 10. Forms of Risk Shifting Risk shifting can take the following forms: 1. Outsourcing • Outsourcing involves shifting the risks involved in a project to another party. Most businesses engage in outsourcing as a way of transferring the risks to a more competent entity and then focusing on the functions that they are more competent in. • For example, an online e-commerce store may decide to shift the production of its main products to a contract manufacturer who owns the infrastructure and resources required to manufacture the product at a lower cost. • Such a practice allows the e-commerce store to focus its attention and energy on areas such as design, customer service, and marketing where it is more competent. All the risks associated with the manufacturing process are shifted to the contract manufacturer.
- 11. 2. Derivative • A derivative is a financial asset that derives its value from the value of an underlying asset, such as stocks, bonds, and currencies. It is a contract between two or more parties, where one party shifts the financial risk to another party. • Businesses purchase derivatives as a way of hedging potential financial risks, such as exchange rate risk. Investors use derivatives to speculate on the movement in the price of the underlying asset or hedge against the financial risk of loss. The main types of derivatives include futures, forwards, and options
- 12. Alternatives to Risk Shifting • The following are the main alternatives to risk shifting as a risk strategy: • 1. Risk Sharing • While risk shifting is applicable to negative risks, risk sharing relates to positive risks that present an opportunity to the company. Risk sharing involves increasing the probability of the positive risk happening by distributing the risk to other organizations or departments. • When the company is faced with a positive risk, it agrees to partner with other parties to increase the odds of the risk happening. The company also agrees to share the benefits and burden of loss that arise from the opportunity when the risk occurs. • When undertaking a large project, a company can share the risk with other participants in a mutually beneficial partnership. For example, let’s say ABC Limited specializes in road construction, but it lacks the capacity to carry out large projects. • To address the insufficiency, ABC collaborates with its competitor XYZ Corp. to pool their resources to bid for a large road construction contract. If awarded the contract, both companies stand to benefit from the proceeds of the contract.
- 13. • 2. Risk Transfer • Risk transfer is often confused with risk shifting. Risk transfer is a risk management strategy that deliberately passes on risk to another party. An example of risk transfer is purchasing an insurance policy, where the policyholder transfers the risk of loss to an insurer. • An insurance contract passes the responsibility for the insured risk to another party who is capable of handling the risk. In the healthcare industry, doctors purchase malpractice insurance to protect themselves from the risk of loss due to patient lawsuits. • In the event that the doctor is sued by a patient, the insurer shoulders the cost of the lawsuit, as well as any damages awarded by the court. The insurer charges an insurance premium for accepting the risk.