Honeywell Case

Introduction

Honeywell is a Multibillion dollar company, operating in 95 countries and is a pioneer in the field of control system and industrial appliances. With revenue over $7.3 Billion and income above $400 Million (December 1996), the company was exposed to several types of risk as it operated in a global territory.

Previously, the company had a much compartmentalised approach to risk management, with individual departments managing individual risks pertaining to them. For instance, currency risks were hedged using futures contracts and under the supervision of the Financial Risk Management Unit while traditional (hazard) risks were insured by its treasury - Insurance Risk Management Unit. However, this individualistic approach did not serve the intent of the company well and hence in consultation with insurance specialists Marsh Inc., auditor Deloitte & Touché and insurance Underwriter AIG, a new cost efficient method for managing Honeywell's risk was created. Thus, Integrated Risk Management Program was born that combined protection against Honeywell's currency risk and other traditionally insurable risks.

Decision to be made

A decision has to be taken on the adoption of the new Enterprise Risk Management Program considering its cost implication and savings offered in perspective of adequate coverage of all risks. This decision could well lead on to establishing long term Risk policy for Honeywell as well as whether this integration approach would be suitable for Honeywell. This case identifies the benefits of integrating risks and shows how such an approach might be valuable. Honeywell has diverse variety and variant degree of risks. Given this, how should its risk be managed?

Current Situation

Honeywell's Treasury Unit

Honeywell's Treasury encompassed the following units

* Capital Markets Unit which managed Capital Structure and Liquidity Risks

* Cash Management Unit

* Financial Risk Management Unit which managed Currency Risk, Interest Rate Risk and Credit Risk

* Insurance Risk Management Unit which managed traditional risks generally covered by insurance

Traditionally Insured Risk Policy

The Insurance Risk Management Unit of the Treasury looked after traditionally insured risks, which included the following.

1. General liability

2. Property risks

3. Product liability

4. Automobile liability

5. Employer liability

6. Ocean marine transit

7. Worker's compensation risk

Each type of insurable risk had a different semi-annual renewable risk policy. Each policy had specified deductible (retention) in an amount ranged between 0 and $6 million. Honeywell would absorb losses up to retention level before calling insurance company for any claim. Separate retention was issued for each loss and a new deductible was paid for.

Firm's historical loss was utilized to estimate the future expected loss and decide on insurable risk, given that each risk followed a particular probability distribution. Firm's expected losses, losses in net of insurance payments received and premiums paid under different contract designs were calculated using Monte Carlo simulation. The net objective was to finding appropriate retention levels and insurance coverage for each individual risk category. All this was done to ensure that retention rate 45% was lower than the probability of loss.

Currency Risk Management Policy

The Currency Unit of the Treasury managed Financial Risks of the company, including currency risk. Currency risk (also called contractual risk) arose out of transactions from the company's foreign operations. It is the specific exposure faced by the firm when it enters into a contract with a future payoff. It was managed by estimating future foreign-currency based earnings, and hedging in a way to offset the effect of exchange-rate movements on those estimated earnings. More importantly, currency-hedging operations were independent of any other hedging or insuring carried out in other parts of the firm. Features of this:

o In order to hedge against exchange rate exposure, Honeywell used at-the-money options

o A basket option of 20 currencies was used that matured quarterly. These 20 currencies represented 85% of the company's foreign profits

o This option provided protection when the US Dollar strengthened against the currency basket. This basket