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 & Touche 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
Traditionally Insured Risk Policy The Insurance Risk Management Unit of the Treasury looked after traditionally insured risks, which included the following.
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: oIn order to hedge against exchange rate exposure, Honeywell used at-the-money options oA basket option of 20 currencies was used that matured quarterly. These 20 currencies epresented 85% of the company’s foreign profits oThis option provided protection when the US Dollar strengthened against the currency basket. This basket was purchased late in the year from banks, after forecasting the company’s planned and expected foreign profits for the next year o3 years estimated foreign currency exposure was submitted by each operating unit to HQ oThe notional amount was 80% to 90% of upcoming fiscal year’s total exposure oThe basket option’s strike price weighted different currencies to reflect proportion of firm’s profits originating in a given country.
Annual option premium ranged between $ 3 – 9 million and averaged $ 5 million. Analysis of New Integrated Risk Management Program Features ?First of its kind ?Provided combined protection against HW’s currency risks along with other traditionally insurable risks ?Multi-year ?Insurance based ?Integrated risk management program ?Would extend its innovation into the financial arena The new Enterprise Risk Management (ERM) Program provided pooled protection against Honeywell’s currency risk along with other traditionally insurable risks.
Analysis of the program and individual tasks was done by a joint committee formed with group members of both the insurance unit and currency unit. Retention level and insurance coverage for the combined risks were identified in line with the industry practices by the Risk Management team. They estimated expected loss of combined insured and currency translation risks over entire term of policy, which was initially set to 2. 5 years to match Honeywell’s fiscal year.
Since currency movement had little to do with loss pattern experienced from traditionally insured risks, estimated correlation between two major groups of risk was taken as zero. Desired retention and coverage levels were estimated using Monte Carlo analysis with joint probability distribution of risks of portfolio. Existing currency hedging program and currency risk coverage were similar in nature. The basket of currencies approach was realigned with Notional amount and Currency weights decided at the contract’s outset.
Target strike price was reset each year based on weighted-average of preceding year’s monthly spot rates. Amount of currency to be hedged was specified in insurance contract for each of upcoming years covered by policy. However, 1% to 3% adjustment in notional amount of each currency was permitted as a provision in the contract. $ 30 million was set as the annual aggregate retention level, which was equal to the sum of separate retentions under the company’s current program, and also equal to Honeywell’s expected annual losses slightly different from Honeywell’s current coverage of its individual risks.
The maximum payout was set to $100 million over 2. 5 years, over the $30 million annual retention and the program also provided for a maximum payout of an additional $200 million annually for large scale specific risks like general, product and auto liability. The existing program for the portfolio covered risks was above the estimated insurance premium. Pros and Cons of existing program Advantages Meets needs of individual risks by providing customized solution for each risk ?No risk of relying upon single insurance provider as it has flexibility to distribute risk of insurer to different players ?Higher risk coverage as it has higher limits for different risks whose total is much larger than new option’s $ 100 millionDisadvantages ?Higher cost of risk as probability of risk approach to mean ?Pays higher premium Pros and Cons of ERM Advantages ?Minimizes cost of risk when probability of risk approaches to 50% ?Provides higher level of earnings protection by minimizing variability in earnings
Being first firm to introduce this innovation, firm runs in risk of innovation ?Brings down coverage significantly Conclusion Apart from providing economies of scale and low cost, the new ERM program provides diversification benefits for the insurer. Covering multiple risks, it provides savings to the company. However, lack of existing model to compare with, and uncertainty in estimation of coverage, risk might still occur. It is highly recommended to implement the new ERM as the advantages outweigh the disadvantages.
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