Honey Well Case Corporate Risk

Ans 1) The team wanted to re-evaluate the risk that various division of the company faced and then create an insurance contract that would combine traditional hazard risk with foreign – exchange translation risk within a unified multiyear policy. The management wanted to reduce the cost of Risk by combining all the uncorrelated risk into one contract.

The shareholders are risk averse and would prefer stocks with lower risk. They can diversify the nonsystematic risk but not the systematic risk. By treating its risk exposures as portfolio of risk Honeywell could reduce its total risk and lower the cost. The money thus saved would help in increasing the enterprise value of the firm there by benefiting the stakeholders in directly.

 Ans2): Honeywells new policy differed from the old policy. The traditional insurance policies were not correlated with the currency fluctuation risks were as the new policy, combined the individual risk with the derivative risks. Also, new policy involved using tools that were managed by both the traditional and the derivative division of the risk management. Moreover, integrating the different risk involved cross functional interaction between teams from various departments.

Ans3): We can combine uncorrelated contract and reduce the volatility of the risk for the firm thereby reducing the cost of risk. This could create extra cash that could be used to smooth the cash flows. The combined policy can help to reduce premium or cost of Risk, increase Free cash flows and enable cross-functional interaction among various departments there by increasing the operational efficiency. But, as Honeywell is the first company to implement such as policy the risk of failure was high and there is no proven or tested method to decide the optimal risk management structure. Moreover, by combining all the risk together total risk exposure is reduced because the combined products are not correlated and this results in lower volatility therefore lower total risk. Lower volatility would result in lower premium or cost of risk charged by insurance company.

Ans 4): Although, both the traditional and new policy had approximately the same retention amount, the premium paid under the new policy was 15% to 20% lesser than the existing premium. This made the new policy cheaper. Honeywell was able to get such a lower contract by retaining greater part of the risk, thereby exposing the firm to greater volatility in earning and value. Also, by combining the individual risk with derivatives the firm was able to reduce its volatility and this resulted in lower premium for the firm. AIG cannot give lower premium to all the companies. Only historic companies, that have been running for years, with stable cash flows, huge assets and an ability to provide sufficient retention amount should be considered for lower premium.