FORETHOUGHT

best practice

A Better Way to Manage Risk

Through an innovat ive insurancepolicy, Honeywell has taken a f i rs tstep toward making integratedrisk management a real i ty.

by Usa Meulbroek

Most managers treat risk managementas a series of unrelated tasks best dele-gated to specialized experts. If a com-pany needs to insure its plant and equip-ment, an insurance team in the treasurydepartment runs the numbers andnegotiates a contract. If it starts export-ing to Japan, another team of foreignexchange specialists will hedge thecompany's exposure to currency move-ments using futures and options.

Yet these two very different tasksshare one goal-trying to control thecompany's exposure to financial dis-tress. On the face of it, then, unifyingthe management ofa company's diverserisks would seem a ripe source of effi-ciency gains and cost savings. But untilrecently that hasn't really been a prac-tical option, since no insurers offeredcoverage for a company's consolidatedrisk exposure.

A Brave Pioneer

A few companies have now begun towork with insurers to develop morecomprehensive risk-management agree-ments. And they're finding that suchpolicies not only save them money butbring wider organizational and strate-gic benefits as well. One of these is theU.S. engineering giant Honeywell.Through an innovativeinsurance contractit developed inpartnership withits main insurer,American Inter-

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By bundling itsdiverse insurancerisks, Honeywellhas cut its overallrisk-abatementcosts by 15%.

national Group (AIG), Honeywell hassuccessfully integrated its managementof several different kinds of risks.

Under this single policy, Honeywellnow groups together not only tradi-tionally insurable risks-product liabil-ity, property, employee crime, and soon - but also protection against changesin a host of foreign exchange rates. Pre-viously, the insurance risk-managementunit in Honeywell's treasury depart-ment had covered each risk under a sep-arate policy, while its derivatives grouphedged currency risks through the usualarray of forwards, futures, and options.

Bundling tbe company's risks like thishas enabled Honeywell to cut its overallrisk-abatement costs by more than 15%.Tbe savings come in two ways:

Combining the Deductibles. First,the new policy lets Honeywell poo! pre-viously separate deductibles. This not

only saves money but, perhaps more im-portant, puts the company in better con-troi ofthe amount of risk it can afford tounderwrite itself Here's how that works:Let's say Honeywell can safely withstandunexpected losses of up to $30 milliona year, but it has to buy separate poli-cies for product liability, fire, and for-eign exchange risks. To keep its lossesto no more than $30 million, it wouldhave to set deductibles at $10 millionfor each policy. The lower the de-ductible, of course, the more expensivetbe policy for coverage the companyreally does not need. If a factory caughtfire, for instance, causing damage worth$25 million, Honeywell would shoulderonly tbe $10 million deductible, whenit could afford to absorb the entireamount It would end up unnecessarilypaying for the insurer to pick up the re-maining $15 million. But by negotiating

HARVARD BUSINESS REVIEW

FORETHOUGHT

an aggregated deductible of $30 million,Honeywell pays for exactly the level ofprotection it needs.

Netting Off Diverse Risks. Some ofthe risks in a company like Honeywellare mutually exclusive; a fire that de-stroys a factory eliminates the chancethat the company will have to pay out ondefective products that the factorymight otherwise have produced. Apartfrom the issue of deductibles, insuringthese risks with one company is cheaperthan insuring with two because the re-serve that a single carrier would putaside for insuring against fire can be off-set against the reserve put aside for prod-uct liability. That translates into a muchlower premium than if the two riskswere insured separately.

Winning OrganizationalAcceptance

Honeywell recognized that an in-tegrated approach might meetwith intemai resistance. After all,although they were nominally grouped

under the common treasury umbrella,the insurance and financial risk-man-agement units actually had little to dowith each other. They came from dif-ferent cultures, used different tools, andthought of themselves as having differ-ent objectives; on the face of it, tradi-tional insurance contracts would seemto have little in common with tradedfinancial securities.

To overcome this resistance, Honey-well created a team drawn from bothunits to prepare a detailed design andevaluation of the proposed policy. Tofoster unity and encourage membersto think beyond their traditional risk-management frameworks, Honeywell

eliminated all titles within theteam. As a result, everyone has

been able to take owner-ship of the new pol-icy's success. In fact,the former headof the insurancerisk-managementunit-intially the

person who was the most skeptical ofthe integrated approach-is today itschief proponent.

The Real Buried TreasureHoneywell's new policy is only a taste ofthe benefits of integrated risk manage-ment The savings possible from freeingup expensive equity capital are poten-tially far greater. A company that doesnot identify and measure its risk accu-rately has no choice but to adopt a con-servative capital structure, using equityas a cushion against financial distress.But a company that carefully controls itsrisk of financial distress contractuallycan afford a more aggressive capitalstructure. An effective risk-managementstrategy, therefore, frees a company tobecome as fully leveraged as it should beand capture the significant tax and otherbenefits that accompany debt financing.

Lisa Meulbroek is an associate professor atHarvard Business School in Boston.

Reprint FOIO2B

tool

The Law ofthe PackMove over, Metcalfe. Here's a new techniquefor measuring the value of networks.

by David P. Reed

The Internet is a network of networks,and its value lies in the connectionsit enables. As managers and entrepre-neurs try to measure that value, theyhave paid a great deal of attention totwo types of networks. The simplest isthe one-to-many - or broadcast - net-work, through which a central supplierbroadcasts information to a large num-ber of users. An example is the Webportal, which delivers news and othercontent to many visitors. More complex,and more valuable, is the one-to-one - ortransactional - network, which connectsindividual users with other individualusers to exchange information or com-plete other transactions. Common exam-ples are e-mail and instant messaging.

But there's a third type of networkthat, although less understood than theother two, is actually the most valuableof all. It's the many-to-many - or group-forming-network, which allows net-work members to form and maintain

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