Honeywell, Inc. and Integrated Risk Management

1. Introduction

In one week, on July 10, 1997, the Finance Committee members of Honeywell Inc.'s board of directors would vote on whether to proceed with a new risk management program. For the past two years, members of Honeywell's Treasury Management Team, in conjunction with insurance specialists J&H Marsh & McLennan (now Marsh Inc.), auditor Deloitte & Touche, and later with insurance underwriter American International Group (AIG) had worked to create a new, more cost- efficient method for managing some of Honeywell's risks. Their proposal, the first of its kind, provided combined protection against Honeywell's currency risks along with other, more traditionally-insurable risks, in a multiyear, insurance-based, integrated risk management program. Honeywell had a long history of product innovation; this new proposal would extend its innovation to the financial arena. While a significant amount of time and effort had been invested in developing this new concept and in simulating program results, the absence of a precedent was a source of concern. The Finance Committee's vote depended, in part, on whether the anticipated savings of the program would be realized, and whether the coverage provided by the new contract would be adequate. Because Honeywell viewed the proposed plan as a first step in a firm-wide integrated (sometimes referred to as enterprise) risk management program that would extend to cover all of Honeywell's financial and operational risks, the Finance Committee's decision would establish Honeywell's risk management strategy for some years tocome.

1. BusinessDescription

Honeywell was a multibillion-dollar, international corporation, employing 53,000 people and managing operations in 95 countries. It was the largest producer of control systems and products used to regulate heating and air conditioning in commercial buildings, and of systems to control industrial processes worldwide, and was also a leading supplier of commercial, military, and space avionics systems. Exhibit 1and the Appendix contain Honeywell's consolidated financial statements and excerpts from Management's 1996 Discussion and Analysis of Operations, which together provide recent detail on both corporate and business-unit level performance. Exhibits 2and 3provide comparative operating and stock price performance measures for Honeywell and its competitors, and Exhibit 4shows Honeywell's volatility of equity relative to the S&P500 from 1985- 1996.

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1. Honeywell's Risk ManagementReview

Honeywell's managers reviewed the firm's existing financial practices, determining that change was needed in order to support the firm's operational goals. As Honeywell's Treasurer Paul Saleh explained, "We did not have a whole set of strategies in place that identified exactly what we were trying to do, in dividends, in debt management, in risk management and so on."1

Honeywell's Existing Risk Management Policies

Exhibit 5shows a number of risks that Honeywell concurrently managed in order to achieve its financial objectives. Honeywell's risk management activities were dispersed throughout the firm (see Table A). Active hedging or insuring of risks occurred only for currency, interest rate, liquidity risk, credit risk, pension fund, and traditionally-insured risks. Other risks were managed operationally.

Table A

TypeofRisk Department with OversightResponsibility

Traditionally-Insured (i.e.,Hazard)Risksa TreasuryInsurance Risk Management unit CurrencyRisks TreasuryFinancial Risk Managementunit

Other Financial Risks (interest-rate risk, credit risk, liquidity risk)

TreasuryFinancial Risk Management and Capital Markets Units

PensionFundRisk Financial Dept. (outside of Treasury but still reporting toCFO)

OperationalRisks OperatingUnits

CompetitiveRisks Operating Units Credit (customer andvendor)Risks OperatingUnits

EnvironmentalRisks Health, Safety and EnvironmentalDepartment

TechnologicalRisks TechnologyCenter

LegalRisks Office of General Counsel

MarketRisks MarketingManagement

RegulatoryRisks Office of GovernmentalAffairs

Honeywell, Inc. and IntegratedRiskManagement 200-036

Treasury's Role in Risk Management

Honeywell's Treasury group encompassed a capital markets unit, a cash management unit, a financial risk management unit, and an insurance risk management unit. The financial risk management unit managed currency risk, interest rate risk, and credit risk. The capital markets unit managed risks associated with the firm's capital structure, including liquidity risk. The insurance risk management unit's activities involved risks traditionally covered by insurance. Each unit's risks had different loss characteristics, and were managed using different risk management methods and instruments.

The Insurance unit, under the leadership of Tom Seuntjens, was responsible for general liability, property, product liability, automobile liability, employer liability, ocean marine transit, and workers' compensation risk. Exhibit 6displays Honeywell's insurance risk management program, prior to the redesign currently under consideration. Honeywell used separate, annually-renewable, insurance policies for each type of insurable risk. Each policy had a specified deductible (or, in insurance terms, a "retention") in an amount that ranged between zero and $6 million. Honeywell would absorb any losses up to the retention level before it received any insurance payments for a loss (referred to as "attaching"). Each loss was subject to a separate retention, meaning that Honeywell paid a new deductible for each loss that occurred.

The Currency unit, under the direction of Deyonne Epperson, was responsible for managing financial risks, including tactical transaction and translationrisk arising from Honeywell's foreign operations.2Transaction risk (sometimes called contractual risk) is the specific exposure faced by a firm when it enters into a contract with a future payoff. A U.S.-based firm may, for example, agree to buy a Japanese machine today, but actually pay for that machine (in Japanese yen) upon delivery, say in three months time. During the three months that elapse from the time the amount of the payment is fixed (in yen), through the time that the company pays for that machine, the company faces yen- dollar exchange-rate risk. A firm can mitigate this exchange-rate risk by taking a long position in yen to offset the risk associated with its future yen-based payment. Honeywell used such a strategy to manage transaction risk. Translation risk, in contrast, refers to the difference in reported earnings (in dollars) that can occur when a U.S.-based firm translates its earnings denominated in foreign currency back into its home currency (dollars) for reporting purposes (financial statements must be reported in a common currency). This reporting-based translation from foreign currency into dollars may or may not represent repatriation or actual exchanges of the foreign-currency into dollars. Honeywell managed its translation risk by estimating its future foreign-currency based earnings, and hedging in a way to offset the effect of exchange-rate movements on those estimated earnings. Honeywell's currency hedging operation was independent of any other hedging or insuring carriedout in other parts of thefirm.

To hedge its exchange-rate exposures, the Currency unit used at-the-money options. The centerpiece of the program was a basket-option of 20 currencies that matured quarterly. These 20 currencies represented 85% of Honeywell's foreign profits. The basket-option provided protection if the U.S. dollar strengthened against the basket, yet allowed Honeywell to retain profits when the reverse was true. The basket was typically purchased late in the year from 2 or 3 major banks at the same point in time with the amount of currency hedged in the basket (otherwise referred to as the "notional" amount) determined by the company's forecasts for the following year's planned profits.

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Each operating unit determined its own foreign-currency exposure and submitted these long-range estimates to corporate headquarters in the form of a three-year forecast. The notional amount was typically 80%-90% of the upcoming fiscal year's total exposure. The basket-option had a strike price that weighted the different currencies to reflect the proportion of the firm's profits originating in a given country. The United Kingdom, Germany, and Canada, for example, comprised 40% of Honeywell's profits, so the basket-option was constructed to weight the currencies of these countries more heavily than those of other countries. This process was repeated annually, as each operating division updated its three-year forecasts. Annual program costs, consisting primarily of option premiums, ranged from $3-$9 million, and averaged $5 million.

Re-thinking Risk Management within Treasury

The treasury team began an extensive evaluation of current program design, examining whether Honeywell's existing strategy was consistent with its risk management objective of minimizing earnings volatility and its "cost of risk" (defined by Honeywell as the sumof retained loss costs, administrative expenses, and insurance and optionpremia).

One focal point for the team was Honeywell's traditional hazard insurance, noting that the current practice was to manage each risk separately, with an individual insurance policy. The team wondered about the applicability of the relatively new concept of enterprise risk management, that is, grouping many risks together into a portfolio of risks, rather than managing each risk separately. Enterprise, or integrated, risk management was based, in part, upon financial portfolio theory: when stocks are less than perfectly correlated, the total risk of a portfolio of stocks will be less than the sum of the risk of each individual stock. If Honeywell treated its risk exposures as a portfolio of risks, perhaps this "portfolio effect" would reduce its total risk (s) exposure, thereby warranting a lower premium from the underwriter who would then assume the risk of the entire portfolio. A similar portfolio strategy was currently in place in the currency program with the use of a basket option, in place of individual options for each specific currency.

Following an internal assessment, the treasury team met with members of Honeywell's insurance consultant and broker, Marsh Inc., to discuss possible design modifications to their current program. The team thought that the new enterprise risk management concept could be implemented through an innovative insurance contract. Such a contract would combine traditional hazard risk with foreign-exchange translationrisk within a unified multiyear policy. Insurance underwriters, such as AIG's Risk Finance division, had been working on the integrated risk concept for some time, and Marsh's Scott Sanderson believed that other insurance underwriters would also be receptive to the new concept. If such a program could be developed, expected annual cost savings would include a reduced premium as "portfolio effects" across traditional insured coverages, across multiple currencies and across multiple years led to decreased volatility. Because traditionally-insured risks were virtually uncorrelated with currency fluctuations, such savings should besignificant.

Honeywell's treasurer, Paul Saleh, believed the idea was promising, but thought that the organizational barriers involved in developing such a program were daunting. The traditional insurance-based risk management area historically had little to do with the derivatives-based currency risk management team. On the surface, the objectives of their risk management programs seemed quite different and the tools they used to manage risk did not seem at all related. Nonetheless, risk was risk, reasoned Mr. Saleh, and Honeywell's approach to traditionally insured risks should be consistent with its currency risk management program. Mr. Saleh had already laid the groundwork for a unified attempt to manage risk by putting all of the risk management units on the same floor and holding monthly cross-functional meetings to encourage interaction within the two groups so that each side understood the other's tasks. He now accelerated this process, and assembled a multi-specialty team from both the insurance unit and the currency risk management side of the Treasury area. To unify the new team and to encourage members to think beyond their traditional risk management frameworks, Mr. Saleh eliminated all titles and all memberswere

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Honeywell, Inc. and IntegratedRiskManagement 200-036

subsequently referred to as "member, Treasury Management Team."3The team beganby establishing guidelines that any new program would have to meet in order for it toreplace Treasury's existing risk management practices. Specifically, the new program would need to provide an equal or greater level of earnings protection, have a total cost lower than existing program costs, have the flexibility to incorporate additional risks in the future, and comply with all accounting standards.

Modeling the Treasury-based Integrated Program

A significant challenge for the Honeywell team members designing the new integrated program was understanding how to find the "optimal" risk management structure, in terms of the appropriate retention and insurance coverage levels, and adapting the insurance program to incorporate foreign-currency translation risk (usually managed with derivatives). The team thought that the standard approach to finding the optimal level of insurance could be adapted to meet their needs if they explicitly modeled the interactions between the different types of risk.

Standard industry practice to determine insurance structure (i.e. retention and coverage limits) was to use the firm's historical loss record to estimate the future one-year "expected loss" for each insurable risk. To reach this estimate, one must assume that the total losses follow a specific probability distribution function. While the true underlying distribution is unknown, a typical assumption for property and casualty losses, for example, might be that the losses fit a log-normal distribution.4Sometimes, the analyst constructs the total loss distribution function by explicitly modeling a separate distribution for the frequency and the severity of each type of loss.5Having identified the loss distribution function, the analyst must estimate the parameters of that distribution. For instance, the relevant parameters for a normal distribution are the mean and standard deviation. Monte Carlo analysis can be used to simulate both the firm's expected losses and its losses net of insurance payments received and premiums paid under different insurance contract designs. The analyst uses this information to find the appropriate retention levels and insurance coverage for each individual risk category. This decision involves trading off the lower premium cost associated with assuming higher retention levels, and the greater risk exposure associated with that higher retention level. In other words, the greater the risk retained by the firm, the lower the insurance premium and the greater the firm's exposure to volatility in earnings and firm value. Honeywell's usual practice was to set retention levels such that the probability of having a loss greater than the retention above that level was roughly45%.

The risk management team followed a process similar to the standard insurance industry practice to determine the optimal aggregate retention and coverage levels. Their analysis, however, was no longer performed on a risk-by-risk basis; instead, the team estimated the expected loss of the combined insured and currency translation risks over the entire term of the policy (the initial term of the policy was 2.5 years to match Honeywell's fiscal year). The team thought it reasonable to assume that currency movements had little to do with the loss pattern experienced from traditionally insured risks (e.g. property and casualty and workers' compensation risk) so they estimated the correlation between the two major groups of risk to be zero. This assumption, combined with the expected loss estimate for the portfolio of risks (which equaled the weighted sum of the expected losses for each individual risk), and an idea about the probability distribution of each individual risk, yielded an

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estimate of the probability distribution of the aggregate portfolio of risks, along with its relevant parameters. Monte Carlo analysis was again used, with the joint probability distribution of the risks of the portfolio, to find the desired retention and coverage levels. Exhibit 7, Charts 1and 2 show the individual probability distributions that underlie the existing program and the simulated joint probability distribution that was the basis for identifying the expected aggregate loss, retention level, and premium for the proposedprogram.

The Proposed Integrated Risk Management Program

The aforementioned analysis, the subsequent development of a structure consistent with the stated program objectives, and the evaluation of potential designs took almost 12 months. Exhibit 8displays the team's final proposal. The "Integrated Risk Management Program" was a multiyear insurance-based strategy that covered all traditionally- insured global risks and currency translation risk in a single master insurance policy. In contrast to Honeywell's existing plan, the proposed program had one annual aggregate retention (deductible) of $30 million, rather than a separate retention for each individual risk. This aggregate retention was set to approximately equal the sum of theseparateretentionsunderthecurrentprogram.The$30millionretentionalsoroughlyequaledthe firm's expected annual losses for the portfolio of covered risks. That is, Honeywell "self-insured" its first $30 million of annual losses (the aggregate of traditionally-insured and foreign currency translation losses).

The specific risks covered in the integrated program included global general liability, global products liability, global property and business interruption, global fidelity, global employee crime, global ocean marine transit, global political risk, director and officer (D&O) liability (entity side B),

U.S. auto liability, U.S. workers' compensation, and foreign currency translation. Aviation product liability was covered under a separate $1 billion per occurrence policy as only a small group of specialized aviation insurers offered aviation product liability insurance, effectively prohibiting its bundling into the integrated insurance policy. If this first integrated risk management program were successful, Honeywell anticipated that other risks (e.g. interest rate exposures, weather risk, commodity price risk, and perhaps others) could eventually be incorporated into the contract. The coverage offered by the proposed contract differed slightly from Honeywell's existing coverage, complicating side-by-side comparisons, but the team estimated that the insurance premium cost of the new program would be on the order of 15%-20% less than that of the existingprogram.

As Exhibit 8shows, under the proposed program, Honeywell would receive reimbursement for losses in excess of the $30 million annual aggregate retention under the "Combined Integrated Program," subject to a maximum pay out of $100 million over the two and one-half year term of the policy.6Exhibit 8also shows that the proposed program provided excess annual coverage, subject to a maximum pay out of an additional $200 million, for specific risks having the potential for large- scale losses, including general, product and auto liability as well as workers' compensation and propertyrisks.7

The foreign-currency coverage of the proposed insurance contract was similar, in a number of ways, to the existing currency hedging program. The new program retained the basket-of- currenciesapproachtomanagingtranslationrisk,butthenotionalamountsofthebasketcurrencies,

Honeywell, Inc. and IntegratedRiskManagement 200-036

as well as the weights assigned to each currency, were determined at the contract's outset. The target strike price (weighted by the proportion of Honeywell's profits in the individual foreign currencies), however, was re-set each year based upon a weighted-average of the preceding year's monthly spot rates. The amount of currency to be hedged was specified in the insurance contract for each of the upcoming years covered by the policy, although a provision in the contract permitted 1%-3% adjustments in the notional amount of each currency.

Exhibit 9shows the expected savings of the proposed program based on AIG's pricing at the chosen $30 million annual aggregate retention.

The Decision

The integrated risk management plan had the tentative support of Honeywell's CEO, conditional on the Finance Committee's in-depth evaluation of the Treasury team's proposal. Such an evaluation required the Finance Committee to determine whether the Treasury team's estimate of 20% annual premium savings were real or illusory. Would Honeywell have the same degree of protection under the new program as it had had under its existing program? If so, how could the insurance underwriters afford such a generous "discount" given the competitive nature of their business? More broadly, was "integration" the right approach for Honeywell? While traditional insurance was, of course, viewed as a business necessity, the integrated risk management concept had not yet reached such a degree of acceptance by the broader business community. Was Honeywell the right firm to innovate in this area? Finally, as complex as the proposed program was, further development would probably become even more Byzantine, so the Finance Committee's decision needed to set the right course for future risk managementefforts.

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Exhibit1 Honeywell Inc. Annual Income Statement($	Millions)
	31-Dec-96	31-Dec-95	31-Dec-94
SalesCore Business	7,311.6	6,731.3	6,057.0
Total Sales	7,311.6	6,731.3	6,057.0
Cost of Goods Sold	4,975.4	4,584.2	4,082.1
SG&A Expense	1,313.1	1,263.1	1,173.8
Research and Development	353.3	323.2	319.0
Unusual Income/Expense	0.0	0.0	62.7
Total Expenses	6,641.8	6,170.5	5,637.6
Interest Expense, Non-Operating	-81.4	-83.3	-75.5
OtherNet	21.8	28.0	25.8
Pre-Tax Income	610.2	505.5	369.7
Income Taxes	207.5	171.9	90.8
Income After Taxes	402.7	333.6	278.9
Net Income (Excluding E&D)	402.7	333.6	278.9
Discontinued Operations	0.0	0.0	0.0
Extraordinary Items	0.0	0.0	0.0
Accounting Change	0.0	0.0	0.0
Net Income (Including E&D)	402.7	333.6	278.9
Primary EPS Excluding E&D	3.18	2.62	2.16
Primary EPS Including E&D	3.18	2.62	2.16
Dividends Per Common Share	1.06	1.01	0.97
Shares to Calculate Primary EPS (millions of shares)	126.6	127.1	129.4
Source: Honeywell Inc. 1995 and 1996 Annual Reports.

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Exhibit1(continued) Honeywell Inc. Annual Balance Sheet ($Millions)

	31-Dec-96	31-Dec-95	31-Dec-94
Assets Cash and Equivalents	127.1	291.6	267.4
Other Short-Term Investments	8.6	9.0	7.4
Accounts Receivable	1,714.7	1,477.3	1,406.9
Inventory	937.6	794.4	760.2
Other Current Assets	193.2	194.6	207.5
Total Current Assets	2,981.2	2,766.9	2,649.4
Long-Term Investments	247.6	244.8	242.8
Property, Plant and Equipment	2,973.6	2,857.1	2,716.8
Accumulated Depreciation and Amortization	-1,839.4	-1,758.2	-1,617.3
Property, Plant and Equipment, Net	1,134.2	1,098.9	1,099.5
Goodwill/Intangibles	690.9	624.2	566.2
Other Long-Term Assets	439.4	325.4	328.0
Total Assets	5,493.3	5,060.2	4,885.9
Liabilities Accounts Payable	584.8	491.5	429.6
Short-term Debt	153.7	312.4	360.6
Current Long-term Debt and CLOs	98.7	0.0	0.0
Other Current Liabilities	1,229.7	1,218.6	1,281.6
Total Current Liabilities	2,066.9	2,022.5	2,071.8
Long-term Debt	715.3	481.0	501.5
Total Long-Term Debt	715.3	481.0	501.5
Deferred Taxes	46.0	0.0	0.0
Other Long-term Liabilities	460.2	516.6	457.9
Total Liabilities	3,288.4	3,020.1	3,031.2
Stockholders' Equity Common Stock	281.7	282.2	282.4
Additional Paid in Capital	528.8	481.3	446.9
Retained Earnings	3,074.7	2,805.8	2,600.4
Treasury Stock	-1,763.5	-1,650.2	-1,576.5
Other Equity	83.2	121.0	101.5
Total Shareholders' Equity	2,204.9	2,040.1	1,854.7
Total Liabilities + Shareholders' Equity	5,493.3	5,060.2	4,885.9
Shares Outstanding	126.4	126.8	127.3

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Exhibit1(continued) Honeywell Inc. Statement of Cash Flows ($Millions)

	31-Dec-96	31-Dec-95	31-Dec-94
Net Income (SCF)	402.7	333.6	278.9
Depreciation	236.1	236.1	235.3
Amortization	51.4	56.8	52.1
Deferred Taxes	38.5	67.2	14.0
Other Non-Cash Items	15.4	23.6	19.9
Other Operating Cash Flows	-250.3	-144.8	-130.7
Cash from Operations	493.8	572.5	469.5
Capital Expenditures	-296.5	-238.1	-262.4
Other Investing Cash Flows	-285.7	-25.6	-64.8
Cash from Investing	-582.2	-263.7	-327.2
Dividends Paid	-133.5	-127.5	-125.6
Purchase or Sale of Stock	-105.9	-76.9	-156.6
Purchase and Retirement of Debt	170.4	-89.9	160.4
Cash From Financing	-69.0	-294.3	-121.8
Exchange Rate Effects	-7.1	9.7	4.6
Net Change in Cash	-164.5	24.2	25.1
Cash Interest Paid	77.3	86.0	69.1
Cash Taxes Paid	113.1	128.3	79.4

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Exhibit2 1996 Profile: Honeywell andCompetition

Johnson ($MM) Honeywell Controls	Emerson Electric	Siemens	Siebe	Smith Inds.	Asea Brown Boveri	Rockwell International
Sales 7,312 10,009	11,150	63,771	4,069	1,536	32,905	10,373
OperatingProfit 670 500	1,793	2,097	580	262	3,029	1,002
NetWorkingCapital 914 291	1,166	17,297	1,053	227	4,012	1,077
Property, Plant and Equipment (1995-1996 change)	35	160	316	496	127	90	(133)	(364)
Earnings	403	235	1,019	1,543	302	182	1,233	726
Long-term Debt	814	792	785	1,642	964	145	1,823	178
Market Value of Equity	8,314	3,113	20,163	25,676	8,775	1,392	9,993	12,318
Volatility (per year, measured for 1996)	27%	18%	19%	14%	13%	13%	13%	27%
Beta	.99	1.17	1.24	.45	.38	.49	.71	.84
% Sales
North and South America	63	77	69	10	45	44	20	78
Europe	25	17	23	83	36	55	56	14
Other Regions	12	6	8	7	19	1	24	8

Source: Company annual reports and casewriter estimates.

Exhibit 3

Source: Casewriter estimates based on CRSP (Center for Research in Security Prices, University of Chicago) data.

Honeywell, Inc. and IntegratedRiskManagement 200-036

Exhibit 4

Source: Casewriter estimates based on CRSP (Center for Research in Security Prices, University of Chicago) data.

Exhibit5 Risks Faced byHoneywell

PProroppeertrytyRRisiskk

CCuurrrerennccyyRRisiskk

InIntetereressttRRaateteRRisiskk

LLiaiabbilitiytyRRisiskk

DDirierecctotorsrs&&OOfffifciceersrsRRisiskk

PPooliltiitcicaallRRisiskk

Financial Priorities

PPeennssioionnRRisiskk

EEnnvvirioronnmmeenntatallRRisiskk

BBuussinineessRRisiskkLLeeggaallRRisiskk

CCrereddititRRisiskk

Source: T. Seuntjens

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Exhibit6 Existing ProgramDesign

$6,600

GeneralLiability

ProductLiability

Auto Liability

Workers' Compensation

Ocean Marine

PoliticalRisk

Property Directors

& Officers, Slide A

Directors &Officers, SlideB

Aircraft ProductsLiability

Currency

Source: T. Seuntjens, prepared by casewriter.

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Exhibit 7

Chart 1Traditional Insured Risks and Currency Translation Risk Individual Probability Distributions

Confidence Intervals

Chart 2Traditional Insured Risks and Currency Translation Risk Joint Probability Distribution

$000

$0

Confidence Intervals

Source: T. Seuntjens.

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Exhibit8 Retention and Coverage Limits, Existing vs. Proposed Multiyear Integrated Risk ManagementProgram

Type of Risk

Existing Retention (per occurrence)

Coverage Limit (per occurrence)

Proposed Combined Aggregate Retention

Coverage Limit (Combined Losses)

Excess Coverage Limit

$200,000,000

Combined,Annual

$100,000,000

Combined Integrated Program,

2.5 Years

$30,000,000

Combined, Annualc

General/ProductLiability $6,000,000 $300,000,000

Auto $3,000,000 $300,000,000

Workers'Compensation $1,000,000 $300,000,000

OceanMarine$100,000$7,500,000 pershipment

$870,000,000

Annual

PoliticalRisk$0$10,000,000 Property$1,000,000$6.6Billion

blanket versus per

occurrence Directors and Officers,SideB$750,000a$100,000,000a

Currency $0 $280,000,000

AircraftProductsLiability $0 $1Billion $0 $1 Billion Directors and Officers,SideA $750,000 $100,000,000 $0b$100,000,000

Source: T. Seuntjens, prepared by casewriter.

aDirectors and Officers coverage for sides A and B have the same retention and coverage limit in the existing program.

bDirectors and Officers coverage, side A (personal liability) has no retention and a separate $100 million limit in the proposed program.

cIf adopted, Honeywell's new program would begin mid-year. The proposed combined aggregate retention would, therefore, be pro-rated to $15 million for the first year. The combinedaggregate retention would be $30 million for each of the following twoyears.

Exhibit9 Program Cost Comparison: No Coverage vs. Current Policy vs. ProposedPolicy

WithoutInsuranceCoveragea With InsuranceCoveragea

A B C D E F

Expected Total Loss (Mean)

Standard Deviation of Expected Loss

Total Retained Loss (Expected)

Premiums Paid (Insurance or Option)

Total Cost of Risk (Expected) = C+D

Standard Deviation of Total Cost of Risk (Existing)

Existing Program
General Liability	12,200,000	8,540,000	11,235,856	1,300,000	12,535,856	4,172,693
Property	1,120,000	5,566,415	1,055,400	3,486,000	4,541,400	4,512,700
Workers' Compensation	11,200,000	2,566,348	10,900,000	350,000	11,250,000	2,163,105
Auto	4,325,410	4,411,918	4,200,000	850,000	5,050,000	4,104,447
D&O, Side B	365,815	4,445,785	154,481	250,000	404,481	840,934
Currencyb	4,094,396	3,352,815	0	5,000,000	5,000,000	0
Total Without Coverage	33,305,621	30,795,330
Total Existing Program	27,545,737	11,236,000	38,781,737	15,793,879
Total Proposed Program	26,135,432	8,509,000	34,644,432	3,819,568
Source: Casewriter estimates.
aEstimates in dollars.
bLosses only, gains removed from consideration.

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Appendix

Excerpts from Management Discussion and Analysis of Financial Condition and Results of Operations in Honeywell's 1996 10k

OPERATIONS

SALES

Honeywell's sales increased to $7.312 billion in 1996, compared with $6.731 billion in 1995 and $6.057 billion in 1994. Sales in the United States of $4.478 billion were up 10 %, as a result of increased volume in all threebusinessunits.Internationalsales,whichrepresent39%oftotalsales,increased7%to$2.834billionin1996.

The international sales increase was the result of positive sales growth of 9% measured in localcurrency, partially offset by negative currency effects as the U.S. dollar strengthened an average of 2% against local currencies in countries where Honeywell does business. U.S. export sales, including exports to foreign affiliates,were$973millionin1996,comparedwith$839millionin1995and$780millionin1994.

NET INCOME

Honeywell's net income increased 21 % in 1996, primarily due to increased sales volume and lower operating expenses. Net income was $403 million ($3.18 per share) in 1996, compared with $334 million ($2.62 per share) in 1995 and $279 million ($2.15 per share) in 1994. Net income in 1994 included an after-tax provision for special charges of $38 million ($0.29 per share) and a reduction of the provision for income taxes of $38 million ($0.29 per share) from a favorable tax settlement.

CURRENCY

The U.S. dollar strengthened an average of 2% in 1996 compared with 1995, in relation to the principal foreign currencies in countries where Honeywell products are sold. A stronger dollar has a negative effect on international results because foreign-exchange denominated transactions translate into fewer U.S. dollars, which Honeywell manages through its hedging strategies. Information about Honeywell's exposure to, and management of, currency risk through the use of derivative financial instruments is provided on page 19 and in Notes 4, 12 and 13 to Financial Statements on pages 28, 33 and 33,respectively.

EMPLOYMENT

Honeywell employed 53,000 people worldwide at year-end 1996, compared with 50,100 people in 1995 and50,800peoplein1994.Approximately30,300employeesworkintheUnitedStates,with22,700employedin other regions, primarily in Europe. Total compensation and benefits in 1996 were $2.8 billion, or 42% of total costsandexpenses.Salesperemployeewere$138,500in1996,comparedwith$132,800in1995and$118,600 in 1994.

ENVIRONMENTAL MATTERS

Honeywell is committed to protecting the environment, both through Honeywell's products and in our manufacturing operations. Our use and release of chemicals to the environment continues to decline steadily. Releases of toxic and ozone-depleting chemicals are being phased out well ahead of regulatory requirements. We are increasing our commitment to pollution prevention: reducing, reusing and recycling to minimize wastes. The costs of managing wastes are decreasing as well. For more information on environmental matters, see Note 20 on page 45.

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DISCUSSION AND ANALYSIS BY SEGMENT HOME AND BUILDING CONTROL

THREE-YEAR OPERATING PROFIT OVERVIEW

Home and Building Control 1996 operating profit was $346 million compared with $309 million in 1995 and $236 million in 1994, which included $29 million in special charges to streamline operations. In 1996, operating profit increased 12 %. Home Control profit improved through volume increases and cost reductions. Building Control profits declined due to a very competitive energy retrofit business and investment in programs to enhance productivity.

In 1995, operating profit rose 16 %, primarily from strong international volume increases, new products and cost reductions. Excluding special charges, 1994 operating profit increased moderately, due to improvement in the U.S. economy and growing consumer confidence.

BUSINESS STRATEGIES

Increased regulation of the environment and a focus on energy management, coupled with customer demands for greater comfort and security, position Home and Building Control well for the future. Growth strategies include expanding and globalizing the product portfolio, including consumer products and heating, ventilation, and air conditioning (HVAC) products. Our strategies also include broadening solution capabilities with a focus on open system technology, globalizing energy retrofit and district energy solutions and enhancing life cycle building serviceofferings.

INDUSTRIAL CONTROL

THREE-YEAR OPERATING PROFIT OVERVIEW

Industrial Control operating profit in 1996 was $255 million, $234 million in 1995 and $207 million in 1994. Operating profits increased in 1996, and the profit rate also showed improvement, as a result of continuing strategic actions to reduce overhead, streamline business operations, improve the mix of higher--margin field instruments and automate component manufacturing.

In 1995, operating profit increased, spurred by a sharp rise in profitability in Sensing and Control as switch margins improved in the United States and as Europe experienced favorable volumes and lower product costs. Operating profit in 1994 included special charges of $14 million to streamline operations and improve productivity.

BUSINESS STRATEGIES

Industry consolidation and introduction of new standards for open systems generate opportunities for new products and applications, as customers look to a single control partner to improve productivity and meet safety and environmental regulations. Industrial Control growth and value creation strategies complement these trends. Industrial Automation and Control will grow by providing the best valueintegrated solutions forprocess industries, expanding the measurement and control product business, broadening our service portfolio and focusing on fast-growing global markets such as Asia, Middle East, Eastern Europe and LatinAmerica.

Sensing and Control's strategies include broadening offerings in the rapidly growing smart sensor market, integrating factory floor solutions with intelligent sensors and focusing on fast-growing customer segments such as information technology and on-board automotive sensors.

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SPACE AND AVIATION CONTROL

THREE-YEAR OPERATING PROFIT OVERVIEW

Space and Aviation Control 1996 operating profit was $163 million compared to $128 million in 1995 and $81 million in 1994. In 1996, operating profits increased 28 %, driven by improvements in the commercial markets, continued productivity improvements and reductions in overhead expenses.

Operating profit in 1995 increased due to improved margins in commercial aviation systems, lower development expenses and productivity improvements. Operating profits in 1994 included special charges of

$20 million to consolidate facilities.

BUSINESS STRATEGIES

The commercial aircraft industry is poised for strong growth in 1997 and beyond. Government spending for electronic components is stabilizing, international opportunities for military avionics retrofits and space systems are increasing, and commercial space programs are growing at a fast pace. Space and Aviation Control strategies are positioned to take advantage of these trends with a strong portfolio of products and solutions.

Growth strategies include expanding our global positioning-based guidance products and systems; enhancing our offerings in growth markets such as aircraft service and airport control; broadening our role in international military and space programs; pursuing retrofit opportunities; and continuing to optimize our investment in 777 technology application.

FINANCIAL POSITION

LIQUIDITY

Through its banks, Honeywell has access to variouscredit facilities, including committed credit lines for which Honeywell pays commitment fees and uncommitted lines provided by banks on a non-committed, best-efforts basis. Available general-purpose lines of credit at year-end 1996 totaled $1.128 billion.This consisted of $725 million of committed credit lines to meet Honeywell's financing requirements, including support of commercial paper and bank note borrowings, and $403 million of uncommittedcredit lines available to certain foreign subsidiaries. This compared with $1.089 billion of available credit lines at year-end 1995, consisting of $725 million of committed credit lines for general financing requirements and $364 million of uncommitted credit lines available to certain foreign subsidiaries. On January 30, 1997, Honeywell increased its committed credit lines from $725 million to $1,375billion.

SHARE REPURCHASE PROGRAMS

In December 1994, the Board of Directors authorized a program to purchase up to 2 million Honeywell shares. This program was completed in the third quarter of 1995. In July 1995, the Board of Directors authorized an open-ended program to repurchase $250 million of Honeywell shares, of which $49 million was used in the second half of 1995, and $163 million during 1996. The purpose of the repurchase plan is to offset the shares issued as part of the 1993 Honeywell Stock and Incentive Plan and other issuances (see Note 15 on page 35.) Honeywell repurchased $129 million of shares in 1995, and $168 million of shares in 1994.

At year-end 1996, Honeywell had 188 million shares issued, 126 million shares outstanding and 31,734 stockholders of record. At year-end 1995, Honeywell had 188 million shares issued, 127 million shares outstanding and 32,569 stockholders of record.

DIVIDENDS

Honeywell has paid a quarterly dividend since 1932 and has increased the annual payout per share in each of the last 21 years. In November 1995, the Board of Directors approved a 4% increase in the regular annual dividend to $1.04 per share, from $1.00 per share, effective in the fourth quarter 1995. In July 1996, the Board of Directors approved an additional 4% increase in the regular annual dividend to $1.08 per share effective in the

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third quarter 1996. Honeywell paid $1.06 per share in dividends in 1996, compared with $1.01 in 1995 and $0.97 in 1994.

DERIVATIVE FINANCIAL INSTRUMENTS

Honeywell is exposed to market risk from changes in interest rates and foreign currency exchange rates, which may adversely affect its results of operations and financial condition. In seeking to minimize this risk, Honeywell manages exposure to changes in interest rates and foreign currency rates through its regularoperating and financing activities and, when deemed appropriate, through the use of derivative financial instruments. Honeywell policy prohibits the use of derivative financial instruments for trading or other speculative purposes and Honeywell is not a party to leveraged financialinstruments.

Honeywell has entered into various foreign currency exchange contracts designed to manage its net exposure to exchange rate fluctuations on foreign currency transactions (see Notes 4, 12 and 13 to Financial Statements on pages, 28, 33 and 33 respectively). Foreign exchange contracts reduce Honeywell's overall exposure to exchange rate movements, since the gains and losses on these contracts offset losses and gains on the assets, liabilities and transactions being hedged. Transactions that are hedged include foreign currency denominated receivables and payables on the balance sheet, firm purchase orders and firm sales commitments. At year-end 1996, the notional amount of outstanding foreign exchange contracts was $1.111 billion.

It is Honeywell's practice to manage the relative proportions of its fixed and floating rate debt in the context of the interest rate environment. The objective is to manage the cost of Honeywell's debt financing over an extended period of time. To manage this mix in a cost efficient manner, Honeywell enters into interest rate swap agreements, in which it agrees to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed-upon notional principal amount (see Notes 12 and 13 to FinancialStatementsonpage33).Atyear-end1996,thenotionalamountofoutstandinginterestrateswapswas

$390 million.

LITIGATION

On March 13, 1990, Litton Systems, Inc. filed suit against Honeywell in U.S. District Court, Central District of California, alleging Honeywell patent infringement relating to the process used by Honeywell to coat mirrors incorporated in its ring laser gyroscopes; intentional interference by Honeywell with Litton's prospective advantage with customers and with its contractual relationships with Ojai Research, Inc.; and attempted monopolization and predatory pricing by Honeywell in certain alleged markets for products containing ring laser gyroscopes. Honeywell generally denied Litton's patent, tort and antitrust allegations; contested both the validity and infringement of the patent; and alleged that the patent had been obtained by Litton's inequitable conduct before the United States Patent and TrademarkOffice.

Separate trials were held on the patent and antitrust claims, and at the conclusion of both trials, juries awarded Litton significant monetary damages. However, the damage awards were set aside by the trial court judge and a new trial ordered on the issue of damages for both claims. The parties have also appealed various legal issues related to these cases. For a more detailed discussion of this litigation, see Note 20 to the financial statements, which appears on page 43 of this report.

CREDIT RATINGS

Honeywell's credit ratings by Standard & Poor's Corporation and Duff and Phelps Corporation are at A/A-1 and A/Duff1, respectively for short-term and long-term debt. Honeywell's credit rating by Moody's Investors Service, Inc. improved to A2/P1 in 1996.

On January 27, 1997, Honeywell announced a definitive agreement to acquire MeasurexCorporation forapproximately$600millionincash(seeNote22onpage46).Theacquisitionwillbefinancedwithdebt.After careful review of Honeywell's capital structure and financial position given the debt increase, the major credit rating agencies confirmed Honeywell's current creditratings.

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Appendix(continued) Cautionary Statements for Purposes of the Safe Harbor Provisions of the Private Secur