Livestock Revenue Insurance: Price protection using an insurance tool

1
Livestock Revenue Insurance Price protection
using an insurance tool

• Ed Kordick,
• Director, Market Education and Information
• Iowa Farm Bureau Federation

2
Presentation Objectives

• Review Risk Management Factors
• Livestock Revenue Insurance Pilot Programs
• Livestock Gross Margin (LGM) Insurance
• Hogs
• Livestock Risk Protection (LRP) Insurance
• Hogs
• Fed Cattle
• Feeder Cattle

3
Important !

• This presentation is from a general risk
  management perspective.
• Examples used are to teach concepts and may not
  reflect current conditions ! ! !
• Education resources used include
  
  Center for Agricultural and Rural Development,
  ISU Extension and RMA.

4
Risk Management is not predicting prices!!

• No one can know the future!
• UNKNOWN factors move the market and that
  is the risk !

5
Markets are unpredictable

• Market movement generally results from random
  events that are external to the market, and thus,
  are unpredictable.

• changes in consumer preferences,
• international trade disputes,
• competing products,
• disease outbreaks,
• government reports, many more unknowns

6
Revenue Insurance

• Approach/Attitude toward risk management tools is
  important !
• Crop/Livestock insurance is not an
  investment.
• Other forms of insurance are not viewed
  as investments!
• Revenue Insurance is risk management, and should
  not be expected to pay.

7

• Risk Management Tools

8
Risk Management Tools

• Futures options
• Constant hedge, targeted hedges
• Forward Contracts
• Fixed price
• Formula pricing arrangements
• Plus many others
• Livestock Revenue Insurance

9
The job of any risk management tool

• Is to minimize negative outcomes
• by taking some action.

10
Risk Management..Structured Common Sense
Market prices are a risk for livestock producers.
11
Livestock Marketing Information Center
12
December Lean Hog Futures
Risk is unexpected change in price !
13
Slaughter Capacity Affects Hog Price

• Inverse relationship between slaughter capacity
  utilization and hog prices.
• As more capacity is utilized, hog prices decline.
• When capacity utilization is pushed above 100 of
  normal, hog prices plummet.

14
Swine Production One Litter
Cost are large in hog production and so is the
risk !
Output price is important and remember that feed
cost is 54 of total costs !
15
Risk Management Tools

• Each tool has advantages disadvantages.
• Livestock Revenue Insurance is simply another
  tool in the risk management toolbox.
• The products have distinct advantages to point
  out

16
Livestock Revenue Insurance

• Convenience
• Saves the producer management time and effort
  over using options strategies.
• Customization
• Products are flexible and fit any operation.
  Coverage can be purchased for any number of hogs
  or cattle.
• Futures contracts have specific size (40,000 lbs.
  216 head)
• New products fit well with small to medium size
  operations.

17
Livestock Revenue Insurance

• May have lower cost
• Premiums vary, but some examples show that
  coverage can be cheaper.
• Producer subsidy may make coverage cheaper than
  ag options.
• Other Advantages . ? . ?

18

• Livestock
• Revenue
• Insurance

19
Livestock Revenue Insurance

• Two Pilot Projects were approved for hogs in
  Iowa
• Livestock Gross Margin (LGM)
• Livestock Risk Protection (LRP)
• Available since last summer (2002)
• Allowed as result of ARPA, Agriculture Risk
  Protection Act of 2000.
• LRP Pilot has since expanded to 12 other states.

20
What perils should livestock insurance cover?

• Revenue production X price.
• Production risk is greater than price risk for
  crop farmers, although both are large.
• Price risk is much greater than production risk
  for livestock producers.
• Insurance companies carry existing lines of
  insurance for production risk.

21
Livestock Revenue Insurance

• Uses futures based values to help producers
  manage price risk.
• Very similar to CRC and RA crop insurance.

22
Livestock Revenue Insurance

• Futures based revenue calculations are meant to
  mirror the farmers cash based situation.
• The revenue referred to in Revenue Insurance
  products are not cash price revenue protections.

23
Livestock Revenue Insurance

• Livestock Gross Margin (LGM)
• Protects against a negative change in gross
  margin (hog less feed cost).
• Livestock Risk Protection (LRP)
• Protects against a negative change in hog price.

Lets look at LGM first ? ? ? ? ?
24

• Livestock
• Gross
• Margin
• (LGM)

25
LGM Hog Insurance Policy
Hogs are assumed to be marketed at 260 lb. Lean
hog futures price converted to a live weight
basis by multiplying by a 0.74 factor. Feed
prices are lagged to represent the middle of the
feeding period. The production plan is based on
est. livestock returns series from ISU Extension.
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Livestock Gross Margin

• Guarantees a minimum return over feed costs
  (gross margin)
• Gross margin is based on
• Price of lean hog futures contracts.
• Price of corn futures.
• Price of soybean meal futures.

27
Determining the Guarantee

• Classify the operation as farrow-to-finish or
  finish only.
• Insurance periods are Aug. - Jan. and Feb. -
  July. (there is an upcoming change.)
• Project the number of hogs that will be marketed
  in each of the 6 months.
• Maximum is 15,000 head in each period.

28
Determining the Guarantee

• Hog, corn and bean meal prices during the last 3
  trading days before July 15 or Jan. 15 are used.
• Each month uses the price for the contract that
  expires in that month, or an average of the
  contracts that expire in the surrounding months.

29
Determining the Guarantee

• Feed prices are lagged
• 3 months for farrow-finish
• August marketings use feed priced in May
• 2 months for feeder finish
• August marketings use feed priced in June
• Feed consumption assumed is
• 12.95 bu. corn 185 lbs. of meal (farrow to
  finish)
• 10.41 bu. corn and 149 lbs. of meal (finishing)

30
Determining the Guarantee

• Projected gross margin 260 lb. x 74 x hog
  price - feed cost.
• Projected gross margin per pig in each month
  x number of head to sell monthly
  gross margin.
• Add together all 6 months total gross margin.
• Guarantee can be from 80 to 100 of
  projected total gross margin.

31
Gross Margin Per Hog

• 2.6 x 0.74 x Lean Hog Pricet
• 12.95 x Corn Pricet-3
• (184.89 / 2000) x SoyMeal Pricet-3
• 2.6 x 0.74 x 65.20
• 12.95 x 2.53
• (184.89/2000) x 197
• Gross Margin per Hog 74.46

For August Marketings

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Actual GM Per Hog

• 2.6 x 0.74 x Lean Hog Pricet
• 12.95 x Corn Pricet-3
• (184.89 / 2000) x SoyMeal Pricet-3
• 2.6 x 0.74 x 59.80
• 12.95 x 2.53
• (184.89/2000) x 197
• Gross Margin per Hog 64.07

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Internet Table
www.rma.usda.gov/policies/2003LGM.html
34
LGM Report
35
LGM Report
36
LGM Report
Hog, corn and soymeal futures used for projection
Hog, corn and soymeal futures closes used for
actual
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Internet Table
www.rma.usda.gov/policies/2003LGM.html
38
Projected Gross Margin (GM)
GM
Total
Month
per head
Head
GM
August
74.46
100
7,446
September
70.07
100
7,007
October
65.67
100
6,567
November
64.17
100
6,417
December
63.12
100
6,312
January
66.42
100
6,642
Total Projected GM
40,391
39
Coverage and Guarantee
Coverage
Guarantee
Selected
100
40,391
95
38,371
90
36,352
85
34,332
80
32,313
40
Example

• With 95 guarantee, the guaranteed gross margin
  is .95 x 40,391 38,371.
• In February the actual gross margin is
  calculated, using the actual closing futures
  prices for last 3 trading days each month
• For example, actual GM 33,000
• Payment 38,371 - 33,000 5,371
• Or 8.95 per head.

41
Premiums

• Premiums are dependent on a number of variables
• Amount of coverage selected
• Producers marketing plan
• Level of futures prices
• Amount of price volatility

42
Premiums

• Higher guarantees will have higher premiums
• Also, if more hogs will be marketed early in the
  period, premiums should be lower (prices in
  nearby months should change less than for later
  months)

43
Example Effect of LGM Coverage Level on Per-Hog
Premium

• Per hog premium is directly related to the
  coverage level.
• There is no producer premium subsidy in this
  program.

4.50
4.00
3.50
3.00
2.50
/hog
2.00
1.50
1.00
0.50
0.00
80
85
90
95
100
Coverage Level
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Who can benefit from LGM?

• Producers who depend on the daily cash market or
  a formula related to it.
• Smaller producers who do not have the volume to
  use futures contracts.
• Producers who dont want to put up margin money.
• Producers who have feed price risk.

45
Changes coming for LGM ???

• Sold monthly rather than bi-annually.
• Price discovery and sales period moved closer
  together.
• Coverage will be for 5 month periods (begins one
  month after sales closing date).
• Segregated Early Weaned (SEW) pigs can be
  covered.

46

• Livestock
• Risk
• Protection
• (LRP)

47
Livestock Risk Protection (LRP)

• Coverage in lots of 1 to 10,000 at any one time,
  but no more than 32,000 head/yr.
• Sold throughout the year.
• Available to insure hogs with end dates at 13,
  17, 21, 26 weeks.
• Select end date closest to market date.

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Livestock Risk Protection (LRP)

• Priced daily throughout year, premiums calculated
  using formula based on hog futures prices.
• Coverage available from 70 to 95
  of hog price (not 5 increments).

49
Livestock Risk Protection (LRP)

• Producer chooses target weight (example 250),
• Lean weight conversion (.74) 1.85 cwt.
• Premium rate changes w/ coverage price.
• Premium subsidy is 13.

50
LRP Simple Example (Swine)

• Expected ending value (17 weeks) 58.508,
• Choose to insure price protection at 52.68
  (90.04 coverage,)
• If avg. cash price was 49.00 for insured hogs,
  insured producer paid 3.68/cwt.
• If avg. cash price was gt 52.68 for insured hogs,
  no loss, no indemnity.

51
Internet Table LRP Swine

• LRP Insurance Table includes
• Expected Ending Value,
• Coverage Price,
• Coverage Level ,
• Rates
• and Cost.

www3.rma.usda.gov/apps/livestock_reports/lrp_selec
t_date.cfm
52
Internet Table LRP Swine
www3.rma.usda.gov/apps/livestock_reports/lrp_selec
t_date.cfm
53
LRP Internet Table Example
11/03/03
Expected
Cost
Endorsement
End
Coverage
Per
Coverage
Rate
Length
Value
Price
Level
Cwt.
0.9193
13
55.726
51.230
0.0399
2.049
13
55.726
49.230
0.0284
1.400
0.8834
13
55.726
47.230
0.0200
0.946
0.8475
0.8116
13
55.726
45.230
0.0148
0.670
There will be 4 to 6 choices at each endorsement
length 13, 17, 21, 26
week coverages.
End date 2/2/04
54
LRP availability
The Expected Ending Value, Coverage Price,
Coverage Level , Rates and Cost are based on the
previous days markets. Result protection
available from 7 a.m. until 8 p.m CST the
following day.
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Indemnity Calc. Includes

• Indemnity payments based on two producer sold
  data series in an official Agricultural Marketing
  Services (AMS) report.
• The National Daily Direct Hog Prior Day Report
  Slaughtered Swine
• Available on Internet www.ams.usda.gov/mnreports/
  lm_hg201.txt

56

• Actual Ending Value uses end date and previous
  day (2 day average) from the AMS 201
  report.
• Takes into account negotiated and formula priced
  marketings
• Weighted average by head marketed.

57
LRP Example

• 600 head to market in 17 weeks times 1.85 1,110
  cwt.
• Expected Ending Value 58.508
• Coverage price 52.68 (90.04)
• 1,110 cwt. times the coverage price of 52.68
  equals 58,475
• 58,475 times the insured share of 1.00 equals an
  insured value of 58,475

58
LRP Example

• 58,475 times the rate of .040167 equals 2,349
  total premium.
• 2,349 times .87 (reduction for 13 premium
  subsidy) equals 2,043.
• 2,043 divided by 600 head 3.41/head for hog
  price coverage below 52.68.

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LRP Example

• Hog price coverage below 52.68.
• Hog price actual 49.00 (9.50
  below Expected Ending Value)
• Indemnity of 3.68 per cwt.
  or 6.81 per head.

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Livestock Revenue Insurance for Hogs

• Livestock Gross Margin (LGM)
• Protects against a negative change in gross
  margin (hog less feed cost).
• Livestock Risk Protection (LRP)
• Protects against a negative change in hog price.

Two distinct products covering risk differently !
61
Livestock Revenue Insurance

• LGM and LRP
• Are year long policies (coverage is in shorter
  time periods).
• Cant have both policies in place at same time
  even if no coverage is selected.
• Can cancel one to use the other if no coverage is
  in place.

62
LGM and LRP Similarities

• Market based risk management for producers,
  without locking out chance for better outcome.
• Forward looking, using current market
  opportunities.
• Premium due at purchase.
• Based on target market.

63
LGM and LRP Differences

• Gross Margin protection vs. Price Protection.
• Coverage levels.
• Ownership shares
• LGM 100, LRP partial shares
• LGM 260, LRP producer selects weight
• Appeal in different situations to unique pork
  operations.

64

• Livestock Risk Protection
• (LRP)
• Fed Cattle
• Feeder Cattle

65
Risk Management Tools

• Similar to hogs, cattle producers have a number
  of risk management tools
• Futures options
• Constant hedge, targeted hedges
• Forward Contracts
• Fixed price
• Basis forward contracts
• Formula pricing arrangements
• Plus others
• Livestock Revenue Insurance

66
Livestock Risk Protection (LRP)

• USDA RMA announced that a new insurance product
  available starting June 9, 2003.
• Designed to offer price insurance for feeder and
  fed cattle producers.

67

• Livestock Risk Protection
• (LRP)
• Fed Cattle

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Live Cattle Futures Contract

• 40,000 pounds of 55 choice,
• 45 select grade live steers
• Physically Delivered

69
Livestock Risk Protection (LRP)

• Livestock Risk Protection (LRP) program for fed
  cattle in Illinois, Iowa Nebraska.
• Fed cattle will be marketed for slaughter at the
  end of the insurance period.
• Include cattle expected to grade select or better
  with a yield grade 1-3.

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Livestock Risk Protection (LRP)

• Fed cattle insurance periods range in 30-day
  increments from 13 to 52 weeks.
• Max. number of fed cattle insured by any one
  entity in any one crop-year is 4,000 head.

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Livestock Risk Protection (LRP)

• The Federal Crop Insurance Act limits the amount
  of livestock insurance that may be reinsured each
  year.
• When the annual capacity for livestock insurance
  is obligated, the system closes sales of new and
  renewed policies.

72
Livestock Risk Protection (LRP)

• Coverage range 70 to 95
• RMA began accepting applications
• Monday, June 9, 2003

73
Internet Table LRP Fed Cattle

• LRP Insurance Table includes
• Expected Ending Value,
• Coverage Price,
• Coverage Level ,
• Rates
• and Cost.

www3.rma.usda.gov/apps/livestock_reports/lrp_selec
t_date.cfm
74
Internet Table LRP Fed Cattle
www3.rma.usda.gov/apps/livestock_reports/lrp_selec
t_date.cfm
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USDA 5-Area Weekly Price

• USDA 5-Area Weekly Weighted Average Direct
  Slaughter Cattle price (Live Basis 35 65
  Choice category) is used for LRP Fed Cattle
  settlement price.
• Markets in Texas/Oklahoma, Kansas, Nebraska,
  Colorado, Iowa/Minnesota.
• Website for information www.ams.usda.gov/mnreport
  s/lm_ct150.txt

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LRP Simple Example (Fed Cattle)

• Expected ending value (17 weeks) 85.53,
• Choose to insure price protection at 78.06
  (91.26 coverage,)
• If average cattle price was 75.00 for insured
  cattle, insured producer paid 3.06/cwt.
• If average cattle price was gt 78.06 for insured
  cattle, no loss, no indemnity.

81

• Livestock Risk Protection
• (LRP)
• Feeder Cattle

82
Feeder Cattle Futures Contract

• 50,000 pounds of 700 849 pound, Medium Frame 1
  and Medium Large Frame 1 feeder
  steers
• Cash Settled

83
Livestock Risk Protection (LRP)

• LRP feeder cattle program is available in CO, IA,
  KS, NE, Nevada, OK, SD, TX, UT and Wyoming.
• Feeder cattle steers that will weigh 650-900
  pounds and be ready to be placed in feedlot at
  the end of the insurance period.
• Predominantly dairy or Brahma? not
  eligible for insurance.

84
Livestock Risk Protection (LRP)

• Feeder cattle insurance periods available range
  in approximately 30-day increments from 21 to 52
  weeks.
• The maximum number of feeder cattle that may be
  insured by any one entity in any one crop-year is
  2,000 head.

85
Internet Table Feeder Cattle
www3.rma.usda.gov/apps/livestock_reports/lrp_selec
t_date.cfm
86
Internet Table Feeder Cattle
www3.rma.usda.gov/apps/livestock_reports/lrp_selec
t_date.cfm
87
Chicago Mercantile Exchange Feeder Cattle
Index

• CME Index is used for LRP Feeder Cattle
  settlement price.
• Index is a weighted average price from
  29 auctions in the country.
• Website for information
  www.cme.com/prices/cash-settled_commodity_index_p
  rices.cfm

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Livestock Risk Protection (LRP)

• LRP Feeder Cattle
• Similar to Fed Cattle insurance, except the
  actual ending value is the
  CME Feeder Cattle Index.
• If CME Feeder Cattle Index is less than coverage
  price, there is an indemnity.

92
Livestock Revenue Insurance

• Convenience
• Saves the producer management time and effort
  over using options strategies.
• Customization
• Products are flexible, fit any operation.
  Coverage can be purchased for any number of head.
• Futures contracts have specific size (40,000
  lbs., 50,000 lbs.)
• New products fit well with smaller to medium size
  operations.
• Lower cost may be possible
• Premiums vary, but LRP is subsidized so it is
  worth investigation.

93
Livestock Risk Protection (LRP)

• More information
• Coverage prices and premium rates for LRP Fed
  Cattle and Feeder Cattle change daily.
• LRP's policies, daily coverage prices, rates, and
  actual ending values may be viewed on
  www.rma.usda.gov.

94
More information

• Summary of LRP for cattle (from ISU)
• www.econ.iastate.edu/outreach/agriculture/periodic
  als/ifo/050103.pdf
• Summary of LGM and LRP for hogs (from ISU)
• www.econ.iastate.edu/research/webpapers/paper_2082
  .pdf
• RMA R D Bulletin with lots of links
• www.rma.usda.gov/news/r-and-d/2003/pdf/rd03-019.pd
  f
• RMA Web tool
• www3.rma.usda.gov/apps/livestock_reports/main_menu
  .cfm

95
Risk Management is . . . Protecting Financial
Security

• Guarantee cash flow
• Replace working capital
• Protect net worth
• Using insurance doesnt mean the pricing job is
  done -- may need to lock in price using another
  tool (contract, hedge, etc.)

96
Who needs to protecting financial security with
livestock revenue insurance ?????

• Operations dependent upon the open market,
• Those with any contract tied to the cash market
  including shackle space contracts that price on
  3 day average,
• In future, those in contracts now !
• Everyone in livestock production
  has risk management needs.

97
Points to Ponder for Producers

• Consider the new tools on at least a small
  portion of production to learn concepts for
  future use.
• These products can be stay in
  business insurance (remember hogs in 1998!)
• Check with insurance agent for more information
  and details.

98
In Summary

• There is always sufficient reason for producers
  to have a risk management plan in place for
  livestock operations.
• Producers should consider how the new revenue
  insurance products can help manage risk.

99
Thank you !!!
Ed Kordick Iowa Farm Bureau Federation 515-225-543
3 ekordick_at_ifbf.org