Risk Management Basics What Every Farmer Needs to Know RISK MANAGEMENT BASICS. Dr. Albert E. Essel Delaware State University

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1 RISK MANAGEMENT BASICS Dr. Albert E. Essel Delaware State University Dr. Laurence M. Crane National Crop Insurance Services Today s Discussion Risk and sources of risks in agriculture Risk management principles Risk identification and prioritization Common strategies for risk treatment Some important risk management priorities 1

2 Risk Chance of loss Likelihood /probability of adverse outcome Uncertain consequences Exposure to hazard, peril or potential loss Two Components of Risk Frequency (probability) of Loss Severity (Size) of loss 2

3 The world according to risk Random assumptions (and thoughts) about risk: Risk is not inherently bad There is a risk return trade off Risk can be managed If you can t measure it, it is hard to manage it Accurate information is essential in formulating plans and strategies Individuals perceptions of risk differ, thus they respond differently to common risky events Often there is more than one right way of responding to risk Where to begin One common method of classifying risk is to look at risk as it affects the various functions on a farm: Production Marketing Finance Human Resources Legal [Remember there is tremendous overlap and interaction between these categories.] 3

4 1. In your opinion, which of the following categories of risk is the greatest for producers in North Carolina? 1. Production 2. Marketing 3. Finance 4. Human Resources 5. Legal Production Risk What is it? Any crop or livestock production related activity or event that is uncertain. Variability in production caused by weather, disease, pests, genetic variation, machinery failure, timing, etc. 4

5 Production Risk Production uncertainty in crop enterprises is caused by variations in weather and by disease, insects, and other biological pests. Livestock enterprises also involve production uncertainty. Death losses from disease and adverse weather conditions are common. 2. Of the following production risks, which is the most threatening to your operation? 1. Drought too dry 2. Excess moisturetoo wet 3. Temperature (too hot or too cold) 4. Disease 5. Pests 6. Old (unreliable) machinery 7. Increasing input costs (diesel, fertilizer, etc.) 8. Other 5

6 Marketing Risk What is it? Any marketing related activity or event that is uncertain leading to variability of prices for outputs and/or inputs. Fluctuations in farm input and product prices caused by basic supply and demand relationships, competition from substitutes, government interference, technological change, etc. Fluctuations in input prices (purchased inputs) 3. Of the following marketing risks, which is the most threatening to your operation? 1. Low commodity prices 2. Lack of market access 3. High input prices 4. Meeting quality requirements 5. Market proximity (distance to market) 6. Lack of Value Added opportunities 7. Competition 8. Other 6

7 Financial Risk What is it? Any uncertainty that directly threatens the financial health of the farm business or results in financial loss. This includes: 1. Cost and availability of capital 2. Meeting cash flow needs 3. Ability to maintain and grow equity 4. Ability to maintain family living expenses 4. Of the following financial risks, which is the most threatening to your operation? 1. Loan approval (Lender doesn't understand my farm operation) 2. Poor debt structure inadequate equity; asset life doesn t match loan term 3. Poor asset structure inadequate asset turnover rate; low rate of return on assets 4. Meeting cash flow and/or family living requirements 5. Current debt level too high 6. Bad credit history 7. High credit card/consumer debt 8. Other 7

8 Human Resource Risk What is it? Any event relative to the human element of the farm that is uncertain. The character, health, behavior, and interrelationships of people are unpredictable Death, disability and divorce are critical risk factors Unpredictable family and hired labor relations 5. Of the following human resource risks, which is the most threatening to your operation? 1. Off farm employment opportunities 2. Poor health/disability 3. Availability, reliability, and/or the cost of hired labor 4. No written operating plan for your farm business 5. No formal retirement plan or management succession plan 6. Working with family 7. Exhaustion, stress, and/or burnout 8. Other 8

9 Legal Risk What is it? Any activity or event that threatens the legal standing of the farm or puts the farm in legal jeopardy. Business structure, estate planning, contractual arrangements, tort liability, statutory compliance, environmental issues, etc. 6. Of the following legal risks, which is the most threatening to your operation? 1. Contract requirements 2. Product liability 3. Personal or employee liability 4. Property title/ownership entanglements (heir, joint ownership) 5. Environmental regulations 6. Transfer to next generation 7. Urban/rural interaction issues 8. Other 9

10 7. Of the risk factors listed below which do you consider as most important in your operation? 1. Output price variability 2. Yield variability 3. Availability of credit, too much debt 4. Operator injury, illness, or death 5. Market access 6. Changes in environmental regulations 7. Costs of inputs Risk Management All the things that a producer may do to influence the bottom line of the business and grow the long term value or net worth of the business. Risk and return (or profitability) are related and the relationship must be managed. 10

11 Risk Management Steps Identification Assessment Treatment Implementation Evaluation Identification Know (inventory) and document your farm Identify the different sources of risks in the farm operation: Production risks Marketing risks Financial risks Human resource risks Legal risks 11

12 Assessment Determine implication of each risk on farming operation Two measures used for assessing risks are: 1. Frequency (probability) of loss 2. Severity (size) of loss Frequency How often a risky event may happen over a given period Severity How large/small is the potential loss arising from the event Assessment Place each risk into a quadrant High frequency Low severity High frequency High severity Frequency Low frequency Low severity Low frequency High severity Severity 12

13 Treatment: Mitigating Strategies Tools for alleviating (handling) risks Avoid Control (Reduce) Retain (Accept) Transfer Treatment Frequency High frequency Low severity RETAIN/ CONTROL Low frequency Low severity RETAIN/ CONTROL High frequency High severity AVOID Low frequency High severity TRANSFER Severity 13

14 Implementation Select appropriate tool to manage risk Choose your risk management team Common Tools for Managing: Production Risks Enterprise choice / Diversification (Control) Contract production (Control) Yield (crop) insurance (Transfer) Revenue insurance (Transfer) Technology Irrigation, inputs, etc. (Control) Best management practices (Control) 14

15 Common Tools for Managing: Marketing Risks Marketing plan (Control) Revenue insurance (Transfer) Vertical integration/value addition (Control) Contract production (Control) Hedging (futures /options contracts) (Control) Marketing cooperative (Control) Direct marketing (Control) Common Tools for Managing: Financial Risks Recordkeeping and analysis (Control) Budgeting (Control) Insurance (Transfer) Pay down debt (Control) Family living expenses (Control) Estate planning (Control) Off farm employment (Control) 15

16 Common Tools for Managing: Human Risks Develop and maintain operating procedures for farm (employee procedures and management practices) (Control) Good family and labor relations (Control) Disability, Health, Life insurance (Transfer) Estate and transition plan (Control) Common Tools for Managing: Legal Risks Legal business entity (Control) Insurance (Transfer) Contracting (Control) Estate/Transition plan (Control) Government actions and regulations affecting your operations (Control) 16

17 Implementation Select appropriate tool to manage risk Select your risk management team Extension educators Loan officers/bankers Crop insurance agents Cooperatives Lawyers Commodity organizations Accountants, private consultants Commodity brokers, marketing advisors Evaluation Evaluate annual successes and challenges of your risk management plan Compare your performance to your goals Adjust your risk management plan 17

18 So where do we go from here? Overview of a few special concerns for small farmers Suggest some common sense priorities/ practices that all small farmers should be able to incorporate into management practices to reduce their risk exposure. Risk Management Priorities Minimize safety risks nothing is more important than safety!! Take the time to do things right Don t move faster than you can think Wear protective gear Properly store chemicals, fuel, pesticides, etc. Maintain equipment Adopt a stress management plan Teach your children (and others) about safety Age appropriate tasks Friends and visitors 18

19 Risk Management Priorities Use good agricultural practices Follow industry and university standards IPM, nutrient management, rotational grazing, herd health, chemical & fertilizer application rates, etc. Record and maintain adequate records Documentation required for some chemicals Limit legal liabilities in some cases Required for insurance purposes Improves management skills and decisions Risk Management Priorities Support your neighbors Develop a strong network of friends Share labor, equipment, knowledge Reduces costs Increases satisfaction Make emergency plans in case of illness, etc. Write down procedures so someone else can follow Create study group/club 19

20 Risk Management Priorities Property, liability, and health insurance Review policies and know their terms Pay attention to exclusions Evaluate coverage levels and deductibles Shop around and compare Get a good agent who gives you the service you need Pay attention to your liability exposures Risk Management Priorities Pay attention to business management Analyze in writing the impact of decisions What, how, why, expectations, results Maintain orderly records Keep and file receipts Keep and file ownership manuals and paperwork Create memory aids Document, Document, Document Engage in formal farm business planning 20

21 8. In your opinion, which of the following best describes the trend in South Carolina agricultural production? 1. More specialization 2. More diversification 3. Going organic 4. Value added increasing 5. Farming is a respected profession 6. Increased opportunities 7. Other 9. In your opinion, which of the following is the greatest constraint to successful agriculture in South Carolina? 1. Population growth 2. Environmental conflicts 3. Food safety 4. Competition from 5. Public attitude 6. No next generation 7. Other 21