Livestock Risk Protection

Transcription

1 E Livestock Risk Protection William Thompson, Blake Bennett and DeDe Jones* Livestock Risk Protection (LRP) is a single-peril price risk insurance program offered by the Risk Management Agency (RMA) of USDA through commercial crop insurance vendors. An LRP policy protects producers from adverse price changes in the underlying livestock market. The policy does not cover any other peril, such as death or disease. RMA has launched a pilot program for LRP insurance in several states. Fed cattle policies (LRP Fed Cattle) are available to producers in Illinois, Iowa and Nebraska. Feeder cattle policies (LRP Feeder Cattle) are available to producers in Colorado, Iowa, Kansas, Nebraska, Nevada, Oklahoma, South Dakota, Texas, Utah and Wyoming. How LRP Works A producer must submit an LRP policy application through an authorized crop insurance vendor. Insurance vendors must have completed an RMA training program to become authorized. The application process establishes producer eligibility by documenting a substantial beneficial interest in the cattle. A producer with a partial interest in a group or pen of cattle may independently insure his or her portion. After completing the policy application, producers select a coverage price and endorsement length that meets their risk management objectives. This information may change daily and is posted on the RMA Web site. Table 1 lists key RMA Web sites. Table 1. Key LRP Web sites. The coverage price is a percentage of the expected ending value. These values and the associated rates are based on the current day s closing futures prices and correspond to separate endorsement lengths. The difference between the expected ending value and the coverage price is similar to the deductible on an auto insurance policy. A larger deductible (a lower coverage price relative to the estimated ending value) corresponds to a lower premium. * Assistant Professor and Extension Economist, Assistant Professor and Extension Economist, and Extension Program Specialist Risk Management, The Texas A&M University System.

2 Endorsement lengths are in increments of about 30 days from 13 to 52 weeks. Both feeder cattle and fed cattle producers will want to purchase price risk insurance with an ending date of coverage that meets their risk management objectives. Feeder cattle producers may want the end date of coverage to match the expected date the cattle will be sold or moved to a feedlot. Fed cattle producers, on the other hand, will want to match the ending date of coverage with the anticipated date the cattle will be ready for slaughter. Both policies, however, can be purchased with shorter endorsement lengths. LRP coverage does not begin until a Specific Coverage Endorsement (SCE) is submitted and accepted by RMA. The submission of the SCE to the RMA is done online after the application has been completed and accepted. The SCE specifies the elected coverage price, the specific number of head covered, and the length of coverage. New provisions for crop year 2004 LRP policies require that sales be allowed from the time rates are set and validated (based on the current day s CME prices) to 9:00 a.m. Central time the following day. Once the SCE is accepted, coverage is in place and a premium is due. If, at the ending date of coverage, the Actual End Value has dropped below the selected coverage price, the producer must file an indemnity claim within 60 days. The indemnity will be paid whether or not the cattle were sold by the ending date of coverage. However, selling the cattle more than 30 days before the end of coverage will terminate the policy unless the insurance provider has specifically approved the sale. Cattle seized, quarantined, destroyed, or not salable because of death or disease will still be covered by the SCE if written notice of the circumstances is provided within 72 hours. It is crucial for producers to understand that the ending value of the LRP contract is not the cash price received or a closing futures price as of the end date of the policy. The LRP Feeder Cattle policy uses the Chicago Mercantile Exchange (CME) feeder cattle price index as the actual end value. This cash-settled commodity index is a mathematical calculation that averages the head counts, weights and prices from several livestock sales across the nation to determine its settlement price. The LRP Fed Cattle policy uses a weekly weighted average of the slaughter cattle prices in five areas as reported by the Agricultural Marketing Service (AMS). Contract Specifics Feeder cattle policies for crop year 2004 (July 1 through June 30) have an expanded coverage level that insures all feeder cattle weighing up to 900 pounds. It allows insurance for heifers and for Brahma and dairy breeds. A fixed percentage price adjustment factor (PAF) is used to adjust the expected ending values and coverage price from standard-weight, beef breed feeder cattle for various combinations of light-weight heifers or non-beef breeds. Table 2 shows the LRP feeder cattle price adjustment factor percentages. The PAF is also applied to the actual end values at a contract s end date. Table 2. Price adjustment factors for LRP Feeder Cattle contracts. LRP Fed Cattle policies provide coverage on fed cattle that will weigh 1,000 to 1,400 pounds at slaughter. Table 3 lists the contract specifics for both the feeder and fed cattle contracts. Table 3. Contract specifics for LRP Fed Cattle and LRP Feeder Cattle policies. Let s work through an example to calculate the insured value, the producer s premium and the indemnity.

3 Example 1: LRP Feeder Cattle for a West Texas cow-calf producer. In mid-october, the owner of a 340-head cow/calf operation is buying an LPR Feeder Cattle policy for his current calf crop. The calves are typically weaned (88 percent calf crop) about September 15 each year and carried over to the middle of January before the producer decides whether to market them, retain ownership for additional winter grazing, or move them to a feedlot. It is estimated that by mid- January the steer calves will average 700 pounds and the heifers will average 650 pounds. Coverage will be purchased on all of the heifer calves, including those that will be retained as replacements. This producer has no partners and owns 100 percent of the calves. This producer will use actuarial data from the RMA on October 15, 2004, which is shown in Table 4. Table 4. LRP expected end values, coverage prices, levels, rates and contract end dates for October 15, Source: www3.rma.usda.gov/apps/livestock_reports/main_menu.cfm Insured value and premium computations 1. The Insured Value = Number of Head multiplied by the Target Weight (live weight, in cwt) multiplied by the Coverage Price multiplied by Ownership Share. 2. The Total Premium = Insured Value multiplied by the Rate. 3. The Subsidy = Total Premium multiplied by the Subsidy Rate. The subsidy percent is 13 percent. 4. The Producer Premium = Total Premium minus the Subsidy

4 Indemnity calculation Assume that on the end date of coverage, the CME feeder cattle index has dropped to $98.00/cwt. Since the actual ending value is less than the coverage price ($ $98.00 =$2.12), an indemnity is due the producer on the insured steers. The PAF for heifers is applied to the actual ending value ($98.00 x 90% = 88.20). Again, an indemnity is due on the heifer calves ($ $88.20 = $1.91). The indemnity is equal to the number of head multiplied by the target weight (in cwt as defined in the specific coverage endorsement), multiplied by the difference between the coverage price and the actual ending value (in dollars per cwt), and then multiplied by the ownership share (percentage). Other LRP applications Other situations in which LRP may offer producers limited price insurance are presented in examples 2 and 3. The calculations for insured value, total premium, producer premium, and indemnities are similar to those in example 1, though each producer s situation is slightly different. Example 2. An LRP Feeder Cattle policy for a south plains wheat pasture/stocker operator. A Texas producer placing weaned calves on wheat pasture in mid-november can purchase coverage at weaning on those calves coming off the pasture in mid-march, assuming they are expected to weigh less than 900 pounds. Example 3. An LRP Fed Cattle policy for a fed cattle producer. A producer who will send yearling cattle from summer pasture to a feedlot (in a state included in the LRP pilot) can buy coverage, at the time of placement into the pasture or feedlot, on cattle to be slaughtered the next spring, assuming they will weigh between 1,000 and 1,400 pounds. Comparison to CME Put Options LRP policies have many similarities to put options offered on CME futures contracts. As with a put option, producers are purchasing downside price protection while retaining upside potential. Example 1 illustrated how the LRP functions when prices (i.e., the CME Feeder Cattle Index) decrease. If prices increase or do not drop below the coverage price, producers will realize their local cash market price less the premium paid for the LRP policy. Purchasers of LRP policies are still going to bear some local basis risk in that their local cash price could decrease relative to the price index on any particular day that an LRP contract could expire. Advantages of LRP policies LRP policies are sold at the coverage prices quoted on the RMA Web site. This is a distinct advantage over put options. Thin trading in deferred months can make it difficult to fill a put option order at the desired price. LRP Feeder Cattle policies also allow producers to insure as few as one head or as many as 2,000 head (4,000 for fed cattle policies), whereas put options are sold in 50,000-pound feeder contracts (40,000 pounds for fed cattle). With multiple SCEs and the ability to insure a specific number of head per SCE, both small and large producers can have a high level of marketing flexibility. The RMA also subsidizes 13 percent of producer premiums and pays the administrative costs and commissions of insurance vendors. When the subsidies, administrative costs and commissions are taken into consideration, LRP policies may at times have a cost advantage over the options market. LRP policies also have some appeal to leveraged producers and lenders. Disadvantages of LRP policies Because LRP is an insurance policy, it cannot be offset as an option can. Selling cattle more than 30 days before the coverage end date will void the policy unless coverage is transferred to an eligible transferee and is approved by the

5 insurance company. LRP prohibits a producer from purchasing a policy and then taking an offsetting position in the futures or option market. Another LRP policy limitation is that a producer can purchase price insurance only at levels below the expected ending value (70 to 95 percent of estimated ending value). Put options allow producers a wider range of pricing levels, both above and below the current market. Response to the 2003 BSE Discovery The sale of LRP policies was halted in December 2003 in response to the discovery of bovine spongiform encephalitis (BSE) in the state of Washington. Sales were not resumed until October Several changes were made to the actual policies and to their marketing and availability because of the BSE discovery. These changes are intended to limit adverse selection, which is the purchase of insurance after the covered catastrophe has occurred. Policies are no longer offered for sale while the CME is actively trading. Coverage levels and rates are based on the current day s markets rather than the previous day s, as was the case before December The RMA has also established a daily premium limit of $1 million. Sales of policies will cease once the total of premiums collected on any single day reaches this limit. Other restrictions on the sale of LRP policies pertain to periods of major volatility in the futures market. Policies will be unavailable if the CME has a 2-day limit move on four or more contracts. Sales will resume if the CME does not have a limit move on four or more contracts. Procedures were also implemented to give the Federal Crop Insurance Corporation authority to suspend LRP sales in the case of a catastrophic event. Marketing Strategies Livestock producers can use LRP policies to establish a minimum average sales price, or get price protection in the event of some catastrophic event. To establish a minimum average sales price for some or all of their cattle, producers will submit their SCEs at a coverage price and endorsement length that meets their risk management objectives. For insurance against a catastrophic event, producers may simply buy LRP policies at a low coverage price to counter extreme market volatility. Produced by Agricultural Communications, The Texas A&M University System Extension publications can be found on the Web at: Visit Texas Cooperative Extension at Educational programs conducted by Texas Cooperative Extension serve people of all ages regardless of socioeconomic level, race, color, sex, religion, handicap or national origin. Issued in furtherance of Cooperative Extension Work in Agriculture and Home Economics, Acts of Congress of May 8, 1914, as amended, and June 30, 1914, in cooperation with the United States Department of Agriculture. Edward G. Smith, Interim Director, Texas Cooperative Extension, The Texas A&M University System.