The collapse in hog prices in the fall of 1998 has renewed interest in using insurance as a means of providing an affordable safety net to U.S. farmers. One option that has received attention is to expand the U.S. Department of Agriculture’s crop insurance program to include livestock producers. Because the ongoing financial crisis in the hog sector was not caused by production or disease problems, it is apparent that producers could have benefited from either price insurance or revenue insurance

Babcock, Bruce

Hayes, Dermot

English

The collapse in hog prices in the fall of 1998 has renewed interest in using insurance as a means of providing an affordable safety net to U.S. farmers. One option that has received attention is to expand the U.S. Department of Agriculture’s crop insurance program to include livestock producers. Because the ongoing financial crisis in the hog sector was not caused by production or disease problems, it is apparent that producers could have benefited from either price insurance or revenue insurance.</p

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8        CENTER FOR AGRICULTURAL AND RURAL DEVELOPMENT      SPRING 1999Iowa Ag Reviewby Bruce A. Babcock andDermot J. HayesThe collapse in hog prices in thefall of 1998 has renewed interestin using insurance as a means ofproviding an affordable safety net toU.S. farmers.  One option that hasreceived attention is to expand theU.S. Department of Agriculture’s cropinsurance program to include livestockproducers.  Because the ongoingfinancial crisis in the hog sector wasnot caused by production or diseaseproblems, it is apparent that producerscould have benefited from either priceinsurance or revenue insurance.The creation of a price or revenueinsurance program raises a number ofpractical issues regarding what toinsure, how to insure it, and how muchthe coverage should cost.  This articlediscusses some of the issues raisedby an expansion of revenue insur-ance, and provides an example of awhole-farm insurance product thatinsures against revenue losses from afarm that raises corn, soybeans, andhogs.Whole-Farm Revenue Insurance for Crop and Livestock ProducersLIVESTOCK RISKAll farm operations face twosources of risk that affect grossrevenue: output price risk and produc-tion or yield risk.  In addition, livestockproducers are exposed to significantrisk arising from changes in the priceof inputs such as feed.  Until 1996, theonly form of insurance provided by theUSDA was traditional crop insurancethat protects farmers against yieldlosses.  The question arises whetherinsurance programs should cover bothproduction risk and price risk or justprice risk?Producers generally face less riskin livestock production than in cropproduction.  Livestock are moreadaptable to variations in weather thancrops, and modern operations attemptto insulate animals against stresscaused by adverse weather condi-tions.  Thus, production risk is rela-tively minor compared to price risk.Figure 1 illustrates the amount of pricevariability in the U.S. hog market andis an illustration of why it is difficult fora hog farmer to count on a certainprice being available five or six monthsahead.Output prices and input costs arethe two sources of most of theincome risk faced by hog producers.And, variation in input costs particu-larly affects them.  With the run-up incorn and soybean prices that beganin the fall of 1995, hog productioncosts were much greater than antici-pated.  In these circumstances, anattractive insurance option wouldprotect net revenue, i.e., outputrevenue less feed costs.A WHOLE-FARM SAFETY NETOne term that occurs frequentlyin the debate about adding livestockrevenue guarantees is the concept ofa whole-farm safety net (or farmincome safety net).  In short, farmerscare more about their end-of-yearfinances than about any of thecomponents (enterprise-specificproduction levels, output prices, orinput costs) that contribute to thisyear-end position.From an insurance perspective,the concept makes sense because thefair insurance premiums of a whole-farm policy may be far lower than themarketable emissions trading permits.One of the conference’s mainthemes was that climate change andclimate change policy could havesignificant implications for agriculture.CARD Director Bruce Babcock dis-cussed the considerable uncertaintyabout the effects of climate change onthe environment and agriculture, andthe difficulty that that uncertaintycreates for establishing appropriatepolicy responses. Policy responsesshould, according to Babcock, promote“free trade and non-distorting subsi-dies.” There are other steps that theagricultural community can take to dealwith the problem, including expandingenvironmentally sound farming mea-sures that are already in use andparticipating in carbon sequestrationprograms, Babcock said.Kevin Herink, a Tama County,Iowa, farmer representing the IowaFarm Bureau Federation, noted thatIowa farmers have been progressive intheir adoption of precision farming andother conservation measures but areconcerned about their ability tocompete in a global market, where theplaying field is not level.  Clearly, theclimate change debate stands togenerate more research, discussion,and controversy.Information about the conference,along with audio and text of selectedpresentations and links to related sites,can be found at the CARD website,http://www.ag.iastate.edu/card/about/agforum/agforum99.html.Since 1990 the National Forumfor Agriculture has promoted thediscussion of national issues affectingU.S. agriculture. Each year the forumfocuses on a particular aspect ofagricultural policy, technology, oreconomics issue—usually a combina-tion of all three.  Iowa State Universityorganized the Climate Change confer-ence. Sponsors included the U.S.Department of Energy, the U.S.Environmental Protection Agency, theGreater Des Moines Chamber ofCommerce Federation, the IowaEnergy Center, ISU’s colleges ofAgriculture, Engineering, and Veteri-nary Medicine, ISU Extension, and theCenter for Agricultural and RuralDevelopment.tSPRING 1999        CENTER FOR AGRICULTURAL AND RURAL DEVELOPMENT   9Iowa Ag Reviewsum of insurance premiums on theindividual components.  Whole-farmpolicies can offer higher coveragelevels as well, not only because theyare more affordable due to lower risk,but also because the moral hazardproblems that may occur when onecomponent (such as yield) is insuredare far less important when thepolicyholder has insured all enterpriseson the farm.  (Moral hazard is thepossibility of the insurance companylosing money from a claim).  Thepossibility of protecting entire farmrevenue at a high, but affordable,coverage level creates the safety netthat is much in demand.WHOLE-FARM REVENUE INSURANCEINCORPORATING LIVESTOCKThe most straightforward way toincorporate livestock into a farmsafety net would be to add the outputprice and input cost risk associatedwith livestock enterprises to anexisting whole-farm crop or revenueinsurance policy.  To date, the onlycommercially available whole-farm,crop revenue policy is an option underRevenue Assurance (RA).  This croprevenue insurance product is ownedby the American Farm Bureau Insur-ance Services Inc., and is now sold insix states in the upper Midwest.Before working out an example, wemust account for some of the differencesbetween crops and livestock.  Cropfarmers generally harvest once per year,at a predictable time, and the price usedto value harvest is the price that occursat harvest time.  For example, for CropRevenue Coverage (CRC) and RA, theprice used to value harvested corn is theaverage November quote of the Decem-ber futures contract on the ChicagoBoard of Trade.  With livestock, however,“harvest” can occur many times duringthe year.  A livestock revenue insurancepolicy should be flexible enough to matchthe harvest price with livestock delivery.For hog producers, the ChicagoMercantile Exchange has seven futurescontracts in a given year: February,April, June, July, August, October, andDecember.  Typically, farmers have agood idea about both the timing ofdeliveries and the quantity that will bedelivered each year.  A sensible way ofdetermining an expected hog price touse is to construct a weighted-averagesettlement price, with weights given bythe number of hogs to be marketed ineach contract month.  For example,suppose a farmer plans on delivering100 hogs in April, June, and August, and200 hogs in October and December,and the current prices (adjusted to a per100 pounds live-weight basis) on thesecontracts are $50, $50, $40, $45, and$45, respectively.  Therefore, theexpected live hog price per 100 poundsused to value the average hog producedthat year would equal $45.71.We would then need to adjustthis expected live hog price for anexpected feed cost.  In the examplecited, we use the corn and soybeanfutures markets to calculate anexpected total ration cost for eachhog.  For example, if the Decembercorn contract was trading at $2.50and the November soybean futureswere at $5.50, then our expectedration cost would equal $0.176 perpound of live animal.  The producerwould then have expected netrevenue of $28.11 per 100 pounds.Actual futures market settlementprices would later be used to calcu-late the actual net revenue using thesame methods.  A component of thewhole-farm revenue guarantee wouldthen be the difference betweenactual and actual net livestockrevenues.The timing of the revenue guaran-tee is a factor to consider.  For spring-planted crops in the Midwest, March 15is the sales closing date for cropinsurance policies.  Correspondingly,CRC and RA use the average February10        CENTER FOR AGRICULTURAL AND RURAL DEVELOPMENT      SPRING 1999Iowa Ag Reviewquote of the December futures con-tract for corn as the price used to setrevenue guarantees for corn.  In theexample, we maintain a March 15sales closing date and use the aver-age of the first five trading days inMarch as the projected price for eachof the live hog futures contracts.The way this example contract isset up, the farmer has until March 15to determine the number of hogs thatwill be guaranteed under eachfutures market contract.  This willsubsequently determine the whole-farm revenue guarantee.  Theamount of market revenue from hogsthat will be added to harvest revenuefrom crops to determine whole-farmrevenue can be determined onlyupon settlement of the last futuresmarket.  Waiting for the last futurescontract to close may delay calcula-tion of whole-farm revenue becausecrop revenue from corn is known onDecember 1, and payment of indem-nities will have to wait if the farmerplans on delivering hogs under theDecember or February contract.A REPRESENTATIVE CORN-SOYBEAN-HOG FARMTo show the effects of addinghogs to a corn-soybean whole-farminsurance contract, we look at a 500-acre farm in Webster County, Iowa,with 250 acres each of corn andsoybeans.  Projected local prices ofcorn and soybeans in the fall are$2.10 and $5.00, respectively.  Theapproved yields are 135 bushels forcorn and 40 bushels for soybeans.We determine the cost of coverage bycalculating how much an insurancecompany would lose on average if itsold this producer this policy for 5,000years.Figure 2 shows how the introductionof hogs affects the actuarially fair whole-farm premium for this farm.  When nohogs are marketed, the fair premiumdepends only on the percent of ex-pected crop revenue insured.  Theformula for expected revenue fromcrops is springtime price % expectedyield %  acres for each crop—$123,500for the 500 acres.  At 90 percentcoverage, the whole-farm revenueguarantee is $111,150, and the fairpremium is $7,936.  At 85 percentcoverage, the fair premium is $6,004.At 80 percent and 75 percent coveragelevels the fair premiums are $4,479 and$3,020.  For a 500-acre crop farmer, a90 percent premium of almost $8,000 isprobably not affordable and may raiseconcerns regarding moral hazard.When we add 2,000 hogs to themix, however, the whole-farm fairpremium actually declines (seeFigure 2) even though hogs greatlyincrease the level of the revenueguarantee.  The premium decreasesas the amount of insurance increasesbecause a corn-soybean-hog farmeris more diversified than a corn-soybean farmer, and greater diversifi-cation means lower risk.The premium rate declinesbecause hog prices are largelyuncorrelated with corn and soybeanprices; that is, when corn and soybeanrevenue is low, there is a 50 percentchance that hog revenue will begreater than expected.  Thus, addinghogs significantly lowers the probabilitythat an indemnity will be paid on cornand soybeans.  Additionally, becauserevenue from hogs is less variable thancorn and soybean revenue, thepremium rate continues to decline as afarmer specializes in that less riskyenterprise.Figure 2 shows that premiumrates eventually rise as more hogs aremarketed.  The turning point dependson the coverage level.  When 3,850hogs are marketed at the 90 percentcoverage level, the whole-farmpremium with hogs equals the whole-farm premium without hogs.  Thedifference is that the farmer whomarkets 3,850 hogs has $239,663more insurance coverage than thefarmer who markets no hogs.The break-even number of hogsat 85 percent coverage is 8,800hogs.  At 80 percent coverage, thebreak-even number of hogs isapproximately 19,000.  As shown, thepower of diversification means that afarmer can have a lower insurancepremium even though the amount ofinsurance increases.  A commonresponse to this type of diversifica-tion is to increase coverage level.For example, if this farmer were toinclude 5,500 hogs in a whole-farmrevenue insurance policy, the totalfair premium at 85 percent coverageis approximately equal to the totalpremium at 80 percent coverage fora crop-only whole-farm policy.  Thefair premium is the same, but thewhole-farm revenue guaranteeincreases by $328,500, from $96,700to $431,279.THE NEXT PHASEThe U.S. agricultural insuranceprogram has evolved from insuringonly individual crop yields to insuringthe combined revenues from severalcrops.  The next phase may involvethe addition of livestock.  Here, weargue that the most effective way toinsure livestock is to insure expectedannual production against output pricerisk and input cost risk.  We also arguethat it would be technically feasible toadd this livestock net revenue guaran-tee to existing whole-farm croprevenue guarantees.These policies could comple-ment existing financial instrumentsoffered on the Chicago MercantileExchange and the Chicago Board ofTrade. In some preliminary samplerates presented here, we show thatthe addition of livestock to whole-farm revenue guarantees candramatically reduce both insurancerates and insurance premiums.These lower rates make 90 percentcoverage affordable and economi-cally justified.  The availability of a90 percent revenue guarantee wouldcreate a farm income safety net forlarge numbers of diversified familyfarms.t

Whole-Farm Revenue Insurance for Crop and Livestock Producers

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Whole-Farm Revenue Insurance for Crop and Livestock Producers

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