Livestock risk protection insurance for feeder cattle
May 25, 2010
The cattle market has seen an increase in price volatility in recent years. This increased volatility translates into greater risk and uncertainty for cattle producers. For a risk seeking individual, more volatility means a possibility of receiving higher returns on his cattle. However, for risk adverse individuals, increased volatility is something to be avoided if at all possible.
Forward price contracts and futures market contracts are used by producers to help manage this price volatility. However, while each of these alternatives limits downside price risk, they also limit any upside potential. Options on futures were created to help producers limit downside risk while still being able to take advantage of upside market moves. Livestock Risk Protection (LRP) insurance is another tool producers have to insure against lower prices and still take advantage of higher prices. LRP insurance is very similar to a put option. However, with feeder cattle put option contracts must be purchased in 50,000 pound increments but with LRP insurance a producer can insure as few cattle as he or she wishes.
The way in which LRP insurance works is really quite simple. At the time the insurance is purchased, an expected ending value is estimated. This expected value is basically the current futures price of the cattle for the month in which they will be sold. The producer then chooses which level of coverage he desires. This level can be between 70 to 95 percent of the expected ending value. The premium is then calculated based upon the level of coverage chosen.
Once the insurance period is over, the coverage price chosen by the producer at the beginning of the contract is compared to the actual ending value. This value is a seven day rolling national average for 700 to 849 pound medium or medium/large #1 framed steers.
If the actual ending value is larger than the coverage price, then no indemnity will be paid to the producer. If the actual ending value is less than the coverage price, then an indemnity is paid which is simply the coverage price minus the actual ending value. If the indemnity is collected, the gain or loss from the LRP insurance is the indemnity minus the premium paid. If no indemnity is paid, the loss to the producer is the premium paid.
Caleb Bott, a graduate student at Utah State University, recently completed an analysis of how effective LRP insurance was for cattle producers. He simulated returns for a thousand iterations to see how often the insurance paid out and to determine if most producers would prefer the insurance or would prefer to remain in the cash market. The simulation was based on observed prices for the past 20 years to understand the volatility in the market place. LRP premiums were tracked since the inception of the insurance product. To try and make the simulation as real as possible, not only were cattle prices varied but feed costs were also varied in the analysis.
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The results of his analysis were very interesting. He found that on average returns to a backgrounding type program were reduced by $6.50 per head if producers consistently purchased the LRP insurance. When the market price was equal or higher than anticipated, returns were reduced about $13 per head, the price of the insurance. However when prices were lower, returns had the potential of being much higher with the insurance. In some of the worst price wrecks, returns with insurance were more than $150 per head higher than if the producer had remained strictly in the cash market.
So, the decision each producer faces is do they prefer a slightly lower return on average so that they can avoid the large losses or would they prefer a higher average return and know that some years are going to be very profitable and some years they are going to incur large losses. It is likely that each producer will evaluate this decision a little differently. If you have a higher debt load on your operation, you may not be able to tolerate large losses and therefore the insurance may look better to you. Conversely, a producer who has sufficient equity may prefer to take the good and the bad in the market and know that in the long run they will make more money without the insurance. The one thing that we would all like to do, but which I am doubtful any of us can do, is to only insure in years when price will decline and not insure when price will be stable or higher.
Economists and those in the insurance business have tried to group people into categories such as risk averse, risk neutral and risk preferring. Most people tend to fall in the risk averse category, but even this category is really a continuum from slight risk averse to highly risk averse. Caleb Bott also did an analysis to determine the types of producers who may prefer the insurance. He found that those cattle producers who were risk preferring or risk neutral definitely would not purchase the insurance. He also found that producers who were only slightly risk averse probably would also not purchase the insurance. However, he found that as a producers risk aversion moved to moderate or highly risk averse, then they would prefer to buy the LRP insurance. Prior studies of agricultural producers have found that most are in the slight to moderate risk averse category.
If you are interested in more information about LRP insurance I would suggest you visit the following web site: http://livestockinsurance.unl.edu/