Iowa Tests Insurance Against Market Price Dips

A livestock pilot project, aimed at protecting against price disasters such as those seen in 1998, is expected to be offered to Iowa pork producers by mid-2002. The project is a spin-off of the Federal Crop Insurance Program that has offered insurance against production losses for years.

Iowa was selected because it has over 80% participation in the Federal Crop Insurance Program, according to Bruce Babcock, director of the Center for Agricultural and Rural Development (CARD) at Iowa State University.

Price Insurance Authorization

The Agricultural Risk Protection Act of 2000 amended the crop insurance act and authorized livestock insurance pilot programs. Two Iowa crop insurers, Iowa Farm Bureau Mutual Insurance Company and American Agrisurance, Inc., are offering the price protection plan in a joint effort with the Iowa Department of Economic Development, the Iowa Pork Producers Association (IPPA) and CARD.

A separate plan, Livestock Risk Protection, is also being offered privately by American Agribusiness Insurance Company of Des Moines, IA.

Iowa Pork Producers Association (IPPA) President Joel VanGilst of Oskaloosa says, “The IPPA was given direction by the county producer delegates at the 1999 annual meeting to work with a group of insurance companies to develop a hog price insurance product. This product was designed to assist the small- to medium-sized producers.”

In setting the premiums, CARD's Babcock makes it clear that the goal is to provide an insurance program to cover unexpected price dips. “We've designed this so that over the long haul, it is a breakeven proposition. There is no free lunch here. You should get back what you put in it, when you need it,” he remarks.

The payment should increase as price prospects worsen. For example, if you bought price insurance for $35/cwt. on your hogs, and the price was $40/cwt., no payment would be made, says Babcock. If the price fell to $30/cwt., you'd receive a payment of $5/cwt. If the price dipped to $20/cwt., you'd receive a larger payment of $15/cwt. to make up the difference.

Premiums also vary based on coverage level, degree of diversification across your marketing plan, level of prices and price volatility or the level of price variation.

Like a futures price option, where you pay an option's premium up front, producers pay a premium for coverage in this insurance plan.

Payment Options

In some sense, price insurance is already offered by options plans on the Chicago Mercantile Exchange, says Babcock.

So why buy insurance? The main reason is because this insurance plan is more convenient than options. With insurance, you make one decision every six months. With options, if you are going to cover your feed costs, you must manage at least nine contracts, he says.

“If you are marketing hogs every month, you need to manage nine to 10 contracts to duplicate this insurance,” says Babcock. The revenue insurance policy can be tailored to fit individual marketing plans.

Also, producers don't like working with commodity brokers. Price insurance is cheaper. For 100% coverage, premiums for hog price insurance are estimated at $4.50/hog.

“If you were to try to replicate that insurance coverage with futures options, your out-of-pocket expense would be almost $7/hog,” says Babcock.

Another market price alternative is packer contracts. They do provide some risk guarantees. Ledger contracts protect you from downside price risk. The same is true of forward price contracts. The problem with packer contracts is you give up all the upside price benefits, says Babcock.

“This product simplifies risk management in a package insurance product by setting a floor under the feeding margins using the futures market prices for hogs, corn and soybean meal,” adds VanGilst.

Types of Coverage Plans

There are two types of insurance coverage options, farrow-to-finish and finish only. And, there are two, six-month coverage periods, Feb. 1-July 31 and Aug. 1-Jan. 31. Policies are renewable for each six-month period.

“You would put in a new marketing plan for how many hogs you are going to market in each of the next six months covered under the insurance period,” he notes. Price guarantees are adjusted for each six-month period. It is based on marketing hogs at 250 lb.

Babcock explains, “The guarantee that is being offered is a margin between what the expected revenue from the hogs will be, less what the expected cost of feeding them will be. It takes into account your feed cost (gross margin).”

The marketing plan works like trading on the futures market. The closer the marketings are to the current month, the smaller the cost of the premium. Using the February-July marketing period as an example, it would be about four times less expensive to guarantee (insure) a hog in February as it would in July.

“The standard deviation or variation in hog prices one month out is about one-fourth the uncertainty of six months out,” says Babcock. “Therefore, the further out in the contract that you market your hogs, the more it is going to cost you.”

Based on his formula for marketing 100 hogs February to July, if you market all 100 hogs in February, the cost would be $1.56/hog. The cost would be $6.49/hog, or just more than four times as much, if you market all 100 hogs in July.

Figure 1 details a proposed marketing plan developed by Babcock in which the 100 hogs are marketed evenly throughout the six-month period. Table 1 shows the effect of coverage level on hog premiums using the Figure 1 marketing plan. All prices are quoted as lean hog futures. Multiply by 0.74 to convert to a live weight basis.

Long-Range Impact

Babcock estimates this insurance product would have cost an average of $4 to $4.50/hog for 100% coverage during the past 15 years.

For pork producers hit especially hard by the rock-bottom hog prices of 1998, livestock revenue insurance would probably have proven to be a lifesaver, he claims. It would have paid out in a big way because no one was projecting prices to drop that much.

Crop insurance companies can weather big payouts because they are insured federally to make up the difference or a loss situation.

For more information on livestock price insurance, log on to www.card.iastate.edu.