Disclaimer: This web page is designed to aid farmers with their marketing and risk management decisions. The risk of loss in trading futures, options, forward contracts, and hedge-to-arrive can be substantial and no warranty is given or implied by the author or any other party. Each farmer must consider whether such marketing strategies are appropriate for his or her situation. This web page does not represent the views of Kansas State University. 
Disclosure:  Dr. Barnaby’s research was the basis for the privately developed Crop Revenue Coverage.

Adverse Selection on the Livestock Risk Protection Contract[1]

Adverse Selection.  The Livestock Risk Protection (LRP) contract is based on yesterday’s market and premium cost.  If the market closes down today, producers will be able to purchase their LRP coverage not based on today’s lower market price but yesterday’s higher market price and associated premium costs.  Therefore, LRP may meet the technical definition for adverse selection but it is very limited because of the length of time until expiration of the contract.

This is similar to the situation with the loan deficiency payment that is based on a one day lag in the market.  Farmers have traditionally made LDP claims on days when the market moves in their favor based on the previous day’s market.  However, in the marketing loan program for cotton there is a one week lag in the prices.  Also farmers can take out the loan and effectively have a 60 day window to repay the loan and take advantage of a market that is moving in their favor.  Those are certainly much longer time lags than available in the LRP contract which only has a single day lag.  Under normal market circumstances the one day lag in the LRP is not a great advantage for producers.  Other than an academic definition of adverse selection this one day lag is of little concern to RMA or the insurance industry. 

Adverse Selection with Catastrophic Price Move.  One scenario that would change this viewpoint is a catastrophic price event in the cattle market.  Examples might include:  a disease outbreak such as “mad cow disease” or a bio terrorism act that would scare customers away from purchasing beef, limit exports and create other negative market impacts.  Under this catastrophic market scenario one would expect the market to lock limit down if it is open when the event happens.

The question then becomes, if this were to occur, will producers be able to lock in LRP coverage and premium costs based on the previous day’s market close before the current catastrophic event was bid into the market?  It is also possible the catastrophic news might be revealed after the Chicago Mercantile Exchange (CME) market closes.  Under current procedure producers would have from the CME market close until 8:00 p.m. central standard time to purchase their LRP coverage by submitting a Specific Coverage Endorsement (SCE) contract.    In the event of a catastrophic market event it is possible RMA would shut off sales.  However, there is some question how quick this might occur and producers might be able to get their SCE accepted before the system is shut off.  It is unclear if there is a formal procedure for LRP offers following a lock limit down CME price move.  Presumably in the event of a lock limit down move there would be no SCE’s offered the next day because the previous day was a lock limit down price move.

Even without this limited adverse selection window producers may still want to consider an LRP contract just to protect themselves against such a catastrophic event.  Because producers can buy coverages with higher levels of deductibles for lower premium costs, there may be producers willing to buy LRP just to protect against such a catastrophic event.  If one buys an LRP contract with a high deductible, then if such an event were to occur; the LRP contract would provide a significant indemnity payment.

From the “other side of the desk” this is also a major concern of private insurance company’s and reinsurers.  Unlike crop insurance where one gets geographic spread on the risk because not all yields will be a 100 percent loss, every LRP contract sold on the same day that is currently held will be paid.  The losses could be significant because all contracts will have claims unlike the crop insurance contracts where only some contracts, even in the most severe drought, will have claims.  Even those crop insurance contracts that do have claims will not all be 100 percent claims.  For a given coverage level, the LRP indemnity payment will be the same for all buyers.  It is likely LRP contracts will generate underwriting losses over 100% or 100% underwriting gains.  This is very different from other forms of insurance. 

Recommendation to Producers.  A reasonable management strategy certainly would be to submit an application for an LRP contract.  This application through one’s insurance agent will establish the producer’s eligibility to attach coverage with the SCE later.  This will allow producers to be in a position to put the coverage on should market conditions change or even potentially get an SCE approved after a major negative market announcement such as a disease outbreak.  Because markets move so quickly, if producers don’t already have the policy established it is unlikely they will have time to have the policy approved and in a position to submit the SCE in the event of a major negative market news event.

There is no cost for establishing the policy and one is only committed for premium after the coverage is attached by submitting the SCE.  Therefore, there is little reason for cattle producers to not contact their crop insurance agent and establish the policy that makes them eligible to submit the SCE in the event that one becomes concerned about the price risk.

Clearly, the other approach is to create a written market/risk management strategy for livestock as many do with other commodities.  The LRP could be a part of a written risk management plan that would protect against major losses in the cattle market.  LRP will also leave the upside open so that if prices go higher producers will capture those returns less the premium they paid for the LRP contract. 

Unless RMA changes the underwriting rules, every eligible livestock producer will likely find it to their advantage to submit an application for an LRP contract.  There is no cost for the policy but producers will be able to move quickly in the event of a market change.  It may even allow producers to take advantage of a catastrophic price move.  Only when the SCE has been accepted does the producer have coverage and owe premium.  Producers need to get a LRP policy now to be in a position to execute an SCE if they see a change in the price risk.

Underwriting Issue.  From the RMA/insurance industry “side of the desk” there appears to be an underwriting problem if there is a catastrophic price event caused by a mad cow disease case in the USA or a bio-terrorism attack on the beef supply.  If the CME market locks limit down then producers may be able to purchase a SCE based on the previous day close.  The bad news could also occur after the CME closes.  Currently RMA has no public policy on how to handle such an event. 

Most of the Livestock Gross Margin (LGM) sales occurred on the last day of the sales period based on a decline in the hog market.  LGM was only in Iowa so the exposure is relatively small.  The LGM has been reduced from a 2 week purchase window to a 2 day window.  However, RMA did not shut off sales on the last day of the contract but some companies did reach their company underwriting limit and that did shut off sales.

“Needed” Underwriting Rules. Based on this history it is reasonable to concluded RMA needs two more underwriting rules on LRP:

1.  RMA would shut off LRP sales if the CME lock limits down.

2.  RMA would limit daily LRP sales as a percentage of the total book

A daily sales limit would also spread risk over time because it would prevent a large percentage of sales on a single day like happened with LGM.  There is no geographic spread on the risk as there is with the yield risk on crops.  The only spread is over time but that spread is lost if most of the sales occur on a single day.  The daily limit would also put a limit on sales if bad news came after the CME closed.

Why Point Out the Underwriting “Hole”?   At a recent conference producers raised the question why is the author calling attention to this underwriting issue?  In order for the current private/public insurance program to work rates and underwriting rules need to be “fair”.  If the underwriting rules allow for producers to adversely select then private companies and their reinsurers will drop out of the market.  There was a recent consolidation of two companies and the sale of another, so there are fewer companies in the crop insurance business.  Insurance contracts need to work for the producers, private insurance companies and RMA.  If one side has an advantage then in the long run (probably two years in the private market) then the other side will drop out of the market.  Either producers will not buy or companies will not make the insurance offer.  If this were a total government program these underwriting issues may not be a problem if taxpayers were willing to support the losses.

 Limitations on LRP.  Currently the LRP is not available on heifers or breeds containing significant amounts of Brahma or dairy genetics. The other limitation on the LRP contract is that producers are not allowed to take an offsetting position in the futures market.  For example, they buy an LRP contract on their cattle and then write a put option on the CME.  Clearly, this is probably an unenforceable underwriting rule simply because producers could write the put option on their cattle (heifers?) that have no SCE coverage or they could simply open a speculative account.

Probably this underwriting rule effectively prevents marketing consulting firms from marketing their service to producers on how to extract the subsidy from the LRP contract.  Remember this is suppose to be a risk management protection tool that will reduce the negative effects on producers’ revenues caused by declining prices.  In addition, most lenders who are financing cattle want the protection.  They don’t want producers simply extracting the subsidy because the subsidy is a very small amount of the total dollars at risk in a livestock operation. 

“Unnecessary” Underwriting Rules.  Because this is an index product and the basis (difference between cash price and futures price) risk is retained by the producer there is no reason not to insure heifers and other breeds.  During the recent conference one cattle producer raised the question how much Brahma or dairy “blood” is too much?  Who will determine if the Brahma or dairy genetics in the cattle exceeds the LRP limit?

Based on these current LRP policies, RMA probably does not need the follow underwriting rules:

1.  Remove the limit on LRP sales for heifers, Brahma or dairy breeds.

2.  Remove the restriction on taking an offsetting board position because the rule probably cannot be enforced.

No Moral Hazard.  There is little chance of moral hazard in the LRP contract simply because the contract is not tied to the individual’s production level or price received.  The payment is triggered totally on a market decline and that will affect everyone who has bought an LRP contract.  For example, if 50 people purchased a 30 week contract today and the market declines by $10 below the guarantee, they would all receive a $10 indemnity payment assuming they bought the same coverage level.

The number of head and the target weight are simply a way to determine eligibility for the contract.  RMA does not want non-livestock producers purchasing the LRP contract because this is a subsidized product.  Therefore the calculations used to determine the weight and head of cattle are simply to verify LRP purchasers actually owned that number of cattle and approximate weight certified in the application.

Market for LRP.  This contract may be very attractive to certain classes of producers over a CME feeder cattle put contract even if there is no adverse selection.  Producers may buy LRP only on the number of head they actually own and that may be fewer head than would be required for a CME contract.  For example, if a full CME feeder contract represents about 67 head of 750 pound steers but the producer only has 50 steers then he/she would be able to purchase LRP on just the 50 steers. 

Potentially this is a very large market because Kansas is an important beef cow/calf state.  During 2002 there were 28,000 beef cow/calf operations in Kansas that produced 1.51 million calves.  The bulk of these calves came from relatively small operations.  During 2002, approximately 48 percent of Kansas calves were produced on farms that had a beef cow inventory of less than 100 head, and virtually all operations had fewer than 500 cows (table 1).  This is the segment of the market that is most likely to purchase an LRP feeder cattle contract because the flexible contract size matches their operation as opposed to an option on feeder cattle futures that represents roughly 67 steers weighing 750 pounds.  The LRP also allows producers the flexibility to buy incremental price protection on a few head at a time to secure an average minimum price.  This is not a readily available alternative for small cow/calf operations using the Chicago Mercantile Exchange (CME) traded options.

LRP is an insurance contract because once purchased it can not be cancelled as can be done with a put option.  Because it is an insurance contract with a specified insurance length it will be attractive for lending institutions who are lending money on cattle serving as collateral.

Because LRP is an insurance contract there is also no question that it is a tax deductible expense and would be included as a farm expense item.  Options are also a tax deductible expense although some trading strategies sometimes are not considered deductible expenses. 

One of the attractive features of LRP is that producers will be able to have their coverage accepted at the stated premium rate and guarantee as posted on the RMA web site.  Because put options are traded in an active market, one may submit a purchase order at a specified premium but not get a fill on the contract.  This is an even greater issue with put options that are on the deferred months.  The deferred months are often thinly traded option markets and that increases the odds the order will not be filled.  Even if the producer is purchasing an LRP contract, that will expire in 30 weeks or more, one will still have the contract filled.  Many producers will probably prefer knowing the exact guarantee and premium cost at the time their insurance agent submits their SCE.  Coverage has attached as soon as the SCE has been accepted by RMA and a confirmation number is returned to the insurance agent.

One major advantage of the LRP is the 13 percent premium subsidy and there is no commission paid by the producer.  The insurance agent commissions and operating expenses of the insurance company are all funded from a separate line item in the RMA budget.

Summary.  This is a very “clean” contract with the exception that the catastrophic price risk appears not to be covered.  Without the proposed underwriting rules listed above, it is the equivalent of being able to call one’s insurance agent and purchase “fire insurance when the house is already on fire”.  If RMA were to adopt those proposed underwriting rules, then producers could still “buy fire insurance if they see a fire off in the distance but has not yet reached their house”.  This is okay for LRP because the premium and guarantees change daily but not if the “house is already on fire”. 

In any case, eligible producer should apply for a policy because there is no cost.  Once the producer has an LRP policy they will be able to purchase coverage quickly if market conditions change suddenly.  However, if they have not submitted an application for the LRP policy before the event they will not have time to react.  If cattle producers don’t later submit an SCE that establishes coverage, producers are only out their time for submitting the policy application because they owe no premium.

NASS Average Wheat Price

The official 12 month weighted national average price for wheat was released by National Agricultural Statistics Service (NASS) for crop year 2002/2003.  The NASS average wheat price is used to settle Counter Cyclical(CC) payments for 2002/2003 wheat (wheat that was harvested in 2002).  The NASS 2002/2003 wheat price was $3.56 compared to the KSU final estimate of $3.59.  Because the $3.56 NASS price exceeded the $3.34 effective wheat target price, the result was no CC payment on 2002/2003 wheat.  The final NASS prices and KSU estimates are listed in table 2.

Estimates for the wheat CC payment for marketing year 2003/2004 (the wheat crop just harvested) will be posted on www.AgManger.info.  The Farm Service Agency (FSA) has not announced if there will be an advanced wheat CC paid on the 2003/2004 crop marketing year.

Wheat Premiums for the 2004 Kansas Wheat Crop

Introduction.  Many growers and insurance agents are using last year’s price elections, Revenue Assurance (RA) volatility, and Crop Revenue Coverage (CRC) high/low factors for calculating 2004 wheat premiums.  The market is about 25 cents lower than last year and that will lower coverage and premium costs per acre.  Currently the estimated RA volatility is a little lower too, but the option market is very thinly traded and those values are volatile.  The new method for setting the CRC high/low price factors are not available to the author, however, based on 2004 soybeans and corn CRC high/low price factor increases it is reasonable to assume the wheat high/low price factors will also be increased. [2]

Central Kansas Wheat Premiums.  Wheat premiums for Central Kansas wheat were analyzed in Table 3.  The premiums calculated were for a 40 bushel actual production history (APH), price elections and rates for 2003.  These premiums were calculated for comparison purposes with the 2004 premiums.  The 2004 premiums were calculated based on a 40 bushel yield and a higher $3.35 MPCI price election for 2004.  The 2004 price election of $3.35 is higher than the $3.15 price election on the 2003 crop, which has the effect of increasing the dollars of coverage.  The increase in price election alone will increase the premium cost per acre but it also increases the coverage.  The estimated 2004 premiums for Revenue Assurance with the Harvest Price Option (RA-HPO) and CRC used an assumed $3.73 price election that was available on the 2003 crop.  The current price estimates for the 2004 crop is about $3.50 (estimated RA volatility, RA, IP, and CRC price elections are currently being updated on www.AgManager.info). 

After American Agrisurance exited the industry the CRC contract was turned over to the Risk Management Agency (RMA) and RMA now owns CRC.  The 2003 wheat rates were submitted by American Agrisurance for RMA for approval.  The 2004 CRC rates are the first wheat rates being set by RMA.  Currently the CRC premiums are difficult to estimate because RMA has changed the rating procedure. 

RMA set the CRC rates on corn and soybeans, which was the first set of rates not developed by American Agrisurance.  RMA increased the high/low price factors used in the rating of CRC by 76 percent on corn and 44 percent on soybeans.  Many agents are calculating CRC rates using last year’s high/low price factors.  It is very likely those high/low price factors for wheat will be increased over the 2003 values. 

The first set of CRC premiums calculated for 2004 were based on the assumption the high/low price factor were increased by the same percentage amount as the soybeans (Table 3).  The second set of premiums under the 2004 CRC premium column were calculated based on the assumption RMA would increase the high/low price factors by the same percentage increase as the corn high/low price factors.  The high price/low price factor will not be released until after September 15 so farmers will have a very short time period to evaluate the CRC premium rates.

Because the MPCI price election was increased from $3.15 to $3.35, it is necessary to compare premium costs with the higher price election removed from the analysis.  Simply increasing the price election and the resulting dollars of coverage will increase premium costs even if premium rates are decreased.  Therefore, in table 4 all of the MPCI-APH and revenue insurance contracts were converted to a dollar per hundred of coverage.  This allows one to compare premium rates across product lines and remove the price election differential effect on the analysis. 

For 2004 Central Kansas wheat (in this county and APH) MPCI-APH rate per hundred dollars of coverage were increased by 12-13 percent at most coverage levels.  The Revenue Assurance rates, assuming a .22 volatility that was applied to the 2003 contract, increased from 15-25 percent.  The RA especially received a higher rate increased at the 80 and 85 percent coverage levels.

If the high/low price factors for CRC are increased similar to the soybean high/low price factors the resulting rate increases on winter wheat would be about 19 percent to 24 percent.  If high/low price factors are increased similar to corn then the percent increase in rates ranges from 26 to 31 percent.  It is possible that these revenue insurance rate increases will not be this severe because the volatility value could be slightly lower in 2004 than it was in 2003 and it is possible the high/low price factors may be less than the estimates.    

In 2003, the CRC rates for 80 percent coverage and less were lower than the RA-HPO rates.  This was a consistent theme with rates in the lower risk production areas until RMA took over the process of setting rates.  At this location if CRC rates are set based on high/low price factors similar to the soybeans then the premium costs for CRC and RA-HPO are very similar for 2004.  The only difference is the RA-HPO has unlimited liability while CRC’s liability is constrained to no more than a $2.00 price increase.  Also, the CRC contract will be adjusted based on a June average harvest price while RA-HPO will be adjusted based on a July 1-14 average price.  Because of the unlimited liability in RA-HPO, it would have a slight advantage over a CRC contract if both are carrying the same premium costs. 

If the high/low price factors on 2004 CRC wheat are increased similar to corn, the resulting CRC rates would be substantially higher than the RA rates and clearly CRC buyers would want to switch to the RA-HPO contract.  Which contract will be the preferred contract depends on those high/low price factors that will not be available until after September 15.  Farmers will probably want to advise their agent they want rates for both the CRC and RA-HPO contracts.  Most growers will simply then pick the contract with the least premium assuming they have made the decision to purchase replacement-revenue insurance.  Because the CRC high/low price factors will not be released until after September 15, agents will only have about 10 days to do the analysis. 

If growers have decided to purchase the MPCI-APH contract and they are definitely not going to purchase either revenue contract, they could do their analysis on coverage levels and price elections now because those parameters are already set for the 2004 winter wheat crop.

Western Kansas Wheat Premiums.  A sample set of rates were also calculated for western Kansas wheat (table 5).  The results are similar to the central Kansas wheat rates with CRC and RA-HPO premiums being very similar if the high/low price factors are increased similar to the soybean values.  If this is the result the less expensive contract will most likely depend on the volatility value but there appears to be only a few pennies difference between the contracts.  However, if the high/low price factors are increased by a percentage similar to the corn high/low price factors then CRC will be higher than RA-HPO and RA-HPO will be the preferred contract. 

The MPCI-APH rates for western Kansas were actually reduced at the higher coverage levels (table 6).  RMA also increased the MPCI-APH rates at the lower coverage levels.  At the same time RA-HPO received a substantial premium increase at the 80 and 85 percent coverage levels.  The combination of increasing the RA-HPO rates and cutting the MPCI-APH rates has the effect of preventing a situation where RA-HPO was cheaper than MPCI-APH. 

Increasing the high/low price factors similar to soybeans resulted in substantial rate increases on CRC at the 50-75 percent coverage levels.  The increases on the 80 and 85 percent coverage were very modest.  Using these high/low price factors resulted in premium costs that were very similar to the RA-HPO premium costs.  However, if the high/low price factor are increased similar to corn the result would be CRC premiums that are higher than the RA-HPO premiums (Table 6).

Summary.  It is clear RMA has done several things with the 2004 winter wheat rates.  First, they have cut the MPCI-APH rates and increased RA-HPO rates for the higher coverage levels in the high risk growing areas.  This will prevent a situation where RA-HPO is cheaper than MPCI-APH.  If the high/low price factors are similar to soybeans the result is the premium costs for RA-HPO and CRC will be nearly identical.  If RMA increases the high/low price factors similar to corn the resulting higher CRC rates will be higher than RA-HPO rates and under those conditions growers would certainly want to switch to the RA-HPO contract. 

Should RMA Combine Products?  If these two revenue contracts are now going to carry nearly the same premium and provide nearly the same coverage (in some cases identical coverage) then it really makes no sense to continue to provide multiple revenue products.  Multiple products covering the same risk only increases the administrative costs of the program for government, insurance agents and insurance companies.  Offering nearly identical insurance products requires maintaining the software to rate multiple products, multiple policies must be updated and simply tracking all the different price measurements adds to the administrative costs of this program. 

If these revenue rates are going to be similar (rates should be similar for similar coverage) this makes the argument even stronger for consolidating insurance products.  RMA could simply reduce the insurance contracts to two basic policies for crops, an APH and a Group Risk Plan (GRP) base policy.   A single APH yield coverage insurance policy would simplify the administrative process, generate one price election, and one APH basic rating structure for software maintenance.  Growers would then add endorsements to get the revenue coverage and a separate endorsement to get the replacement coverage.  This would reduce the multiple price election calculations because MPCI-APH, RA, IP, and CRC would all have the same price election.  The harvest prices for the revenue contracts would all be based on the same market and would reduce the number of prices that currently must be tracked by RMA and the insurance industry.

The other base RMA contract would be the Group Risk Plan (GRP), which would be the base index product.  The Group Risk Income Protection (GRIP) coverage would simply be an endorsement on to the GRP contract. 

Offering two basic crop insurance contracts with revenue endorsements would provide all of the currently available coverage.  It would reduce administrative costs that could be better spent working on new risk protection products.

LRP Coverage for Kansas Hog Producers Will be Offered Soon

RMA has announced the Livestock Risk Protection (LRP) contract for swine has been expanded to Kansas .  The other states with the swine LRP offer include Iowa, Illinois, Indiana, Minnesota, Nebraska, Nevada, Oklahoma, Texas, Utah and Wyoming. The LRP contract on swine is expected to be similar to the LRP on feeder cattle.  Currently RMA is projecting swine LRP sales will start in mid-November.

Kansas State University , University of Nebraska , and Colorado State University will be conducting three crop insurance workshops for insurance agents, lenders, and producers.  One of the main topics will be livestock insurance and Dr. Peter Griffin who developed the LRP contract is scheduled to present seminars at all three locations.  This is an excellent opportunity to ask questions and get answers without being “filtered through me”.  Mark your calendar now for the most convenient location and time listed below:

2003 INSURANCE WORKSHOP
THE CHANGING WORLD OF CROP INSURANCE:

LIVESTOCK INSURANCE, WHAT IS NEXT?

November 18, 2003

Great Bend , Kansas

Holiday Inn

November 19, 2003

Grand Island , Nebraska

Holiday Inn - I-80

November 20, 2003

Brush, Colorado

Event Center

Brush Fairgrounds

NASS Prices.  Monthly NASS prices and historical wheat and feedgrain cash prices are presented in Table 7.  These prices are used to calculate the counter cyclical payments once the price weights are determined at the end of the marketing year.  Price election for crop insurance is listed in table 8.

Farm Service Agency (FSA) Loans, Direct Payments and Counter Cyclical Target Prices.  The payment rates and loans are listed in table 9 for 2003.  These are the rates that are current in the law.

Counter Cyclical Payments.  KSU estimated 2003 counter cyclical payments are presented in table 10.  These estimates will be updated monthly with current prices on www.AgManager.info.

TABLE 1.  OPERATIONS WITH BEEF COWS, BY SIZE CATEGORY, SELECTED STATES, 2002.

Source:  USDA

Table 2.  USDA Weighted National Average Wheat Price and Official Counter Cyclical Payments for 02/03 Market Year Compared to KSU Estimates