Livestock Marketing - LRP Insurance

Jay Parsons Author

11/20/2020 Added

27 Plays

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Livestock Marketing

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[00:00:02.770]Welcome to this episode of Livestock Marketing,
[00:00:06.090]Livestock Risk Protection, or LRP Insurance.
[00:00:09.880]My name is Jay Parsons.
[00:00:11.620]I'm a professor and a farm and ranch management specialist
[00:00:15.030]in the Department of Agricultural Economics
[00:00:17.860]at the University of Nebraska-Lincoln.
[00:00:23.530]Livestock Risk Protection Insurance is administered
[00:00:26.240]by the Risk Management Agency as a part
[00:00:28.880]of the Federal Crop Insurance program.
[00:00:32.670]Livestock Risk Protection Insurance use in Nebraska
[00:00:35.450]has been relatively light through the years.
[00:00:38.930]This is the data for the 2019 crop year.
[00:00:43.298]You can see here, where the red arrow is,
[00:00:45.210]that LRP Feeder Cattle is the most popular type
[00:00:50.890]of insurances being purchased in Nebraska
[00:00:53.360]as a part of the LRP program.
[00:00:54.900]And in 2019 that was 10, roughly $10.4 million worth
[00:00:59.250]of liability coverage.
[00:01:01.100]That seems like a lot but that's the full value
[00:01:04.240]of the cattle that were insured, not necessarily anything
[00:01:08.040]that has to do with the margins or the indemnity payments
[00:01:12.780]that were made out of that.
[00:01:14.710]That tails in comparison to some of the neighboring states
[00:01:18.290]to Nebraska with quite a bit fewer cattle in them.
[00:01:21.810]We're one of the lightest users of LRP contracts
[00:01:25.650]in the country.
[00:01:27.530]And part of that's because we tend
[00:01:29.010]to have a positive basis here in the state
[00:01:32.540]and we have very active auction markets
[00:01:34.740]and quite a few buyers with feed yards, et cetera.
[00:01:38.980]The fed cattle market or the fed cattle LRP product,
[00:01:42.310]LRP Lamb and LRP Swine are used even lighter
[00:01:47.060]than the fed cattle situations
[00:01:48.710]because our feed yards are relatively large
[00:01:50.870]and we have a lot of processing facilities in this state
[00:01:53.910]and a lot of private contracts and CMA contracts being used
[00:01:58.320]to manage that price risk.
[00:02:00.230]LRP Lamb, there's not a lot of sheep in the state
[00:02:03.860]to begin with and LRP Lamb has been unavailable
[00:02:06.447]for a number of months recently
[00:02:08.940]because there's a different price reporting deals in this.
[00:02:12.200]And on the swine side, most of our swine producers
[00:02:14.490]are actually quite large producers.
[00:02:17.370]LRP itself was designed
[00:02:19.890]to help the smaller producer participate
[00:02:22.790]in a national market price protection programs
[00:02:27.900]through the CME pricing exchange in particular,
[00:02:32.330]but not have to do full contracts and extend all the costs
[00:02:38.263]that it takes to work with a broker to use those contracts.
[00:02:40.960]So LRP is administered as an insurance product,
[00:02:45.590]but it's connected to those national prices.
[00:02:48.860]So we're gonna take a look at LRP Feeder Cattle
[00:02:51.540]as an example of how this LRP works
[00:02:54.610]and how a person might use it as a part
[00:02:56.580]of their marketing plans, one of the tools
[00:02:58.260]that they use to help protect cattle prices.
[00:03:02.220]So LRP offers price protection only,
[00:03:06.300]it doesn't offer anything, even though it's insurance,
[00:03:08.480]it doesn't offer anything to protect against death loss.
[00:03:11.870]It is available in all counties across all states
[00:03:14.650]in the country.
[00:03:15.700]It's available in cattle protection form of it
[00:03:19.840]in three different weight classes.
[00:03:22.150]There's two weight classes for feeder cattle.
[00:03:24.170]One for those below 600 pounds,
[00:03:26.400]which would be like wean calves coming off the cow
[00:03:29.390]with little or no backgrounding.
[00:03:31.320]And then one for those that take a weight two,
[00:03:33.520]which range from 6 to 900 pounds.
[00:03:36.420]It's also available for fed cattle,
[00:03:38.250]which we might call slaughter cattle,
[00:03:40.320]and for those that are weighing above 900 pounds.
[00:03:43.630]So the producer determines which one
[00:03:45.580]of these products they wanna buy based off
[00:03:47.670]of what the weight of the cattle will be
[00:03:49.950]when they're looking to sell them.
[00:03:52.920]This insurance insures the price,
[00:03:54.730]it does not obligate them to actually sell the cattle
[00:03:58.500]at that time, it's just insuring the national price
[00:04:02.920]as it's posted at that point in time
[00:04:05.300]that they intended to sell them.
[00:04:09.040]It operates like a European Put Option
[00:04:11.270]in the sense that you can't get out of it.
[00:04:13.850]Your insurance premium is determined upfront.
[00:04:16.150]You are obligated to pay that.
[00:04:19.140]Recent changes to LRP don't make that payment due
[00:04:22.670]until the end of the contract,
[00:04:24.280]so if prices go up and you don't need the insurance,
[00:04:27.800]then you need to take some of your sales proceeds
[00:04:30.090]and go pay that premium,
[00:04:31.760]whether you sell the cattle or not,
[00:04:33.517]but for example, you need to pay that premium.
[00:04:36.240]If it turns out that you do collect on the insurance
[00:04:39.560]'cause prices drop and this price protection triggers
[00:04:42.040]an indemnity payment for you
[00:04:44.430]your premium costs will come out
[00:04:46.180]of that indemnity payment before you receive it.
[00:04:49.180]It is offered in 13 to 52-week periods.
[00:04:53.560]So if you rather look at that as months,
[00:04:55.640]it's anywhere from three months to a 12-month year,
[00:04:58.490]that's how far out you can pick
[00:05:00.470]for the end date in terms of your price protection.
[00:05:03.620]And it does leave the producer still subject
[00:05:06.190]to basis risks, just like all the CME products.
[00:05:08.890]This only is a protection against the market risks
[00:05:13.750]that happen on the national level.
[00:05:18.620]Here's some terminology that goes with the LRP insurance.
[00:05:22.660]There's the expected end value,
[00:05:25.010]which is the price at the end of the insurance period
[00:05:28.300]for each specified weight and type of cattle.
[00:05:31.040]And that's announced daily on the RMA website.
[00:05:34.010]For steers weight two, in that six to 900 pound range
[00:05:38.080]that price is tied directly to the feeder cattle contract
[00:05:41.390]on the board of trade.
[00:05:42.990]For heifers, it's generally,
[00:05:45.930]you're looking at 10% below that.
[00:05:47.970]And then for the lighter weight calves,
[00:05:50.630]you're looking at a 10% premium on the respective sexes
[00:05:54.430]as you go down below 600 pounds into weight one,
[00:05:57.430]but that's all triggered by that feeder cattle contract
[00:05:59.760]as is traded on the CMA exchange.
[00:06:02.650]Coverage prices are those prices
[00:06:04.330]that may be insured by the producers.
[00:06:06.630]All of these insurance coverage prices
[00:06:11.460]are out of the money puts,
[00:06:14.670]the best you can be close to half the money put,
[00:06:19.670]but they don't they don't match up exactly
[00:06:22.020]at exactly what it's trading at.
[00:06:23.940]There'll be just a smidge below that.
[00:06:26.380]Coverage levels range from 70 to 80%
[00:06:28.840]of the 100% of that expected value
[00:06:31.750]which is basically reiterating what I just said.
[00:06:34.510]They don't actually get up to a 100%.
[00:06:36.790]They're gonna be just a smidge below that
[00:06:38.510]so they're going to be out of the money,
[00:06:40.050]sometimes not by much.
[00:06:42.230]The actual ending value is what the CME feeder cattle index
[00:06:45.770]has settled at with those adjustments
[00:06:47.450]for different sex of the animal and different weights,
[00:06:49.990]but if you're looking at steers weight two,
[00:06:51.780]it'll match up exactly what
[00:06:53.100]that CME feeder cattle index based off of end date
[00:06:58.100]for that insurance period.
[00:07:04.230]They made a lot of changes to how LRP feeder cattle or...
[00:07:08.690]Yeah, the cattle contracts in general,
[00:07:10.240]feeder cattle were never used the most in Nebraska.
[00:07:13.010]Here, just in the last 15 to 18 months,
[00:07:15.800]for the first 15 years of this,
[00:07:17.830]it was always subsidized at 13%.
[00:07:21.310]Last year in 2019, they bumped that up to a minimum of 20%.
[00:07:25.620]They've made another adjustment this summer
[00:07:27.970]and a third adjustment yet this fall
[00:07:30.980]to where we now have the subsidy levels
[00:07:32.880]that you see here in front of you.
[00:07:35.180]So the minimum subsidy level you will get is 35%.
[00:07:38.340]The maximum will be 55%.
[00:07:40.900]New and beginning producers qualify
[00:07:42.840]for an additional 10% subsidy on top of this.
[00:07:45.930]So they can get up to a 65% subsidy on the premiums.
[00:07:51.180]So if you think about that, whatever the premiums are
[00:07:54.470]which are gonna be tied directly to what put options
[00:07:56.840]are selling for on the board of trade,
[00:08:00.200]the government is gonna pay this portion
[00:08:02.090]of that premium for you.
[00:08:03.340]So it's a good deal for the producers
[00:08:05.070]in the sense that they get a discount
[00:08:07.270]on what those options are trading for on the board of trade.
[00:08:11.220]If they go through this insurance product, okay,
[00:08:13.550]it makes it very appealing then to do that.
[00:08:17.320]Okay, here's an example from last year,
[00:08:20.070]you'll notice the subsidy column, the second one
[00:08:21.920]from the right actually has the premium subsidies
[00:08:24.720]that were in place in 2020.
[00:08:26.290]So it doesn't...
[00:08:27.440]So right now these numbers will be boosted up
[00:08:30.420]by 15 percentage points.
[00:08:31.850]So the same, if this were offered in February of 2021
[00:08:36.980]for the 2021 calf crop,
[00:08:39.280]we would see a 35%, 40% and 45% subsidy showing up
[00:08:45.950]in that subsidy column, second one from the right.
[00:08:49.710]And we'd see those discounts reflected in that net cost
[00:08:53.270]in the far column to the right, to the producer.
[00:08:56.650]So we see here several offerings out there,
[00:08:59.970]anywhere from one 144 a hundred weight
[00:09:01.960]up to 164 a hundred weight
[00:09:03.720]which represents anywhere from 87% to 99%
[00:09:07.170]of that expected price.
[00:09:09.010]The rate is the full rate and the cost per hundred weight
[00:09:12.120]is the full cost of the premium.
[00:09:14.660]And then as I have already alluded
[00:09:16.570]to those last two columns simply reflect
[00:09:19.830]the subsidy discount and the net cost to the producer.
[00:09:25.850]So these are published each day,
[00:09:27.400]it's a board of trade trades.
[00:09:29.270]And when the board of trade closes in the afternoon,
[00:09:31.970]a producer can look these prices up online
[00:09:34.410]and decide if they want to take out any insurance,
[00:09:37.730]LRP insurance based off of these coverage prices
[00:09:41.050]and the cost of the premium that is available.
[00:09:44.650]And if they do wanna do that,
[00:09:46.300]they will contact the insurance agent
[00:09:48.790]and they will tell them what coverage price they want,
[00:09:53.140]how many animals they wanna insure
[00:09:54.780]and at what weight they want to ensure 'em at.
[00:09:57.530]And of course, as a part of that,
[00:09:59.840]they would also include the date
[00:10:01.100]that they're actually looking out
[00:10:02.440]as far as it being a 13 week, 17 week
[00:10:04.530]and so on policy length.
[00:10:08.640]So here's an example, a very simple example.
[00:10:11.750]Let's just say, I am looking at 50 head of steers
[00:10:15.390]that I expect to have a marketed in early October.
[00:10:18.990]So October 1 is my end date here.
[00:10:21.310]I'm currently looking at February 6th.
[00:10:24.410]So I am looking at 34 weeks lapse in between now and then.
[00:10:29.520]So that's what I'd be looking for on the RMA website
[00:10:33.210]and talking to my insurance agent about
[00:10:35.040]in terms of the coverage period that I need.
[00:10:38.010]I have 500 pounds here to insure, right?
[00:10:42.620]So there's 25,000 pounds total that I want to insure.
[00:10:46.650]If I were to go on the board of trade
[00:10:48.250]and try to do a put option for these feeder cattle,
[00:10:50.850]I'd be looking at a 50,000 pound contract.
[00:10:53.692]It would be the minimum I could actually do on there.
[00:10:55.910]So that'd be double what I actually expect to market.
[00:10:58.330]So that's one of the examples where LRP Feeder Cattle
[00:11:01.830]was specifically designed to fit the smaller producer
[00:11:04.610]'cause they can match it up exactly
[00:11:06.520]with what they expect at market.
[00:11:09.000]The expected ending value is 165.54.
[00:11:11.880]I'm buying coverage at 164.14,
[00:11:14.260]which was the highest coverage level I could have picked
[00:11:16.400]on that previous page
[00:11:18.440]where I showed all the different prices that were available.
[00:11:21.330]This would cost me as a producer 6.92,
[00:11:24.280]that would have been last year's premium.
[00:11:26.180]Of course I would get another 15% off that.
[00:11:29.190]So you'd probably looking at about a $5 premium
[00:11:33.400]in the next year if this were to roll around.
[00:11:36.760]The producer premium then would be about 1,729 total. Okay?
[00:11:42.070]And that's the premium that I would be obligated
[00:11:44.370]to pay at some point, either out of my indemnity proceeds
[00:11:48.080]or with a check at the end of the coverage period.
[00:11:52.920]So how does this work?
[00:11:54.060]Suppose the CME report shows an actual ending value
[00:11:58.120]for this contract at 165.93,
[00:12:01.640]would you receive an indemnity?
[00:12:03.160]The answer is no, my coverage is at 164.41
[00:12:08.470]and so I don't have an ending price
[00:12:11.920]that's below the coverage I have in place.
[00:12:17.400]So there's no indemnity coming back there.
[00:12:19.470]So the net on this result
[00:12:21.800]is that I'm out that premium of $1,729.
[00:12:25.270]I would need to write a check for this
[00:12:26.650]at the end of the coverage period,
[00:12:29.140]to settle up with my insurance agent
[00:12:31.800]and I would sell the cattle or keep the cattle,
[00:12:33.570]whatever I wanted to do with them at that point.
[00:12:35.880]I had the protection and I didn't need it.
[00:12:39.050]Now suppose the second scenario occurred
[00:12:41.590]where the price did drop.
[00:12:42.880]Let's say it dropped all the way
[00:12:43.860]to 133.83 a hundred weight, would you receive an indemnity?
[00:12:47.480]Yes, you would because the ending price
[00:12:49.840]was far below the coverage price.
[00:12:52.100]Matter of fact, it's over $30 a hundred weight
[00:12:54.380]below the coverage price.
[00:12:56.020]I was covering 25,000 pounds,
[00:12:58.010]which is 250 hundred weight.
[00:12:59.550]So if you multiply that
[00:13:01.180]by how far we were below the coverage price,
[00:13:04.170]we end up with about a $7,600 indemnity.
[00:13:08.180]So that's what the insurance company
[00:13:09.920]would look to pay me back,
[00:13:11.130]they would subtract that $1,729 premium that I owed them
[00:13:15.780]and I would receive a check for $5,848.50
[00:13:20.060]which amounts to $23.39 a hundred weight
[00:13:24.350]on the 25,000 pounds of calves that I had insured.
[00:13:28.770]So that would help protect me from falling prices.
[00:13:34.860]So that's the way LRP works.
[00:13:37.540]How does it compare to the other choices out there?
[00:13:42.120]Let me summarize with all the different things
[00:13:43.970]that I have gone over in these episodes
[00:13:45.500]for livestock marketing.
[00:13:47.820]Just reiterate that your cash price received
[00:13:50.630]in the local market is your futures price
[00:13:53.550]out on the exchange, the CME exchange
[00:13:56.820]plus a basis or a difference between those two.
[00:14:00.240]Okay, in the cash auction or a spot market,
[00:14:04.100]you have full risk.
[00:14:05.430]If you wait and deliver your calves to an auction barn
[00:14:08.440]and take what they give you that day,
[00:14:10.060]you're accepting full price risk, full market risk,
[00:14:13.470]right up until the day
[00:14:14.630]you actually physically deliver your cattle.
[00:14:18.080]If you enter into a private contract
[00:14:20.470]with somebody out into the future,
[00:14:23.050]so say you're sitting there in February
[00:14:24.730]and somebody offers you a 160 for your calves in October,
[00:14:29.820]then you lock in everything,
[00:14:31.570]you lock in what you're gonna get
[00:14:32.930]for those calves in the fall.
[00:14:35.210]Those are two extremes.
[00:14:36.570]You don't know what you're gonna get in the fall
[00:14:37.920]until the day you deliver, or you do know
[00:14:41.020]for an advance exactly what you're gonna get for them.
[00:14:44.010]The other tools are someplace in between, okay?
[00:14:47.540]Futures contract, depend upon how it's structured here in...
[00:14:52.780]Well, actually a futures contract in the board of trade
[00:14:55.500]will lock in the national price. Okay?
[00:14:58.590]It does keep you exposed to basis risks,
[00:15:01.960]that difference between that futures price on the CME
[00:15:04.747]and the cash price.
[00:15:05.580]So you don't know exactly what you're gonna get
[00:15:06.960]in the local market yet, but you've taken away the risk
[00:15:10.130]of what happens in the national marketplace.
[00:15:12.560]You are subject to margin call risk as I mentioned
[00:15:14.870]in an earlier episode,
[00:15:16.140]and you do have brokerage costs
[00:15:18.040]to trade on the board of trade.
[00:15:20.440]A put option is also on the board of trade.
[00:15:22.470]So it's focused again on that futures price risks
[00:15:25.680]so you're still subject to basis risks,
[00:15:27.390]just like you would be in a futures contract.
[00:15:29.670]You do not have margin calls for the put option.
[00:15:32.190]You pay that premium upfront though.
[00:15:34.230]You gotta buy it, write a check, get it into your account
[00:15:37.670]and pay for that upfront.
[00:15:40.360]So you have premium costs,
[00:15:41.640]you also have broker costs involved
[00:15:43.640]but you do get to participate in the upside potential.
[00:15:47.030]So if national prices move up,
[00:15:48.750]you can let that put option expire
[00:15:51.150]and just let that increase in national prices be reflected
[00:15:55.260]in your local cash price accordingly
[00:15:58.030]and not have to offset that futures contract
[00:16:00.560]and give it back on the board of trade.
[00:16:04.010]LRP contract, which we just covered
[00:16:06.380]is similar to a put option, so it looks a lot like it.
[00:16:08.900]The difference is instead of having a brokerage
[00:16:11.920]and premium costs through the CME exchange,
[00:16:14.730]you simply have insurance costs attached to it,
[00:16:17.290]which is usually called an insurance premium
[00:16:20.420]but it's paid to your local insurance agent
[00:16:22.970]as a part of that.
[00:16:23.980]And again, you can fit that more
[00:16:25.810]to your actual expected production on your operation,
[00:16:29.710]you don't have to trade those full 50,000 pound
[00:16:33.220]or 40,000 pound contracts on the board of trade.
[00:16:36.210]A basis contract is a one where you are just trying
[00:16:39.450]to cover that basis risk.
[00:16:41.030]So you're agreeing upon a price
[00:16:42.970]that's tied to the futures contract.
[00:16:45.230]So you're subject to the futures price risk,
[00:16:48.510]whatever that moves around,
[00:16:50.130]but you've already agreed with the buyer
[00:16:51.900]that you're gonna have a price determined by that.
[00:16:55.530]So it might be $2 above, $10 below,
[00:16:58.300]whatever the case may be that you agree upon,
[00:17:01.230]but you're gonna agree upon that basis difference
[00:17:04.400]and then accept the risk in the futures market.
[00:17:07.860]Now, of course you can combine this basis contract
[00:17:10.830]with some of the up above to take care of
[00:17:13.560]that full risk exposure that you have there
[00:17:17.920]if you prefer, but you are not supposed to do LRP contracts
[00:17:21.730]and do put options and futures contracts at the same time.
[00:17:27.070]That's a no-no that turns you into a speculator
[00:17:30.790]and they don't like for you to do that.
[00:17:35.130]Okay, so with that, that's all the tools
[00:17:36.450]that you have available.
[00:17:38.780]Thank you for joining me today
[00:17:40.020]as we discuss LRP insurance for feeder cattle
[00:17:44.238]and I'll have one more episode
[00:17:46.450]where we actually look at a comparison
[00:17:48.690]of all of these different tools in an example.

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Livestock Marketing - LRP Insurance

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