managing farm risk: issues and strategies farm risk.pdfthe 1996 farm act came recognition of the...

Risk is an unavoidable element in the business of agriculture. Production can vary widely

from year to year due to unforeseen weather andmarket conditions, causing wide swings in com-modity prices. But risk, while inevitable, is oftenmanageable.

Risk management involves choosing among alterna-tives for reducing risks that threaten the economicsuccess of a farm business. The array of risk manage-ment strategies available to farm operators includescrop diversification, controlling cash flow, productioncontracting, forward pricing, and acquiring crop andrevenue insurance.

For eligible producers of major field crops, incomesupport provided in the 1996 Farm Act supplementsthe arsenal of risk management strategies, primarilyby providing fixed annual “contract” payments thatdecline over the period 1996-2002, as well as loandeficiency payments when crop prices drop belowcertain levels. Recently, depressed global commodityprices have pressured farm income as contract pay-ments declined. In response, Federal emergencyassistance packages were enacted that included“market loss” and crop disaster payments, and cropinsurance premium discounts.

In addition, Congress continues to examine legisla-tive alternatives to address the issues of commodityyield and price swings and income support for farmhouseholds. Against the backdrop of concern amongpolicy makers, USDA’s Economic Research Servicehas examined the nature of farm business risk andexplored the effectiveness of various risk manage-ment strategies. Throughout 1999, AgriculturalOutlook published articles reporting on this work.Reprinted here, the articles address the followingquestions:

• Do management/financial strategies used by farm-ers vary by type and size of farm?

• How do prices of agricultural commodities varyseasonally and from year to year?

• How effective for risk reduction are combinationsof crop and revenue insurance products and for-ward pricing strategies?

• What recent steps has government taken to broad-en the array of crop and revenue insuranceoptions for farmers? What are the costs to thegovernment?

Reprint/February 2000

Managing Farm Risk: Issues and Strategies

• How do factors such as insurance price and farmers’ “risk type” affect deci-sions on purchasing insurance?

• Would tax-deferred savings accounts be effective tools in managing risk?

The answers to such questions will likely be useful to policymakers, educa-tors, producers, and others who monitor risk management developments andstrategies.

Robert Dismukes (202) 694-5294 and Joy Harwood (202) [email protected] [email protected]

1 Farmers Sharpen Tools to Confront Business RisksMarch 1999

6 More Farmers Contracting to Manage RiskJanuary/February 1999

8 Assessing Agricultural Commodity Price VariabilityOctober 1999

14 Insurance & Hedging: Two Ingredients for a Risk Management Recipe

April 1999

21 Recent Developments in Crop Yield & Revenue InsuranceMay 1999

27 Demand for Yield & Revenue Insurance: Factoring In Risk,Income, & Cost

December 1999

30 Crop & Revenue Insurance: Bargain Rates but Still a Hard SellAugust 1999

34 Tax-Deferred Savings Accounts for Farmers: A Potential Risk Management Tool

May 1999

Agricultural Outlook is published monthly (except February and July) by the EconomicResearch Service, U.S. Department of Agriculture. Materials may be reprinted without per-mission. Latest and back issues available at www.econ.ag.gov/epubs/pdf/agout/ao.htm

Editorial staff: Dennis A. Shields, Judith E. Sommer, Mary Reardon, Cynthia Ray

Subscriptions: $65 per year ($130 to foreign addresses, including Canada). Call 1-800-999-6779 or 1-703-605-6220. For free e-mail subscriptions (text only): Go to the ERS website atwww.econ.ag.gov; click on “Periodicals,” then “E-mail subscriptions.”

As in any industry, risk is a part of thebusiness of agriculture. With farm incomecurrently under pressure from decliningfarm prices, USDA’s Economic ResearchService is exploring the subject of riskmanagement in agriculture. This article,the first in the series, describes a varietyof management techniques farm operatorsuse to survive swings in weather, markets,and the economy. Other topics in theseries include USDA’s farm risk initiativesand an analysis of the effectiveness of different crop and revenue insuranceproducts.

Farmers face an ever-changing land-scape of weather, prices, yields,government policies, global compe-

tition, and other factors that affect theirfinancial returns and overall welfare. Withthe shift toward less countercyclical gov-ernment intervention following passage ofthe 1996 Farm Act came recognition ofthe need for a more sophisticated under-standing of farm risk and risk manage-ment. Risk management strategies canhelp mitigate the effects of swings in sup-ply, demand, and prices, so that farmbusiness returns can be closer to expec-tations.

Risk management is, in general, findingthe combination of activities most pre-

ferred by an individual farmer to achievethe desired level of return and an accept-able level of risk. Risk managementstrategies reduce risk within the farmingoperation (e.g., diversification or verticalintegration), transfer a share of risk out-side the farm (e.g., production contractingor hedging), or build the farm’s capacityto bear risk (e.g., maintaining cashreserves or evening out cash flow). Usingrisk management does not necessarilyavoid risk altogether, but instead balancesrisk and return consistent with a farmoperator’s capacity to withstand a widerange of outcomes.

Although farms vary widely with respectto enterprise mix, financial situation, andother business and household characteris-tics, many sources of risk are common toall farmers, ranging from price and yieldrisk to personal injury or poor health. Buteven when facing the same risks, farmsvary in their ability to weather shocks.For example, in an area where droughthas lowered yields, falling prices resultingfrom large worldwide production couldhave devastating consequences for localfarm incomes. With such a downturn,some bankruptcies are likely to occur, andproducers who are highly leveraged andhave small financial reserves or lack off-farm income would be most vulnerable.

What do farmers themselves say about therisks they face? USDA’s 1996 Agricul-tural Resource Management Study(ARMS), conducted in the spring of 1997(about a year after passage of the 1996Farm Act), asked producers how con-cerned they were that certain types of riskcould affect the viability of their farms.Three risk factors of greatest concern tofarm operators were uncertainty regardingcommodity prices, declines in crop yieldsor livestock production, and changes ingovernment law and regulation. Issuessuch as price and yield have historicallybeen a focus of government farm pro-grams. But new policy areas, such aswater pollution control and waste man-agement, may well affect future legisla-tion and regulation of agriculture andpose new challenges to operators.

ARMS data show that producers special-izing in wheat, corn, soybeans, tobacco,and cotton were generally more con-cerned about the threat of low yieldand/or low price than any other risk.Reduced government intervention in mar-kets for program crops (wheat, corn, cot-ton, and other selected field crops) underthe 1996 Farm Act may have heightenedproducers’ uneasiness about price risk.

Producers of other field crops, nursery andgreenhouse crops, and poultry expressedgreater concern about changes in laws andregulations than about other risks. Thisperhaps reflects fears that changes in envi-ronmental and other policies could requirecostly compliance by the agricultural sec-tor. Producers of the other field crops maybe wary of changes in regulations address-ing soil conservation, land use, and tillagepractices, while livestock producers maybe particularly concerned about regula-tions related to waste management and thespread of disease.

Livestock producers also expressed con-cern about their ability to adopt new tech-nology, perhaps because failure to investin new production techniques could putthem at a cost disadvantage to other pro-ducers. For farm operators involved incontracts, expenditures necessary to satis-fy production requirements imposed bycontractors, such as modification of exist-ing livestock buildings, may add to risk.

Risk Management

Agricultural Outlook Reprint/February 2000 Economic Research Service/USDA 1

Farmers Sharpen Tools To Confront Business Risks

Jac

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Price & Yield Swings Pose Primary RiskThe possibility of lower-than-expectedyield is one of the risks identified in theARMS as a major concern to farmers,particularly those planting major fieldcrops. Yield variability for a given cropvaries by geographic area and depends onfactors such as soil type and quality, cli-mate, and use of irrigation. Yield variabil-ity for corn, for example, tends to be low-est in the central Corn Belt, where soilsare deep and rainfall is dependable, aswell as in areas that are irrigated. InNebraska, where much of the corn pro-duction is irrigated, yield variability isquite low. Yield variability is also low inIowa, Illinois, and other Corn Belt states,where climate and soils provide a nearlyideal growing environment for corn production.

In areas less well suited to corn produc-tion, yield variability is generally higher,and producers must deal with the prospectof yields that can deviate significantlyfrom planting-time expectations. Risksassociated with high yield variability andthe resulting income variability can bemitigated by programs such as Federalcrop insurance, as well as by diversifica-tion and other tools to help spread farm-level risk.

Like yield variability, price variability dif-fers among commodities. In 1987-96,crop prices showed relatively more vari-ability than livestock prices, largelybecause crop supplies are affected byswings in crop yields while livestock sup-plies have been more stable—althoughrecent variability in the hog market illus-trates that some exceptions exist. Cropsthat exhibited the highest price variability(deviations exceeding 20 percent above orbelow the mean) include dry edible beans,pears, lettuce, apples, rice, grapefruit, andgrain sorghum. The variability of beefcattle, milk, and turkey prices was lessthan 10 percent, perhaps reflecting lowerproduction risk and, in the case of milk,the existence of a Federal dairy program.

Price variability can change across timedepending on year-to-year differences incrop prospects, changes in governmentprogram provisions, and shifts in worldsupply and demand conditions. For exam-

Risk Management

2 Economic Research Service/USDA Agricultural Outlook Reprint/February 2000

Economic Research Service, USDA

Dry edible beansPears for fresh use

LettuceApples for fresh use

RiceGrapefruit, all uses

SorghumOnions

PotatoesAll wheat

CornSoybeans

Oranges, all usesCalves

All hogsUpland cotton

Fresh tomatoesLambsAll hay

All eggsLive broilers

TurkeysAll milk

Cattle, all beef

0 5 10 15 20 25 30

Percent of mean price

Price variability

During 1987-96, Price Variability Was Generally Higher for Crops Than for Livestock

Price variability measures deviation above and below the mean price for the period 1987-96.

1920’s 1930’s 1940’s 1950’s 1960’s 1970’s 1980’s 1990-960

20

40

60


Percent of mean price

Price variability

Corn Price Variability in the 1990’s Is Near the Level of the Past Two Decades

Price variability measures deviation above and below the mean price for each period.

ple, corn price variability was quite highduring the 1920’s and 1930’s, due largelyto the collapse of grain prices after WorldWar I and very low yields in 1934 and1936. Corn prices stabilized during the1950’s and 1960’s, a period of high gov-ernment support, stable yields, and con-sistent demand. Sizable purchases of cornby Russia early in the 1970’s affectedvariability during that decade, while lowU.S. yields in 1983 and 1988 contributedto increased corn price variability in the1980’s. Variability returned to near long-term average levels in 1990-96.

“Natural Hedge” May Stabilize RevenuesPrice and yield risks faced by a producerin a given situation, as well as the strengthof the relationship between price andyield—the price-yield correlation—caninfluence the effectiveness of different riskmanagement strategies. The stronger thenegative correlation (i.e., yield and pricemoving in opposite directions), the betterthe “offsetting” relationship (or “naturalhedge”) works to stabilize revenues.

The price-yield correlation for a commod-ity tends to be more strongly negative for

farms in major producing areas, becauseyields there are more positively correlatedwith national yields, and crop yieldsamong farms within a region tend tomove together. For example, in a majorcorn-producing area such as the CornBelt, corn yields tend to be more positive-ly correlated with a national corn yield,and therefore more negatively correlatedwith the national corn price. For wheat,where production is more dispersed andU.S. production is a smaller share of theworld’s crop, the natural hedge is weaker,making incomes more variable for mostwheat growers.

When other factors are held constant, themagnitude of a producer’s natural hedgehas important implications for the effec-tiveness of various risk-reducing tools. Aweaker natural hedge (where low pricesmore often accompany low yields), forexample, implies that forward contractingor hedging in futures is more effective inreducing income risk than when a strongnatural hedge exists. In this situation,locking in a sales price for part of the ex-pected crop works to establish one com-ponent of the farm’s revenue, reducing thelikelihood of simultaneously low priceand low yield. As a result, hedging can be

an effective risk management strategy forfarms outside major producing regions.

Deciding how much to hedge is morecomplicated than just assessing price-yield correlation. Income risk is also afunction of price variability and yieldvariability. Hedging effectiveness declinesas yield variability increases, and cornyields are typically more variable outsidethe Corn Belt. Since yield variabilitytends to outweigh the impact of price-yield correlation, hedging is generally notas effective in less consistent productionareas as in the Corn Belt.

No Single Approach Suits All FarmsWhile factors such as yield variability,price variability, and price-yield correla-tion can be used to gauge the likely effec-tiveness of various risk managementstrategies, producers’ attitudes toward riskare also determinants in selecting strate-gies. Some farmers are less risk aversethan others, and, for example, might feelmore comfortable in a highly leveragedsituation (e.g., carrying a large mortgage)than would others. Similarly, producersmay differ in their preferences for riskmanagement tools, some perhaps feelingmore at home with forward contractingwith a local elevator while others mayturn to hedging to manage their risks.

Because farmers face different degrees ofvariability and differ in their attitudestoward risk, there can be no singleapproach to suit all farms. Overall, farm-ers appear to be relying increasingly onforward contracting and other risk man-agement tools to reduce their farm-levelrisks, due in part to the recent trendtoward reduced government interventionin farming. Even so, the 1996 ARMSindicates that keeping cash (or liquidassets) on hand for handling emergenciesand for taking advantage of good businessopportunities was the number-one strategyused by farms of every size, every com-modity speciality, and in every region.

Farm size apparently plays a role inchoice of risk management strategy. TheARMS found that operators with annualgross sales of $250,000 or more weremore likely than smaller operators to use hedging, forward contracting, and

Risk Management


Farm yield variability (percent of mean)

Less than 2020-2425-3940 or more

Corn Yield Variability is Generally Lower for Farms in the Heart Of the Corn Belt

Based on farm-level data, 1985-94, and long-term county-level yields. Includes counties with at least 500 acres planted to corn.


Farmers have many options in managing the types of risksthey face. For example, producers may 1) plant short-seasoncrop varieties that mature earlier in the season to beat thethreat of an early frost; 2) install supplemental irrigation inan area where rainfall is inadequate or unreliable; or 3) usecustom machine services or contract/hired labor to plant andharvest quickly during peak periods.

Most producers use a combination of strategies and tools,because they address different elements of risk or the samerisk in a different way. Following are some of the more wide-ly used strategies.

• Enterprise diversification—assumes returns from variousenterprises do not move up and down in lockstep, so lowreturns from some activities would as a result likely be off-set by higher returns from other activities. Diversificationcan even out cash flow. According to USDA data, cottonfarmers are among the most diversified in the U.S., whilepoultry farms, with poultry and poultry products account-ing for 96 percent of the value, on average, of their pro-duction, are the least diversified.

• Vertical integration—generally decreases risk associatedwith the quantity and quality of inputs (or outputs)because the vertically integrated firm retains ownershipcontrol of a commodity across two or more levels ofactivity. Vertical integration also diversifies profit sourcesacross two or more production processes. In farming, ver-tical integration is most common for turkeys, eggs, andcertain specialty crops.

• Production contracts—guarantee market access, improveefficiency, ensure access to capital, and lower startup costsand income risk. Production contracts usually detail inputsto be supplied by the contractor, the quality and quantity ofthe commodity to be delivered, and compensation to bepaid to the grower. The contractor typically provides andretains ownership of the commodity (usually livestock) andhas considerable control over the production process. Onthe downside, production contracting can limit the entre-preneurial capacity of growers, and contracts can be termi-nated on short notice.

• Marketing contracts—set a price (or pricing mechanism),quality requirements, and delivery date for a commoditybefore harvest or before the commodity is ready to be mar-keted. The grower generally retains ownership of the com-modity until delivery and makes management decisions.Farmers generally are advised to forward price less than100 percent of their expected crop until yields are wellassured to avoid a shortfall that would have to be made upby purchases in the open market.

• Futures contracts—shift risk from a party that desires lessrisk (the hedger) to one who is willing to accept risk inexchange for an expected profit (the speculator). Farmers

who hedge must pay commissions and forego interest orhigher earning potential on money placed in margindeposits. Generally, the effectiveness of hedging in reduc-ing risk diminishes as yield variability increases and therelationship (correlation) between prices and yieldsbecomes more negative. Hedging can reduce, but nevercompletely eliminate, income risk.

• Futures options contracts—give the holder the right, butnot the obligation, to take a futures position at a specifiedprice before a specified date. The value of an optionreflects the expected return from exercising this rightbefore it expires and disposing of the futures positionobtained. Options provide protection against adverse pricemovements, while allowing the option holder to gain fromfavorable movements in the cash price. In this sense,options provide protection against unfavorable events simi-lar to that provided by insurance policies. To gain this pro-tection, a hedger in an options contract must pay a premi-um, as one would pay for insurance.

• Liquidity—involves the farmer’s ability to generate cashquickly and efficiently in order to meet financial obliga-tions. Some of the methods that farmers use to manage li-quidity, and hence financial risk, include: managing thepace of investments (which may involve postponingmachinery purchases), selling assets (particularly in crisissituations), and holding liquid credit reserves (such asaccess to additional capital from lenders through an openline of credit).

• Crop yield insurance—provides payments to crop produc-ers when realized yield falls below the producer’s insuredyield level. Coverage may be through private hail insur-ance or federally subsidized multi-peril crop insurance.Risk protection is greatest when crop insurance (yield riskprotection) is combined with forward pricing or hedging(price risk protection).

• Crop revenue insurance—pays indemnities to farmersbased on revenue shortfalls instead of yield or price short-falls. As of 1999, five revenue insurance programs (CropRevenue Coverage, Income Protection, RevenueAssurance, Group Risk Income Protection, and AdjustedGross Revenue) were offered to producers in selected locations. These programs are subsidized and reinsured by USDA’s Risk Management Agency.

• Household off-farm employment—may provide a stream ofincome to the farm operator household that is more reliableand steady than returns from farming. In essence, house-hold members working off the farm is a form of diversifi-cation. In 1996, according to USDA’s ARMS data, 82 per-cent of all farm households reported off-farm incomeexceeding farm income. In every sales class (includingvery large farms), at least 28 percent of the associated farmhouseholds had off-farm income greater than farm income.

Risk Management


A Selection of Strategies for Mitigating Risk

virtually all other types of risk manage-ment strategies. In contrast, operatorswith sales under $50,000 were less likelyto use forward contracting or hedging,and fewer reported using enterprise diver-sification to reduce risk.

The ARMS data also indicated that pro-ducers in the Corn Belt and NorthernPlains were somewhat more likely to userisk management strategies than those inthe Southern Plains, Northeast, andAppalachia. About 40 percent of produc-ers in the Corn Belt and Northern Plainsregions used forward contracting in 1996and about 25 percent used hedging infutures or options.

Farm legislation also affects adoption ofrisk management strategies. About one-third of producers nationwide reportedreceiving direct government commoditypayments in 1996. Of these, between 5and 8 percent (1-3 percent of all U.S.farmers) indicated they had added orincreased use of at least one risk manage-ment strategy or tool (forward contract-ing, hedging, insurance, or other strategy)in 1996 in response to provisions of the1996 Farm Act.

A period of financial stress may induce anoperator to shift risk management strate-gies. The 1996 ARMS questioned farmersabout production, marketing, and finan-cial activities they might undertake iffaced with financial difficulty. A largeproportion of producers with sales of$50,000 or more indicated they wouldadjust costs, improve marketing skills,restructure debt, and spend more time onmanagement decisions.

Producers with sales under $50,000 (whogenerally receive a substantial share ofhousehold income from off-farm sources)also responded that they would adjust costswhen faced with financial difficulties. Butsmall-farm operators would be relativelymore likely than larger operators to sellfarm assets or scale back operations. Fur-ther, small-scale producers were much lesslikely to spend more time on managementor on improving their marketing skills.

When individual efforts to deal withfinancial stress fail and large numbers offarms face significant financial loss, theFederal government has often stepped inwith assistance to agriculture in the formof direct payments, loans, and other typesof aid. In 1999, for example, the agricul-

tural appropriations act authorized emer-gency financial assistance to farmers whosuffered losses due to natural disasters.Under this legislation, farmers were eligi-ble for payments either for losses to their1998 crop, or for losses in any 3 or morecrop years between 1994-98. Farmerswith crop insurance received slightlyhigher payments than those without, andthose receiving emergency benefits wererequired to buy crop insurance (if avail-able) in 1999 and 2000. In addition, thelegislation provides an incentive for pur-chasing higher levels of crop insurancecoverage in 1999 by earmarking an esti-mated $400 million to subsidize farmers’insurance premiums. The 2000 agricultur-al appropriations provided crop loss assis-tance and $400 million to continuethrough 2000 the incentives for purchas-ing high levels of crop insurance.

Such assistance is undoubtedly critical forproducers facing financial difficulty.However, it raises questions as to how thepotential for direct payments in times ofdisaster affects producers’ decisionmakingwith regard to tools and strategies that canhelp them manage risk and perhaps avoidfinancial stress. Linking receipt of gov-ernment assistance to adoption of a riskmanagement strategy, namely the pur-chase of crop insurance, encourages pro-ducers to gain experience with a programthat can provide protection in crisis yearsin the future. Understanding the risksfaced in farming and the use of differenttools by producers can lead to new strate-gies and educational approaches to cutrisk and can perhaps help reduce the inci-dence of farm financial stress.

Joy Harwood (202) 694-5310, RichardHeifner (202) 694-5297, Janet Perry(202) 694-5152, Agapi Somwaru (202)694-5295, and Keith Coble [email protected]@[email protected]

AO

Risk Management


What Steps Would Farmers Take to Manage Financial Difficulties?

Small farms* Large farms**

Less than $50,000- $250,000- $500,000 Total$50,000 $249,999 $499,999 or more U.S.

Percent of farmsManagement/financial strategy:Restructure debt 24 48 46 49 30Sell assets to reduce debt 31 28 31 29 30Use more custom services 7 18 17 20 10Scale back farm business 26 23 20 24 25Diversify into other farm enterprises 12 23 21 21 15Spend more time on management 19 38 47 45 24Use advisory services 19 22 28 26 20Adjust operating costs 34 54 59 57 40Improve marketing skills 30 47 53 53 35

*Annual gross sales under $250,000. **Annual gross sales $250,000 or more.Source: 1996 Agricultural Resource Management Study, USDA


MMaannaaggiinngg RRiisskk iinn FFaarrmmiinngg:: CCoonncceeppttss,, RReesseeaarrcchh,, aanndd AAnnaallyyssiissA report by USDA’s Economic Research Service

* A valuable reference for comparing and assessing risk management strategies * Thorough yet accessible description of risk management concepts

Access it on the ERS website at http://www.econ.ag.gov/epubs/pdf/aer774/index.htmFor printed copies call 1-800-999-6779 (703-605-6220); report #ERS-AER-774

Almost a third of crops and livestockproduced by American farmers was

grown or sold under contract in 1997,according to USDA’s AgriculturalResource Management Study (ARMS).Departing from a tradition of independentfarm operators who have complete controlover production and marketing decisions,contracting is a growing trend inAmerican agriculture (AO May 1997).Today, more than 1 in 10 farm operatorsreport income from contractual arrange-ments.

Contracting offers farm operators theadvantages of reducing risks of priceswings, sharing production costs, and stabilizing income. For contractors (pri-marily processors and packers), thesearrangements assure a ready supply ofuniform, high-quality farm products andease inventory management problems.

Contracts—either written or oral agree-ments—will generally spell out the par-ties’ understanding of how a commodityis to be produced and/or marketed, includ-ing specifications for quantity, quality,and price. Marketing contracts are com-monly used for crops, while productioncontracts are more prevalent in the live-stock industry.

Under a marketing contract, a price (orpricing mechanism) is established for acommodity before harvest or before thecommodity is ready for marketing. Mostmanagement decisions remain with thegrower, who retains ownership of bothproduction inputs and output until deliv-ery. With a marketing contract, the farmerassumes all risks of production but sharesprice risk with the contractor.

A production contract details who sup-plies the necessary production inputs—thecontractor or the farmer (contractee)—aswell as the quality and quantity of a par-ticular commodity and the compensationdue the farmer for services rendered.Under livestock production contracts, thefarmer is paid to provide housing and care

for the animals until they are ready formarket, but the contractor actually ownsthe animals.

Although cash markets still dominate theagricultural sector, nearly $60 billion(31.2 percent) of total production wascovered by contracts. Commodities produced under marketing contractsaccounted for 21.7 percent of the totalU.S. value of production, while thoseunder production contracts accounted for9.5 percent. In 1997, 9 percent of farmerssold at least part of their output throughmarketing contracts, and 2.2 percent hadsome income from production contracts.

Between 1991 and 1997, the share ofcommodities produced under marketingcontracts increased from 16 percent to 22percent of total U.S. value of production.The production contract share of the totalhas varied between 10 and 15 percent,with no clear trend.

Topping the list of crops produced undermarketing contracts were fruits and veg-etables, with $11 billion sold through

contract, 40 percent of the value of allfruits and vegetables produced. Othercrops with large shares of productionvalue under marketing contracts were cot-ton ($1.9 billion, or 33 percent); corn($1.7 billion, or 8 percent); soybeans($1.7 billion, or 9.4 percent); and sugarbeets ($973 million, or 82 percent). Justunder 10 percent of the value of cattleproduction was sold under marketing con-tracts, compared with more than 60 per-cent of the value of dairy products.

Production contracts are more likely to beused for livestock. Poultry and poultryproducts accounted for over 50 percent ofthe total value of commodities under pro-duction contracts, and cattle and hogsanother 41 percent. Within the poultrycategory, 70 percent of the commodityvalue of production was produced underproduction contracts. In contrast, 33 per-cent of the value of production of hogsand 14 percent of cattle were covered byproduction contracts.

While farms of all types and sizes engagein contracting, two-thirds of farms withcontracts (marketing and/or production) in1997 were small family farms (salesunder $250,000). However, larger familyfarms (sales $250,000 and over) and non-family farms accounted for more thanthree-fourths of the value of productsgrown and sold under contract.

Risk Management


Farm Structure

More Farmers Contracting To Manage Risk

Typology of U.S. FarmsSmall family farms (annual sales under $250,000)Limited-resource: Operator household income under $20,000, farm assets under

$150,000, and gross farm sales under $100,000. Limited-resource farmers may ormay not report farming as their major occupation, or they may be retired.

Retirement: Operators report they are retired (excludes limited-resource farms).Residential/lifestyle: Operators report primary occupation other than farming

(excludes limited-resource farms). Farming occupation/lower-sales: Operators’ primary occupation is farming;

gross farm sales are under $100,000 (excludes limited-resource farms).Farming occupation/higher-sales: Operators’ primary occupation is farming;

gross farm sales are $100,000-$249,999.

Larger family farmsLarge: Gross farm sales $250,000-$499,999.Very large: Gross farm sales $500,000 or more.

Nonfamily farmsNonfamily corporations or cooperatives, as well as farms run by hired managers.

Larger family farms were more likely to use contracting than small familyfarms— 53 percent compared with 8 per-cent. Larger farms were also more likelythan other farms to use production con-tracts instead of marketing contracts.Larger family farms accounted for 65percent of the total value of commoditiesproduced under production contract,while nonfamily farms accounted for 21percent and small family farms for theremaining 14 percent.

Farms with marketing contracts—9 per-cent of all farms—outnumbered thosewith production contracts by 4 to 1. Whilesmall farms made up almost 70 percent ofthe farms engaged in marketing throughcontracts, they accounted for only 27 per-cent of the total value of production soldunder marketing contracts.

Dairy products marketed by small farmsunder contract were valued at $6.3 billion,or more than half of the marketing con-tract value of production on small farms.Small family farms sold $1.6 billion offruit and vegetables through marketing

contracts—20 percent of the value of allfruit contract marketings and 5 percent ofthe value of all vegetable contract market-ings. Other crops raised on small farmsand marketed through contracts includesoybeans, cotton, and corn, but contractedvalue of these commodities totaled just$1.4 billion.

Larger family farms sold 70 percent oftheir total value of dairy products throughmarketing contracts, as well as 66 percentof their fruit and 38 percent of their cot-ton. Other crops grown under marketingcontract on larger family farms includevegetables, corn, and soybeans.Commodities under marketing contractson nonfamily farms were predominantlyfruits, cattle, and dairy products.

As government programs become moremarket-oriented, all farm operators willneed to continue developing their riskmanagement skills in order to protecttheir operations from high debt levels andunpredictable price swings. Contracting islikely to be a part of farmers’ efforts toreconcile production preferences withexpected conditions in the marketplace,locking in purchasers for their products,sharing costs with investors, and ensuringcompensation for their labor.

David Banker (202) 694-5559 and JanetPerry (202) [email protected]@econ.ag.gov AO

Risk Management


Two-thirds of Farms with Contracts Are Small...

Larger family farms Nonfamily All

Limited- Retirement Residential/ Farming/ Farming/ Large Very large farms farms

resource lifestyle lower-sales higher-sales

Farms:

All farms (number) 195,572 304,293 811,752 396,698 178,210 79,240 45,804 37,816 2,049,384

All farms (percent) 9.5 14.8 39.6 19.4 8.7 3.9 2.2 1.8 100.0

Farms with contracts (percent) 2.5 9.0 13.9 20.2 21.4 16.5 12.7 3.8 100.0

Value of production:

Total ($ million)1 1,615.5 4,378.2 13,126.7 19,971.5 35,249.7 30,230.7 59,582.5 27,569.3 191,724.0

Contract value($ million) 137.4 542.9 1,758.3 4,678.6 6,834.6 8,421.3 26,409.1 11,043.2 59,825.5

Production contracts ($ million) d 147.2 524.4 943.2 970.7 3,012.6 8,762.3 3,843.8 18,215.7

Marketing contracts ($ million) d 395.6 1,233.9 3,735.4 5,863.9 5,408.7 17,646.9 7,199.4 41,608.8

Share of contract value (percent) 0.2 0.9 2.9 7.8 11.4 14.1 44.1 18.5 100.0

... but Larger Farms Are More Likely to Use Contracting

Percent of farm type with:

Production and/or marketing contracts 2.9 6.7 3.9 11.6 27.2 47.2 62.9 23.1 11.1

Production contracts2 d 0.8 0.7 1.9 4.9 13.3 20.0 2.2 2.2

Marketing contracts2 d 5.9 3.3 9.8 23.1 36.2 45.8 21.6 9.2

Percent of value of production 8.5 12.4 13.4 23.4 19.4 27.9 44.3 40.1 31.2 under contract1. Survey-based estimates exclude Alaska and Hawaii and do not represent official USDA estimates of farm sector activity. 2. Includes some farms that have both production and marketing contracts.d - Data insufficient for disclosure.Source: 1997 Agricultural Resource Management Study, USDA.


Small family farms

For more information on family farms

Structural and Financial Characteristics of U.S. Farms, 1995:20th Annual Family Farm Report to the Congress

To order call 1-800-999-6779. Ask for Stock #AIB-746. $21 Also available on the Economic Research Service website:

www.econ.ag.gov/epubs/pdf/aib746/

Price variability is a component ofmarket risk for both producers andconsumers. Although there is no

consensus as to what constitutes too muchcommodity price variability, it is general-ly agreed that price variability that cannotbe managed with existing risk manage-ment tools can destabilize farm income,inhibit producers from making invest-ments or using resources optimally, andeventually drive resources away fromagriculture.

Market price volatility that is not offset byapplication of risk management strategiescan lead to sudden and large incometransfers among various market partici-pants. For example, grain producers withhigh variable costs or significant debt mayface increased financial stress because ofunexpected downward swings in pricesand income, and may be unable to repaycreditors. Input suppliers, farm lenders,processors, and producers in both thegrain and livestock sectors may see theirbusiness costs rise and may pass thosehigher costs on to consumers. And insur-ance companies trying to set actuariallysound revenue insurance rates when facedwith increases in price variability mustraise premiums charged to farmers inorder to maintain actuarial soundness (AO August 1999).

Counterbalancing society’s interest in thefarm sector’s ability to manage price riskis an equally important interest in preserv-ing a “natural” degree of price variability.Price changes trigger supply and demandadjustments that make markets work moreefficiently. Thus, society has an interestnot only in helping market participantsmanage price risk via appropriate riskmanagement tools, but also in allowingmarkets to function efficiently.

An improved knowledge of the patterns ofcommodity price variability and the forcesbehind it would aid policymakers in pro-viding a policy environment conducive togood risk management practices andwould help farmers to better understandand manage their price risks. USDA’sEconomic Research Service (ERS) hasundertaken research designed to identifytrends or patterns in price movements andvariability over time—nominal and infla-tion-adjusted—and across agriculturalcommodities. The research also exploresfactors influencing price variability, suchas strong seasonal patterns in production,market supply and demand conditions,and government policies.

How Market Conditions Affect Price Variability

Agricultural commodity prices respondrapidly to actual and anticipated changesin supply and demand conditions.Because demand and supply of farm prod-ucts, particularly basic grains, are relative-ly price-inelastic (i.e., quantities demand-ed and supplied change proportionallyless than prices) and because weather canproduce large fluctuations in farm produc-tion, potentially large swings in farmprices and incomes have long been char-acteristics of the sector and a farm policyconcern.

The supply elasticity of an agriculturalcommodity reflects the speed with whichnew supplies become available (or supplydeclines) in response to a price rise (fall)in a particular market. Since most grainsare limited to a single annual harvest, newsupply flows to market in response to apostharvest price change must come fromeither domestic stocks or internationalsources. As a result, short-term supplyresponse to a price rise can be very limit-ed during periods of low stock holdings,but in the longer run expanded acreageand more intensive cultivation practicescan work to increase supplies. Whenprices fall, the cost of storage relative tothe price decline helps producers deter-mine if commodities that can be storedshould be withheld from the market.

Similarly, demand elasticity reflects a con-sumer’s ability and/or willingness to alterconsumption when prices for the desiredcommodity rise or fall. This willingness tosubstitute another commodity when pricesrise depends on several factors, includingnumber and availability of substitutes,importance of the commodity as measuredby its share of consumers’ budgetaryexpenditures, and strength of consumers’tastes and preferences. Since the farm costof basic grains generally comprises a verysmall share of the retail cost of consumerfood products (e.g., wheat accounts for asmall share of the price of a loaf of breadand corn represents a fraction of the retailcost of meat products), changes in grainprices have little impact on retail foodprices and therefore little impact on consumer behavior and correspondingfarm-level demand.

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Assessing AgriculturalCommodity Price Variability

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Increasing demand for grains for industri-al use, whether from processing industriesor from rapidly expanding industrial hogand poultry operations, further reinforcesthe general price inelasticity of demandfor many agricultural commodities.Industrial use of grains generally is notsensitive to price change, since industrialusers usually try to utilize at least a mini-mal level of operating capacity yearround. Also, in most cases, as with retailfood prices, the price of the agriculturalcommodity represents a small share ofoverall production costs of agriculture-based industrial products.

However, feed demand for grain, particu-larly for cattle feeding in the Southernand Northern Plains states, is far moresensitive to relative feed grain prices,since similar feed energy values may beobtained from a variety of differentgrains. Cattle feeders in these states arequick to vary the shares of different grainsin their feed rations as relative priceschange.

In general, elasticities of demand and sup-ply for agricultural products are both lowbut not uniform or consistent across com-modities. For example, there are severalcharacteristics unique to wheat productionin the U.S. that suggest greater supply anddemand elasticity (and, since supply anddemand respond somewhat faster, lessdramatic price swings) relative to otherfield crops in the face of external supplyand demand shocks—e.g., crop failure ina competing exporter country or financialcrisis in a major purchasing country.

First, U.S. wheat production is marked bytwo independent seasons, winter andspring, with planting periods nearly 6months apart. If it becomes apparent thatwinter wheat production is substantiallybelow market expectations due to prevent-ed plantings or weather-related declines inexpected yield, some potential productionlosses can be offset by increased springwheat plantings.

Second, the potential for surplus wheatproduction to enter agricultural marketsfrom a large number of competing wheatexporter nations (principally Canada,Argentina, Australia, the European Union,and occasionally Eastern Europe) increas-es the supply responsiveness of wheat

beyond that of other major grains. Inaddition, since two major U.S. wheatexport competitors are located in theSouthern Hemisphere and their produc-tion cycle runs opposite that of the U.S.,still greater elasticity of supply in interna-tional markets is possible.

Argentina and Australia have the opportu-nity to expand planted wheat acreage inresponse to supply and demand circum-stances in the U.S. within the same mar-keting year, dampening the potential year-to-year variability of prices in the U.S.market. While this potential additionalsupply limits price rises, it may actuallydeepen price declines because high stor-age costs and limited storage capacity fre-quently push surplus production intointernational markets even when pricesare low.

Third, wheat can serve dual functions aseither food or feed. The feed potential ofwheat can have a dampening effect onprice variability, either by introducing anadditional source of demand that preventsprices from falling too low or by shuttingoff that same demand source when pricesrise too high relative to other feed grains.

Fourth, most government-assisted exportprograms have been directed at wheat andhave had a potential dampening effect onprice variability in much the same manneras feed demand—they introduce an addi-tional source of demand that moves oppo-site to prices. Because export programsare funded to deliver a fixed value ofcommodities, the volume of U.S. programgrain exports rises during periods ofexcess supply and relatively lower prices,but falls when supplies are tighter andprices higher.

Similarities Common inCommodity Price Movements

In examining long time series of monthlyaverage spot market prices for corn, oats,soybeans, and several classes of wheatfrom major terminal markets, ERS hasfound strong similarities in nominal andinflation-adjusted price movements andvariability over time and across agricul-tural commodities. Price movements of corn, oats, and most wheat classes are similar mainly because of their substitutability in livestock feeding,but their market-year price volatilityshows greater differences because the

Risk Management



1913-19 1920-29 1930-39 1940-49 1950-59 1960-69 1970-79 1980-89 1990-970

5

10

15

20Soft red winter wheat

Hard red winter wheat

Corn

Soybeans

Percent

Coefficientof variation

Cash Price Variability Was Greatest Before World War II and in the 1970’s

Based on prices at major terminal markets. Soybean price data for 1913-19 not available. The coefficient of variation (CV) is a measure of price variability. CV = (dispersion of monthly inflation-adjusted average cash price over the season divided by mean of monthly average cash price over the season) multiplied by 100. Source: Constructed by ERS using monthly average cash price data from Bridge News Service andUSDA’s Agricultural Marketing Service and the all-urban CPI deflator from the Bureau of Labor Statistics.

commodities differ in their response tosupply and demand shifts.

Nominal prices for these commodities, asreported by USDA’s AgriculturalMarketing Service, have shown a generalupward trend since the early 1930’s, inter-rupted by nearly two decades of fairly sta-ble prices in the 1950’s and 1960’s. Thisperiod of relative stability ended with adramatic price spike in the early 1970’s, atumultuous period marked by an unex-pected surge in world grain demand andtrade, coupled with poor harvests andrapid, dynamic macroeconomic changes(AO September 1996). Since the mid-1970’s, nominal prices appear to haveboth a higher mean level and greater vari-ability. The past three seasons (1996-98)have witnessed a precipitous plunge innominal prices from the May 1996 spikewhen corn and two of the high-proteinwheat classes—hard red winter and hardred spring—attained record-high monthlyaverage spot market prices.

When monthly average price data areadjusted for inflation, a different patternemerges—declining real prices since thelate 1940’s, interrupted by the dramaticupward spike in prices of the early1970’s. The pattern of inflation-adjustedprice variability is less clear than the pat-tern of nominal price variability, but itsuggests that prices were more variableduring the three pre-World War II decadesthan since.

A common statistic for measuring thevariability of a data series is the coeffi-cient of variation (CV), which expressesthe dispersion of observed data values asa percent of the mean. Since the CV isunit-free (a percent), it facilitates compar-ison of price changes in different direc-tions, across different periods of time, andfor different commodities. Marketing-yearCV’s calculated from each commodity’sinflation-adjusted series of averagemonthly spot prices reflect the pricevolatility that occurred within each mar-keting year. The nature and degree of this

within-year price variability affect deci-sions on the mix and level of farm activi-ty, as well as on risk management andmarketing strategies.

On the other hand, comparison of CV’sacross market years provides an indica-tion of a commodity’s longrun price vari-ability. Such across-year price variabilityinfluences firm expansion and capital-asset acquisition decisions, and has adirect bearing on a firm’s economic via-bility. In addition, the longrun variabilityof commodity prices across marketingyears reflects the risk environment foragriculture relative to other sectors.

A shortcoming inherent in using historicalaverages as a forecast of price volatility isthat such estimates fail to fully incorporatecurrent market information. For example,prices are likely to be more volatile thanthe historical average during a year thatbegins with very low carryin stocks.

The degree of variability in commodityprices is traditionally believed to dependheavily on stock levels and on the natureand frequency of unexpected shifts indemand and supply. Thus, essentially allmarket forces affecting commodity priceformation could potentially come into playin determining price variability. Suchforces include own supply (carryin stocks,production, and imports), supply of substi-tute crops (depending on end use), andaggregate demand (domestic mill, feed,seed, and industrial use, and exports). Ownsupply and supplies of competitor cropsare directly affected by weather, acreage,government policy, and international tradefactors. Demand is directly affected byprice, income, shifts in tastes and prefer-ences for end uses, and population growth.Grain and seed characteristics—i.e., type,quality, protein content, and color—arealso key factors in price formation.

The possibility of substitution in use iscritical in determining strength of correla-tion between different commodity prices.For example, inflation-adjusted spot mar-ket prices for three winter wheat classes—soft red, hard red, and soft white winter—and hard red spring wheat are highly cor-related, because they offer some similarcharacteristics to end users. Hard amberdurum, on the other hand, with its highprotein level and specific milling and

Risk Management


Wheat Price Is More Highly Correlated With Corn Price Than With Soybeans. . .

Wheat Corn Soybeans

Soft red Hard red Hard amberwinter winter durum

Correlation coefficient for priceWheat:

Soft red winter 1.00 0.99 0.87 0.90 0.71Hard red winter 0.99 1.00 0.90 0.90 0.71Hard amber durum 0.87 0.90 1.00 0.81 0.62

Corn 0.90 0.90 0.81 1.00 0.72Soybeans 0.71 0.71 0.62 0.72 1.00

. . .but Grain Price Variability Is Less Highly Correlated Than Grain Price

Wheat Corn Soybeans

Soft red Hard red Hard amberwinter winter durum

Correlation coefficient for price variabilityWheat:

Soft red winter 1.00 0.94 0.71 0.46 0.39Hard red winter 0.94 1.00 0.71 0.53 0.35Hard amber durum 0.71 0.71 1.00 0.22 0.30

Corn 0.46 0.53 0.22 1.00 0.39Soybeans 0.39 0.35 0.30 0.39 1.00

Prices are inflation-adjusted monthly spot market prices during various time periods, 1913-98. The correlationcoefficient indicates similarity between two sets of variables: a coefficient of plus one (+1) indicates a perfectpositive relationship, minus one (-1) a perfect negative relationship, and zero no relationship.Price variability is coefficient of variation (CV) for market-year inflation-adjusted monthly spot market prices.CV = (dispersion of monthly inflation-adjusted average cash price over the season divided by mean inflation-adjusted monthly average cash price over the season) multiplied by 100.Sources: Spot market prices from USDA's Agricultural Marketing Service; daily cash settlement prices fromthe Chicago Board of Trade; and monthly average settlement prices from Bridge News Service.


end-use qualities, offers the least opportu-nity for substitution with other wheatclasses and, as a result, tends to haveslightly lower price correlations withother wheat classes.

Price correlations among corn, oats, andwheat, although somewhat lower, are stillvery strong and likely reflect their substi-tutability in feed markets. Price correla-tions between these grains and soybeansare lower yet. Soybean prices are princi-pally derived from demand for its jointproducts—oil and meal. Soybean meal isgenerally included in feed rations as aprotein source, but may compete directlywith other grains in feed rations as anenergy source, depending on relativeprices. However, soybean oil—used prin-cipally as a food with some minor indus-trial uses—has limited substitutabilitywith grains (corn oil being the majorexception), thereby weakening the soy-bean-grain price correlation.

Correlations of market-year price CV’sfor corn, oats, wheat classes, and soy-beans are sharply lower compared withprice-level correlations. This suggests thatwhile general price levels for most grainsand soybeans may be influenced by ormove in tandem with many of the sameforces, commodity price variabilities aremore distinct and less strongly related toeach other, due likely to disparities intheir respective supply and demandresponsiveness to price changes.

Strong Seasonal Pattern forWithin-Year Price Volatility

The principal difficulty in analyzing with-in-year price variability is that while pricescan be routinely observed for almost anytime period (e.g., year, month, week), theeconomic supply and demand factors thatlikely influence price movements are gen-erally reported only on a monthly or quar-terly basis. Research conducted jointly byERS and North Carolina State Universityattempted to circumvent this problem bytransforming monthly and quarterly datainto weekly data representations. Thesewere used to assess the importance of rele-vant market information in forecastingwithin-year price variability (measured asa rate of change) of settlement prices forthe Minneapolis Grain Exchange’sSeptember wheat futures contract and the

Risk Management


Wheat Price Variability Peaks When Uncertainty Is Greatest

Source: USDA’s Economic Research Service and North Carolina State University.

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Sept. Nov. Jan. Mar. May July Aug.

Uncertainty about condition of winterwheat crop and spring planting intentions

Wheat harvest underway and critical growing period for major feed grains


Price variability factor indicates weekly deviation from expected (or forecast) price variability measured over the entire time period. Zero indicates price variability during that week is the same as expected price variability over the entire time period. Seasonal volatility estimated by an economic model of volatility using weekly Minneapolis Grain Exchange September wheat futures contract prices, 1986-97.

Price variability factor

Source: USDA’s Economic Research Service and North Carolina State University.

Corn Price Variability Rises During Planting Time and Ebbs During Harvest


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-1

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1

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3

4

Dec. Feb. Apr. June Aug. Oct. Nov.

Planting time

Harvest time

Price variability factor

Price variability factor indicates weekly deviation from expected (or forecast) price variability measured over the entire time period. Zero indicates price variability during that week is the same as expected price variability over the entire time period. Seasonal volatility estimated by an economic model of volatility using weekly Chicago Board of Trade December corn futures contract prices, 1986-97.

Chicago Board of Trade’s December cornfutures contract during the 1987-96 period.

Futures prices play a critical role in facili-tating seasonal market operations, becausethey provide a forum for forward con-tracting, as well as a central exchange fordomestic and international market supplyand demand information. Regional andlocal grain elevators rely on futures com-modity exchanges for hedging grain pur-chases and generally set their grain offerprices at a discount (in areas of surplusproduction, such as the Corn Belt) or at apremium (in deficit production areas, suchas North Carolina) to a nearby futurescontract. As a result, cash prices andfutures contract prices are stronglylinked—i.e., both prices contain much ofthe same information about variability.

Both corn and wheat futures contractprices display distinct patterns of seasonalvariability. For the December corn con-tract, a strong variability peak occurs inJune when there is a great deal of uncer-tainty surrounding the true extent of plant-ings and likely yield outcomes for cornand other spring-planted crops. Much ofthe acreage uncertainty is resolved withrelease of USDA’s June 30 Acreagereport, while yield uncertainty is resolvedin July after corn pollination has occurred.A second, weaker peak occurs in Octoberand corresponds with the arrival of new

information during the peak corn harvestperiod. The seasonal component of cornprice volatility then declines rapidly priorto contract expiration.

This pattern suggests that the bulk of rele-vant information is synthesized by thecorn market during the critical summergrowing months when estimates ofacreage and yields are largely determined.Supply news then tends to dominate mar-kets into the fall harvest, with little newinformation added during the periodimmediately preceding contract expiration.

The seasonal pattern for September wheatfutures contract price variability alsoshows two peaks, the first a weak early-season peak occurring in January-March,a time of substantial uncertainty about thetrue condition of the winter wheat cropand farmers’ spring planting intentions.Much of the uncertainty is resolved withUSDA’s release of its March 28 PlantingIntentions report.

A second, much stronger peak in variabil-ity occurs in late July and correspondswith the conclusion of winter wheat har-vest and the critical growing period forthe major feed grains and spring wheat.Domestic prices for the U.S. wheat cropalso depend heavily on international sup-ply and demand conditions, and some key

market information governing internation-al developments does not reach the mar-ket until midsummer when USDA beginsforecasting major international crop pro-duction. Following the July harvest-timesurge, the seasonal variability thendeclines rapidly prior to contract expira-tion.

The volatility of corn and spring wheatfutures prices also shows a strong negativerelationship with growing conditions—better-than-average growing conditions areassociated with lower price variation.However, corn and wheat prices differ inthe association of variability with many ofthe remaining supply and demand factorsstudied. This is likely due to differences intheir respective supply and demandresponsiveness to price changes.

For corn, increases in expected U.S.domestic demand—published monthly inUSDA’s World Agricultural Supply andDemand Estimates (WASDE) report—hada positive influence on price volatility, butchanges in actual levels of corn stocks—estimated quarterly by USDA—did notappear important, probably because cornsupply is estimated from a single annualcrop, and because changes in stocks areprimarily a residual of often offsettingchanges in other market forces and therefore tend to move slowly betweenharvests.

For wheat, changes in expected exportsand domestic demand for all wheatshowed no influence on spring wheatprice volatility, while increases in actualall-wheat private stocks had a dampeningeffect on volatility. Lack of a strong rela-tionship between demand factors andspring wheat price volatility is likelyexplained by winter wheat dominance ofU.S. wheat exports, by the shifting impor-tance of wheat as government food dona-tions versus commercial export sales, andby the interplay of food-feed markets.

The study found that the level of day trad-ing (day traders enter and exit the marketwith no outstanding balance at the end ofthe trading day) at each commodityexchange correlated positively with bothcorn and spring wheat price variability,likely because day trading allows prices toadjust to information more quickly. Onthe other hand, market concentration—

Risk Management


Are Prices More Volatile in Recent Decades Than Earlier?An examination of the historical record of wheat, corn, oat, and soybean prices dur-ing 1913-97 indicates the following patterns:

• Wheat prices tend to be less variable than prices for oats, corn, or soybeans overthe entire period and during most selected subperiods. The most notable exceptionis the 1990-97 period when wheat price variability was above average while soy-bean and oat variability were below the average for the entire period.

• All five wheat classes, plus corn and soybeans, exhibited dramatic increases inprice variability during the 1971-75 period.

• Price variability for all commodities is noticeably higher in the post-1970’s era(1976-97) than during the pre-1970’s period (1951-70).

• Price variability in the post-1970’s period (1976-97) is slightly lower than variabil-ity during the 1913-50 period.

Studying such a long price series gives greater perspective to current levels of pricevariability and suggests that perhaps an anomaly with respect to price variabilityoccurred during the 1950’s and 1960’s, when heavy government involvement inagricultural commodity markets—including large government stockholdings ofwheat and feed grains—coupled with low absolute levels of world trade (relative tothe post-1971 period) contributed to artificially stable prices.

measured using Commodity FuturesTrading Commission “commitment oftraders” data on holdings of the fourlargest traders—had a negative influenceon spring wheat price volatility, suggest-ing that the action of large traders in high-ly concentrated markets may decrease thevolatility of wheat prices.

Forces Driving Across-YearPrice Variability

In joint research to investigate determi-nants of across-year price variability, ERSand North Carolina State University con-structed within-year CV’s from monthlyaverage cash prices at major terminalmarkets during 1944-97 for Chicago/St.Louis soft red winter wheat, Chicagocorn, and Chicago/Central Illinois soy-beans. Each CV reflects the price variabil-ity that occurred during a market year.Then these market-year CV’s were exam-ined in light of year-to-year changes inmajor supply and demand factors.

As expected, output price variability forall three commodities was found to benegatively correlated with the level ofstocks relative to total disappearance; aready supply available from stocks tendsto make prices less sensitive to new mar-ket information. However, as in the with-in-year study, corn, soybean, and wheatprice CV’s exhibited key differences intheir association with most of the remain-ing supply and demand factors studied,likely because of differences in their sup-ply and demand responsiveness to pricechanges.

Since increases in production tend todampen both prices and price variabilityby contributing to an increase in total sup-ply relative to market demand, any changein acreage and yield (both of which havepositive associations with production) isexpected to have a negative, indirecteffect on price variability through theinfluence on production. Change in yieldshows a strong negative relationship withcorn price variability, but no relationshipwith soybean and wheat CV’s. Wheat’sdual seasons (winter and spring) within asingle crop year and broad geographicdiversity of production likely diminish theinfluence of a single weather pattern on

the aggregate wheat market. Change inharvested acres is negatively related towheat price variability, but not to corn orsoybean price variability.

Change in demand, on the other hand, isexpected to be positively associated withprice variability since increases in demand,whether domestic or international, drawdown total supplies and stocks, anddecreases in demand have the oppositeeffect. This was confirmed by a positiveassociation between corn price variabilityand both domestic use and exports.

However, wheat price variability showedno relationship to change in domestic useand was negatively related to change inexports. The negative effect of wheatexports on price variability tends to con-firm the smoothing effect of governmentexport assistance programs, and suggeststhat U.S. wheat exports act as a residualsource of supply to world markets whendomestic prices fall low enough. The off-setting roles of food and feed usage inwheat price volatility—positive for wide-spread changes in domestic use formilling and other food and industrial uses,but negative (and offsetting) when actingas a residual outlet to feed markets—result in a net neutral effect.

Similarly, changes in the general level ofinput prices are expected to have positiveassociations with price variability indi-rectly via their negative influences on pro-duction and total supply. For example, ris-ing input prices tend to dampen produc-tion and, in turn, may raise price variabili-ty. However, no relationship was foundwith corn and wheat price CV’s. Instead,soybean price variability showed a nega-tive association with changes in inputprices, suggesting that soybean cost sav-ings relative to corn and wheat played arole (AO May 1999). As input prices rise,producers favor soybeans because soy-bean production costs are relatively lower,resulting in greater acreage, more produc-tion, and lower soybean price variability.

Government policy influences are inher-ent in nearly all related supply anddemand variables. Several governmentprogram initiatives (including some that

preceded the 1996 Farm Act) were studiedto directly measure the influence of loanrates, expected deficiency payments(which were intended to stabilize incomebut often had the unintended consequenceof limiting substitution in productionbecause of associated acreage restric-tions), and acreage reduction programs(which were designed to reduce supply byremoving acreage from production).Results hint at some effects on commodi-ty price variability for wheat and soy-beans from acreage constraints and pricesupport programs, but no government pol-icy variable was found to influence cornprice variability.

While far from conclusive, these resultssuggest that past government programshad a tendency to produce higher levels ofprice variability, at least for wheat andsoybeans. In every case where a govern-ment policy variable was found to beimportant, it had a positive associationwith price variability. At first glance, thiseffect may seem surprising. However,policies that are intended to stabilize producer incomes—a central goal of pastpolicy—are apparently likely to increasethe volatility of market prices if they distort production and marketing arrangements.

Since the 1996 Farm Act, governmentpolicy has shifted away from potentiallyprice-destabilizing direct intervention inagricultural production processes andmarkets. Instead, USDA’s RiskManagement Agency has been working toprovide the necessary tools and informa-tion for farm operators and other partici-pants in agricultural markets to betterunderstand and manage risks associatedwith producing and selling agriculturalcommodities. Although effective tech-niques for managing inter-year price riskremain elusive, a variety of managementtools—e.g., futures and options contracts,and various crop and revenue insuranceproducts (AO April 1999)—exist for man-aging within-year price risk.

Randy Schnepf (202) [email protected]

AO

Risk Management


The past few years have seen a prolif-eration of market-based mechanismsavailable to agricultural producers

for managing yield, price, and revenuerisks. Making the right choices is becom-ing more complicated. Yet the fundamen-tals for making good risk managementchoices remain the same: 1) understandingthe farm’s risk environment, 2) knowinghow the available risk management strate-gies work and which risks they address,and 3) selecting the strategy or combina-tion of strategies that will provide the pro-tection that best suits the farm’s and theoperator’s individual circumstances.

USDA’s Economic Research Service(ERS), using data from the Department’sRisk Management Agency (RMA) andNational Agricultural Statistics Service(NASS), has identified general condi-tions underlying farm-level risk manage-ment behavior in the U.S., how condi-tions relate to the performance of differ-ent risk management strategies, and whycertain risk management strategies workbetter than others at reducing farm-spe-cific risk across a range of different riskenvironments. This research has focusedon three field crops with the highestacres planted—corn, soybeans, and

wheat—but it provides a useful guide forrisk management for other major fieldcrops as well.

Defining a Farm’s Risk EnvironmentWithin a single crop year, once cropdecisions have been made and resourceshave been allocated to production agri-culture, the farm’s principal risk lies inthe uncertainty of the revenue generatedby the production process. Farm revenueuncertainty, particularly the componentrelated to field crop production, is princi-pally a function of yield and price uncer-tainty, as well as the correlation betweenprice and yield.

Weather is the principal cause of yielduncertainty. Within any given agro-climat-ic setting—characterized by weather pat-tern, soil type and fertility, growing sea-son, day length—variability of yield isattributable mainly to factors such as tem-perature, cloud cover, and timeliness andamount of precipitation.

Price uncertainty for farmers combinestwo elements. Price-level uncertainty is

the consequence of imperfect informationabout future domestic and internationalsupply and demand conditions. Basisuncertainty—uncertainty about the differ-ence between a commodity’s local cashprice and its nearest futures contractprice—derives from uncertainty aboutfuture commodity movements and haulingcosts. The tendency for price and yield tochange in opposite directions provides a“natural hedge” which tends to stabilizefarm revenues over time, particularly inmajor producing areas (AO March 1999).

Farmers’ attitudes towards risk can varygreatly and are a key determinant inselecting risk management strategies. Afarmer with a strong aversion to risk willbe willing to pay more for a given levelof risk reduction than a farmer with aweaker aversion to risk. An operator’soverall level of wealth can also have astrong bearing on risk decision making. Ingeneral, at higher levels of wealth an indi-vidual is more willing to undertake agiven level of risk—a phenomenon calleddecreasing absolute risk aversion—butthere are exceptions to this rule. The pre-ferred or optimal risk management strate-gy may also vary because of other man-agement objectives, such as profit maxi-mization or enterprise growth. In addition,lenders may strongly suggest or evenrequire use of risk management tools toprotect their stake in the farm’s produc-tion outcome.

The Mechanics of Crop & Revenue InsuranceThe array of crop and revenue insurancepolicies and coverage levels available toU.S. farmers has been rapidly expandingover the past few years. In spite of thegrowing complexity of agricultural insur-ance programs, the majority of policiesactually sold can still be fairly well repre-sented by two generic types of agricultur-al insurance: standard yield-based cropinsurance and revenue insurance.

The largest share of farm coverage contin-ues to be traditional yield-based cropinsurance, although revenue insurancecoverage is rapidly gaining. Traditionalyield-based crop insurance—referred to asmultiple peril crop insurance (MPCI)—includes both the minimum catastrophiccoverage (CAT) which insures against

Risk Management


Insurance & Hedging: Two Ingredients for a Risk Management Recipe

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severe losses and whose premiums arefully subsidized by the Federal govern-ment, and higher levels of coverage—called “buy-up” coverage—with partiallysubsidized premiums. Revenue insurancepolicies include Income Protection,Revenue Assurance, and Crop RevenueCoverage. All three of these revenueinsurance programs receive partial subsi-dization of premiums by the Federal government.

Two time periods are relevant in calculat-ing insurance program prices. The first isplanting time, when a Projected Price isused to set insurance premium rates andprice elections, and to value coveragelevels. The second is harvest time, whenthe harvest-time futures price is used tovalue the farm’s production whether soldor stored.

For yield-based insurance purposes, RMAestablishes a Projected Price about 3months before the insurance signup peri-od for each commodity. This yield-based-insurance version of the Projected Price isnot derived solely from a futures marketprice average, but is a forecast of the sea-son-average price that incorporates addi-tional market information.

For revenue insurance valuation, theProjected Price is the average of the dailysettlement prices of the harvest-timefutures contract during the month preced-ing program signup. For the price at har-vest time, the average closing price of theharvest-time futures contract during themonth prior to the contract’s expiration isused. For example, the Projected Price fora corn revenue insurance contract is theFebruary average closing price of theChicago Board of Trade’s (CBOT’s)December corn contract. And the harvest-time futures price for the December corncontract would be the average daily settle-ment price during November.

Yield-based crop insurance (MPCI) paysthe operator an indemnity if the actualyield falls below a yield guarantee, butMPCI does not offer price protection.Under MPCI, the producer pays a pro-cessing fee for minimum CAT coverageand a premium for buy-up coverage toobtain partial protection against yield lossonly. The yield guarantee is determinedby multiplying the producer’s average

Risk Management


Offsetting Price-Yield Relationship, a Key Factor in the Farm RiskEnvironment, Varies by Region and Commodity

Corn price-yield correlationUnder -0.40 (strongest)-0.4 to -0.3-0.29 to -0.15Above -0.15 (weakest)

Soybean Producers in Western Corn Belt

Corn Producers in Iowa, Illinois, and Indiana

Soybean price-yield correlation

Under -0.25 (strongest)-0.250 to -0.151-0.150 to -0.100Above -0.10 (weakest)

Wheat price-yield correlationUnder -0.070 (strongest)-0.070 to -0.051-0.050 to -0.020Above -0.020 (weakest)

Winter Wheat Producers in Central Southern Plains


Price-yield correlation indicates strength of offsetting relationship between price and yield movements--the more negative, the better the "natural hedge" works to stabilizerevenue. Based on annual county-level data, 1974-94.

Risk Management


historical yield—referred to as the actualproduction history (APH)—by the cover-age level. Coverage levels range from 50to 75 percent (expanded to 85 percent insome areas for 1999) of the APH yield,and from 60 to 100 percent of theProjected Price.

Example of crop insurance:Suppose a corn producer has an APHyield of 150 bushels per acre, theProjected Price is $2.50 per bushel, andthe producer selects 75-percent APH cov-erage with 100-percent price coverage—referred to as the elected price. The producer’s yield guarantee is 112.5bushels per acre (75 percent of 150bushels). An actual yield below 112.5bushels will result in an indemnity pay-ment to the producer equal to the electedprice of $2.50 times the differencebetween the yield guarantee and the actu-al yield, even if the harvest-time pricerises above the Projected Price. However,if the actual yield does not fall below theyield guarantee, even if the harvest-timeprice falls below the Projected Price, theoperator gets no indemnity. Thus MPCIpartially insures against production risk,but does not insure against price risk.

Revenue insurance—e.g., IncomeProtection and the standard RevenueAssurance programs—protects farmersagainst reductions in gross income when acrop’s prices or yields decline from early-season expectations. The revenue guaran-tee equals the product of the farmer’sAPH yield, the Projected Price, and thecoverage level selected by the producer. Aproducer receives an indemnity when theactual yield, multiplied by the harvest-time futures price, falls below the revenueguarantee. Since revenue insurance cover-age is generally available at a maximumof 75 percent (85 percent in some desig-nated counties), it provides only partialprotection against both price and yieldrisk, and is less effective at reducing riskwhen the natural hedge is strong.

Revenue insurance with replacementcoverage protection is available to farm-ers via the Crop Revenue Coverage pro-gram or the Revenue Assurance programwhen purchased with an increased priceguarantee option. The added replacementcoverage protection (RCP) feature offers arevenue guarantee that depends on the

higher of the price elected at signup or theharvest-time futures price. Thus, the pro-ducer’s revenue guarantee may increaseover the season, allowing the producer topurchase “replacement” bushels if yieldsare low and prices increase during theseason. Replacement coverage comple-ments forward contracting or hedging bypartially ensuring that the farmer can buyback futures contracts or deliver on cashcontracts when yields are low and har-vest-time prices are high. Producers arestill subject to basis risk, and only partialcoverage (up to 85 percent in designatedcounties) can be obtained.

In general, the revenue guarantee of rev-enue insurance with RCP equals the prod-uct of the producer’s APH yield, the cov-erage level selected, and the higher of theearly-season Projected Price or the har-vest-time futures price. Indemnity pay-ments are triggered when the harvest-timerevenue, based on the harvest-time futuresprice, falls below the revenue guarantee.Thus, revenue insurance with RCP alsoprovides only partial protection againstyield and price risk, and is less effectivewhen the natural hedge is strong, becausehigh prices offset low yields and revenueis more likely to stay at least somewhatabove the guarantee.

The premium for revenue insurance withreplacement coverage is more expensivethan for revenue insurance without RCP,partly because the replacement cost pro-tection provides greater price protection.Also, premium differentials increase whenproducers are permitted to subdivide theiracreage into “units,” such as by sectionand irrigated/nonirrigated status (as underCRC), rather than basing the premium ona producer’s total acreage in a county (asunder Income Protection).

Under 75-percent coverage, the standardrevenue insurance guarantee for a cornproducer with an APH yield of 150bushels and a projected harvest-time priceof $2.50 is $281.25 per acre. A revenueinsurance policy with RCP (under 75-per-cent coverage) has $281.25 as an initialminimum revenue guarantee, but thisguarantee may increase if market pricesrise during the growing season. If a lowor normal yield and low harvest-timeprice cause the market value of the cropto fall below the revenue guarantee, rev-

enue insurance policies with or withoutRCP will pay the same indemnity.However, if the low yield is accompaniedby a high harvest-time price, revenueinsurance with RCP will pay an indemni-ty, while policies without RCP will pay alower or no indemnity.

What Is Forward Pricing?Forward pricing involves setting the price,or a limit on price, for a product to bedelivered in the future. Forward pricingstrategies include contracts such as cashforward, futures, options, delayed pricing,basis, minimum price, and maximumprice (for feed purchases). Three generaltypes of forward pricing strategies—acash forward sale, a futures hedge, and aput option hedge—are described here forcomparison with the risk-reducing powerof crop and revenue insurance programs.

A cash forward sale is a contract betweena seller (e.g., a farmer) and a buyer (e.g.,an elevator) requiring the seller to delivera specified quantity of a commodity to thebuyer at some time in the future for aspecified price or in accordance with aspecified pricing formula. Most cropgrowers sell forward at a fixed or “flat”price based on an observed futures pricequote. Some farmers use basis contractsthat specify a “set” price difference rela-tive to the futures price to be applied atdelivery time. Some use “hedge-to-arrive”contracts that fix the futures price compo-nent and leave basis to be determined atdelivery time. Cash forward contractseliminate both price-level and basis riskby locking in a local cash market price forthe quantity under contract, but any pro-duction in excess of the hedged amount isstill subject to routine market price risk.

Example of a cash forward sale:Suppose that a corn producer has planted100 acres of corn with an APH yield of150 bushels per acre. At planting time, theprojected harvest-time price is $2.50 perbushel, the local cash price is $2.38, andthe basis is $0.12. The producer agrees toforward contract the farm’s entire expect-ed corn production of 15,000 bushels at aprice of $2.38, for an expected revenue of$35,700. If the price at harvest-time is$1.80, the operator still gets $35,700 forthe crop, $8,700 above the cash market.However, if the producer harvests only 85

Risk Management


bushels per acre, even though the futuresprice rises to $3.50 (local cash price $3.38with constant basis), the net revenueunder this contract will fall to $13,730($35,700 less $21,970) because the opera-tor has to purchase the shortfall (6,500bushels @$3.38) in the cash market. Thisoutcome illustrates the income risk asso-ciated with yield risk when an operatorforward contracts 100 percent of theexpected production at planting timebased on the projected harvest-time price.

Hedging is designed to reduce price-levelrisk prior to an anticipated cash sale orpurchase. A futures hedge involves thesale (short hedge) or purchase (longhedge) of futures contracts—standard-ized contracts traded on a commodityexchange—as a temporary substitute foran intended sale or purchase on the cashmarket. The futures contract is laterbought (sold) to eliminate the futuresposition as the actual commodity is sold(bought). Crop growers are generallyshort hedgers against crops they intend tosell later in the season.

For example, every corn futures contracttraded on the Chicago Board of Trade(CBOT) calls for delivery of 5,000bushels of No. 2 yellow corn during oneof five designated delivery months eachyear. Hedging requires relatively littleinvestment, because only a small portionof the futures contract’s face value isrequired as a margin good-faith deposit toguarantee performance of the contract.Hedging also provides flexibility, sincethe hedger can eliminate a position in thefutures market by simply contracting foran equal number of offsetting contracts.Still, the primary advantage of a futureshedge is the elimination of the price-levelrisk of an existing cash position by lock-ing in a price.

A producer can hedge by selling futurescontracts—short hedge—covering part orall of anticipated output. For example, acorn grower could sell 10,000 bushels ofDecember corn futures in May to hedgean expected 20,000-bushel corn crop.Such a hedge normally is lifted by buyingan equal number of futures contracts asthe cash commodity is sold. Since near-parallel movements in cash and futuresprices during the period of the hedge tendto offset each other, any losses (gains) in

the cash market are made up by gains(losses) in the futures market.

Any contract, cash or futures, that tendsto fix the price prevents the seller fromgaining from subsequent price increasesas well as losing from subsequent pricedeclines. Moreover, forward pricing con-tracts contain an element of nonperfor-mance or production risk—if the quantityactually produced turns out to be less thanthe contracted quantity and the price atdelivery lies above the contracted price,the producer must make up the shortfall ata loss. Thus, risk is minimized by forwardpricing only part of a crop until yield isassured.

Finally, hedging replaces price risk withbasis risk—uncertainty about the pricedifference between the futures contractand the cash market—and if the basis iswider than was expected when the futuresposition was entered, the producer’s pre-liminary price guarantee is reduced by thechange in the basis. Basis risk is absentfor hedgers who can make deliveryagainst their futures contracts, but the costof making delivery exceeds the loss onthe basis in most cases.

The holder of a futures contract alsoincurs the risk of additional payments(margin calls) necessary to maintain thatcontract position when the quoted pricefor the futures contract changes againstthe short position. Unexpected additionalpayments could result in a strain on thefarm’s cash flow and/or credit reserves,particularly if eventual losses in thefutures market cannot be offset by actualcash sales into the higher price cash mar-ket due to a production shortfall.

Hedging in futures offers farmers many ofthe benefits of forward contracting, butrequires establishing an account with acertified broker, placing orders with thebroker, and being prepared to meet mar-gin calls during periods of adverse pricemovements. Consequently, most farmersprefer to access futures markets indirectlyby forward contracting with their localelevator.

Example of direct use of the futuresmarket (transferring price-level risk butnot basis risk or yield risk):

Suppose a corn producer planted 100acres of corn with an expected yield of150 bushels per acre. At planting time, aDecember corn futures contract is tradingat $2.50 per bushel, the local cash price is$2.38, and the basis is $0.12. The produc-er sells two December corn futures con-tracts on the CBOT (equivalent to 10,000bushels of corn) at a price of $2.50 perbushel.

At harvest-time, if actual yield equalsexpected yield and the basis remains con-stant but prices fall, say futures to$2/bushel and local price to $1.88/bushel,the operator’s total revenue, ignoringtransaction costs, would still be $33,200—$5,000 profit from futures trading (sell10,000 @ $2.50 and buy 10,000 @ $2)plus $28,200 (15,000 @ $1.88) from saleto the local elevator. If the basis widensbecause the local price falls faster thanthe futures price, the gains from hedgingwould remain the same, but total revenuewould be lower. However, if yield falls,say to 85 bushels/acre, even if harvest-time prices rise, say futures to $3.50 andlocal to $3.38 so the basis is constant, the$10,000 loss from hedging (sell 10,000 @$2.50 and buy 10,000 @$3.50) wouldmore than offset the return from the high-er local price (8,500 @ $3.38 = $28,730),bringing net revenue down to $18,730,again ignoring transaction costs.

A put option is the right, but not the obli-gation, to sell a specified number offutures contracts at a designated price(called the strike price), at any time untilexpiration of the option. Hedging with aput option is very similar to buying priceinsurance in that the buyer/farmer pays apremium to the seller/grantor of thisoption to protect against a fall in price.The put option eliminates downside price-level risk by giving the buyer the right toenter into a short position in the futuresmarket at the strike price if the option isexercised, even if futures prices fall belowthe strike price. The farmer who hedgesby buying a put option knows the premi-um in advance and is not subject to mar-gin calls as is the futures hedger. And theput option holder stands to gain if thefutures price rises by more than the costof the premium—if prices rise, the farmercan simply choose not to exercise the putoption and instead sell in the higherpriced cash market.

Risk Management


As with a futures hedge, a put optionhedge is subject to both production riskand basis risk, since ultimately, any futuresposition entered into upon the exercise of aput option will likely be liquidated and thegrain sold into cash markets. But unlike afutures contract hedge, the premium is for-feited upon payment even if the put optionis never exercised.

Example of a put option:Consider again the example of the cornproducer with 100 acres planted to cornand an expected yield of 150 bushels peracre. At planting time a December cornfutures contract is trading at $2.50 perbushel, the local cash price is $2.38, andthe basis is the difference or $0.12. Theproducer buys two put options based onthe CBOT December corn futures contract(equivalent to 10,000 bushels of corn)with a strike price of $2.50 per bushel anda premium of $0.16 per bushel or $1,600.

At harvest-time the December corn con-tract price is down to $2 per bushel, andthe local price is $1.88 (basis is constant).If the harvested yield is the 150 bushelsper acre expected yield and the producerwants to finalize marketing decisions onNovember 1, by exercising the put optionat $2.50 and immediately offsetting theshort position in the futures market bybuying two December corn contracts at$2, the producer realizes a gain of$0.50/bushel, or $5,000. Selling the har-vested corn locally for $1.88/bushel, totalrevenue (ignoring broker’s fees and trans-action costs) is $31,600 (15,000 bushels@ $1.88 plus $5,000 minus the $1,600premium).

Optimal Hedge Ratio Varies Across Pricing StrategiesTo price forward, a farmer must choosenot only the type of contract—cash,futures, or options—but also the share of the expected crop to hedge. For thefarmer, the optimal proportion (in a risk-reducing sense) of the expected cropthat should be forward priced—called theoptimal hedge ratio—depends on theextent of basis and production risk facedby the producer.

While forward pricing in either the cash,futures, or options markets eliminatesprice-level risk, it fails to eliminate

0

2

4

6

8

10

12

Forward pricing,no insurance

Pricing strategy+ yield insurance

Pricing strategy+ revenue insurance

with RCP

$/acre in risk reduction value*

Cash sale at harvest Futures hedge Cash forward contract

Pricing strategy:


0

2

4

6

8

10

12




with RCP

Typical wheat farmLogan County, KS

Typical soybean farmLa Salle County, IL

High yield variability

Low yield variability


With Prices Moving Strongly Opposite Yield . . .

Insurance Provides More Risk Reduction Than Forward Pricing When Yield Variability Is High

* Risk reduction value is the certainty equivalent gain--estimated value to the operator of reducingrisk by adding one or more risk management strategies.

Price-yield correlation indicates strength of the offsetting relationship between price and yieldmovements--the more negative (opposite), the better the natural hedge works to stabilize revenue.

Forward Pricing Outperforms Insurance When Yield Variability Is Low

RCP = Replacement coverage protection.

production risk, and cash forward con-tracting alone eliminates basis risk. Basisrisk generally is small relative to price-level risk, but can be important, particu-larly at locations distant from the futuresdelivery points.

The production risk associated with a for-ward pricing contract depends on a farm’syield variability. As yield variabilityincreases, optimal hedge ratios decreaseand the risk-reducing effectiveness of ahedge declines. In the presence of highyield variability, the probability of havinginsufficient crop to deliver on a forwardcontract is high and the associated risklowers the effectiveness of forward con-tracting.

Yield variability can be only partially off-set by crop or revenue insurance, sincecoverage levels are generally limited to75 percent, so the optimal hedge ratio willvary with both the availability and type ofinsurance coverage. Further, since yieldprotection permits a higher optimal hedgeratio, and because crop and revenue insur-ance do not fully eliminate productionrisk, combinations of forward pricing andinsurance generally result in lower riskthan either alone.

Combination of Strategies Depends on Risk EnvironmentERS used historical data to construct rep-resentative corn, soybean, and wheatenterprises for a variety of risk environ-ments—i.e., across ranges of yield vari-ability and price-yield correlations—toanalyze the risk reducing effectiveness ofdifferent crop and revenue insurance pro-grams and forward pricing strategies indifferent risk environments. The level ofrisk aversion and wealth for a given enter-prise is held constant across risk manage-ment strategies, and all enterprises areassumed to minimize risk per acre of thecrop produced.

The estimated certainty equivalentincome—the income an individual is will-ing to receive with certainty in lieu ofundertaking a risky prospect—associatedwith a straight cash sale at harvest (noinsurance, no forward contracting) is thebaseline scenario against which all otherrisk management strategies are evaluated.Certainty equivalent gains/losses—the

Risk Management



0

2

4

6

8

10

12




with RCP


Typical corn farmPitt County, NC

Cash sale at harvest Futures hedge Cash forward contract

Pricing strategy:


0

2

4

6

8

10

12




with RCP

Typical irrigated corn farmLincoln County, NE

High yield variability

Low yield variability

Insurance Surpasses Forward Pricing in Reducing Risk When Yield Variability Is High

With Weak Price-Yield Correlation . . .

* Risk reduction value is the certainty equivalent gain--estimated value to the operator of reducingrisk by adding one or more risk management strategies.

Price-yield correlation indicates strength of the offsetting relationship between price and yieldmovements--the more negative, the better the natural hedge works to stabilize revenue.

Forward Pricing Is the More Effective Strategy When Yield Variability is Low

RCP = Replacement coverage protection.

estimated value of gains/losses in riskreduction—are then calculated to reflectthe differences in revenue risk reductionand costs (e.g., premiums) over the differ-ent strategies.

Federal subsidies are not included, inorder to compare the pure risk reductioneffectiveness of crop and revenue insur-ance programs and forward pricing strate-gies, independent of government influ-ence. The incorporation of Federal insur-ance premium subsidies per acre wouldbe a direct addition to certainty equivalentincome for the relevant risk strategies.Using this framework, some general rela-tionships emerge between revenue vari-ability and risk management.

For a farm with high yield variability anda weak natural hedge, crop yield or rev-enue insurance alone provides substantialrevenue risk reduction. Forward pricingcombined with insurance—crop yield orrevenue insurance—further reduces risk,although the gains are small relative tothe risk-reduction gains of insurancealone. Forward pricing alone—withoutcrop yield or revenue insurance—pro-vides relatively little risk reduction,because price variability contributes lessto revenue variability than does yieldvariability in this example. Without cropyield or revenue insurance, the revenuerisk stemming from yield variabilitygreatly reduces the effectiveness of for-ward pricing. How-ever, as the naturalhedge strengthens, the risk reduction pro-vided by insurance weakens, even whenyields remain highly variable, and for-ward pricing remains fairly ineffective asa risk transfer tool.

When yields are relatively less variable,crop yield insurance alone affords somerisk reduction, but provides much greaterrisk reduction when combined with

forward pricing, particularly forward cashcontracting. Since price variability pre-dominates when yield variability is low,cash forward contracting, which elimi-nates both price-level and basis risk, is avery attractive option to a producer whoseprimary concern is minimizing risk.

With low yield variability and a strongnatural hedge, forward pricing strategiesare more effective than either crop or rev-enue insurance. Under a strong naturalhedge, low yields are generally associatedwith high prices, thus moderating overallrevenue variability, even without insur-ance or forward pricing. Still, crop or rev-enue insurance, when combined with for-ward pricing, can provide additional mar-ginal risk reduction.

When low yield variability coexists with aweak natural hedge, forward pricing aloneeasily outperforms crop yield and revenueinsurance in reducing risk, because pricevariability plays the dominant role indetermining revenue variability, andbecause of the weaker relationshipbetween the on-farm yield and the aggre-gate market price. Still, additional margin-al gains in risk reduction can be obtainedby combining crop or revenue insurancewith forward pricing.

In summary, ERS findings indicate that:

• Price variability faced by growers ofa given crop is approximately thesame across the country, and basisrisks are relatively small, so differ-ences in revenue variability betweenfarms are caused primarily by differ-ences in yield variability and price-yield correlation.

• Yield variability is generally propor-tionally higher than price variability atthe farm level. As yield variabilityincreases, optimal hedge ratios

decrease and the risk-reducing effec-tiveness of hedging declines. Partiallyoffsetting yield variability with crop orrevenue insurance raises the optimalhedge ratio.

• Price-yield correlations are generallynegative in major growing areas, par-ticularly for corn. Since a farmer’s rev-enue risk diminishes as price-yieldcorrelation becomes more negative,crop or revenue insurance purchasedwith low coverage levels may besuperfluous in the face of a strong nat-ural hedge. Also, optimal hedge ratiosdecrease as farm price-yield correla-tion becomes more negative.

• Price correlation between farms is gen-erally higher than yield correlation.

• The risk-reducing effectiveness ofhedging increases as correlationbetween farm and futures priceincreases. In other words, the moreclosely the futures market price mir-rors the farm price, the better it worksfor hedging risk.

• Combining forward pricing with insur-ance generally results in lower riskthan either alone. With high yield vari-ability, the difference among the for-ward pricing strategies is slight, butwith low yield variability—whereprice variability contributes a largershare to revenue variability—the dif-ference may be significant. When usedin combination with a given type ofinsurance, cash forward contractingprovides the greatest risk reduction fora risk-minimizing producer.

Randy Schnepf (202) 694-5293, RichardHeifner (202) 694-5297, and RobertDismukes (202) [email protected]@[email protected]

AO

Risk Management


The Agricultural Outlook risk management series continues in 2000

Next installment: How additional crop insurance subsidies affect insurance purchases

As policymakers consider strength-ening the farm safety net, cropinsurance is once again in the

spotlight. Among the questions beingasked: How well does the current arrayof crop insurance products and coveragelevels match the risk management needsof producers? How much does insurancehelp producers in extended periods of lowprices or with multiple-year crop losses?How can the government work effectivelywith the private sector to develop anddeliver insurance?

Although overall participation hasdeclined from its peak in 1995 and ques-tions remain about the adequacy of cover-age, crop insurance, which includes yield-based as well as revenue insurance prod-ucts, is used by many growers. In 1998,growers paid about $900 million in cropinsurance premiums for about $28 billionin guarantees on about 180 million acresof crops. About two-thirds of plantedacreage of corn, soybeans, and wheat wascovered by crop insurance.

Crop insurance provides protection from abroad range of perils that can lead to yieldor revenue shortfalls. The type of protec-tion depends on the type of insurance. Forinstance, multiple-peril crop insurance(MPCI) protects against yield shortfalls

that are due to drought, flooding, frost,plant disease, insect infestation, and othernatural hazards beyond a grower’s con-trol. Revenue insurance provides a degreeof price protection—not just yield protec-tion as under MPCI—covering sharpdrops in expected revenue, which mayresult from yield or price declines or acombination of the two.

Although growers obtain insurancethrough private companies and theiragents, the Federal government plays aprominent role in the provision of cropinsurance. During 1995-98, USDA’s RiskManagement Agency (RMA), whichadministers programs of the Federal CropInsurance Corporation (FCIC), has spentabout $1.2 billion per year, on average,for premium subsidies, administrative andoperating subsidies, and net underwritinglosses. RMA promotes crop insuranceparticipation through educational andother outreach activities and—along withthe insurance companies—develops newproducts. FCIC and RMA also oversee theprovision of crop insurance, setting andapproving premium rates and policy pro-visions, ensuring that companies cancover potential underwriting losses, andapproving privately developed insuranceproducts for subsidies and underwritingprotection.

Crop Insurance: A WideningArray of CoverageSince the early 1990’s, the variety ofinsurance products, guarantee levels, andcrops included in the Federal crop insur-ance program has grown substantially.Insurance product choices have expandedfrom a single offering—individual-farmyield insurance called Actual ProductionHistory-Multiple Peril Crop Insurance(APH-MPCI)—to include area-yieldinsurance and a variety of crop revenueinsurance products. The range of guaran-tee levels has been enhanced by pilot pro-grams to increase maximum guaranteesavailable in some areas of the country andby the provision, at low cost to producers,of a minimum level of insurance coveragecalled CAT (short for catastrophic). Thelist of crops for which insurance is avail-able has grown from about 50 in the early1990’s to more than 70 currently, includ-ing several types of fruit and nut trees,grapes, nursery stock, and rangeland.

In addition to the growing array of cover-age options available under the Federalprograms, private insurance companies,agents, and brokers have developed avariety of supplemental insurance prod-ucts and have bundled crop insurancewith other risk management products.Examples of supplemental products, forwhich producers pay additional premi-ums, include those that increase the priceat which insurance indemnities would bepaid. Purely private insurance against hailand fire damage continues to be widelyavailable. In 1998, producers in 46 statespaid about $550 million in crop-hail pre-mium. About 60 percent of the crop-hailcoverage was for corn and soybeans.

While traditional APH-MPCI stillaccounts for the bulk of the Federal cropinsurance business, new types of insur-ance, particularly revenue insurance, haveattracted considerable interest. Revenueinsurance products—Income Protectionand Crop Revenue Coverage—firstbecame available for a few crops inselected areas in the 1996 crop year. Revenue Assurance was added in the 1997crop year and Group Risk Income Protection and Adjusted Gross Revenuewere added for the 1999 crop year. Sincethe introduction of revenue insurance,more crops and more areas have been


Risk Management

Recent Developments in Crop Yield & Revenue Insurance

Risk

Ma

na

ge

me

nt

Ag

en

cy

added, and revenue insurance has come tocover a substantial portion of insuredacreage in some areas. Not all insuranceproducts, however, are available in allareas.

Revenue insurance has been especiallypopular for corn and soybeans, crops thatwere the initial focus of the privatelydeveloped Revenue Assurance and CropRevenue Coverage. In 1998, revenueinsurance products accounted for aboutone-third of the corn and soybean acreage

insured above the CAT level. Revenueinsurance covered more than 50 percentof corn acreage insured above the CATlevel in Iowa and 45 percent in Nebraska,and reached nearly 50 percent of theabove-CAT insured acreage for soybeansin these two states. Although wheataccounts for a smaller portion of the over-all crop revenue insurance business thancorn or soybeans, revenue insurance poli-cies cover a considerable share of wheatacreage in several states. In Kansas,Michigan, Nebraska, and Texas, more

than one-quarter of wheat acreage insuredabove the CAT level was covered by rev-enue insurance in 1998.

Revenue insurance choices continue toexpand, with two new products beingintroduced in 1999. Group Risk IncomeProtection (GRIP) adds a revenue compo-nent to the Group Risk Plan (GRP) area-yield insurance. Coverage is based oncounty-level revenue, calculated as theproduct of the county yield and the har-vest-time futures market price. GRIP isavailable for corn and soybeans under apilot program in selected counties in Iowa,Illinois, and Indiana where GRP is offered.

Adjusted Gross Revenue (AGR), the sec-ond new revenue insurance product,offers coverage on a whole-farm ratherthan on a crop-by-crop basis. AGR basesinsurance coverage on income from agri-cultural commodities reported onSchedule F of the grower’s Federalincome tax return. AGR targets producersof crops—particularly specialty crops—for which individual crop insurance pro-grams are not presently available.Producers who obtain AGR must obtaincrop-by-crop coverage to insure crops forwhich such individual plans are available.In these cases the AGR whole-farm liabil-ity and premium are adjusted. AGR isbeing offered as a pilot program in select-ed counties in Florida, Maine, Massa-chusetts, Michigan and New Hampshire.

In addition to the growth in variety ofinsurance plans, the range of insuranceguarantees, which are calculated as theproduct of expected yield or revenue andpercentage coverage level, has beenexpanded. Crop insurance coverage lev-els—percentages of expected yield—gen-erally range from 50 percent for CAT to amaximum of 75 percent, increasing at 5-percent intervals. Under 75-percent cover-age, for example, the grower wouldabsorb up to a 25-percent loss in expectedyield or revenue, while the insurer wouldpay for losses above 25 percent.

At the high end, FCIC/RMA has in-creased the maximum coverage levelavailable for some crops in some areas,giving growers the option of purchasinginsurance at higher coverage levels, athigher premium costs. At the low end, the

Risk Management


In Many Counties, Revenue Insurance Accounts for More Than A Quarter of the Area Insured at Buy-Up Level

Total includes all yield and revenue insurance above the basic or catastrophiclevel. Shaded areas are counties with at least 1,000 acres of the crop covered by buy-up insurance in 1998 (revenue and yield).Source: Estimated by ERS from USDA Risk Management Agency data.


PercentUp to 2525.01-5050.01-75Over 75

Soybeans

Corn

Acres under revenue insurance asshare of total buy-up insurance

provision of low-cost CAT coverage hasalready increased insurance participation.

Under pilot programs in 1999, FCIC/RMAincreased the maximum coverage levelavailable for selected crops in selectedareas from 75 percent to 85 percent. Onepilot targeted areas where many growershave historically insured at the maximumlevel and where losses have been infre-quent; another focused on areas whererecent low yields may have reduced theyield or revenue history on which guaran-tees are calculated. The maximum cover-age level for individual yield and revenuecoverage was raised to 85 percent in pilotprograms for corn and soybean growers in66 counties in Illinois, Indiana, and Iowaand for wheat growers in 20 counties inIdaho, Oregon, and Washington. In addi-tion, the maximum coverage was in-creased to 85 percent for spring wheat and barley in Minnesota, North Dakota,and South Dakota. Higher coverage levelsare more costly; the premium rate for 85percent coverage is generally about 60percent higher than the premium rate for75 percent coverage, and the additionalpremium is unsubsidized.

While maximum coverage level has beena concern of some growers, others havefocused on the effectiveness of the CATcoverage level. CAT is a low coveragelevel—50 percent of expected yieldindemnified at 55 percent of expectedprice—for which producers pay a flat feeof $60 per crop. Despite the low cost ofCAT to producers, many have questionedwhether it provides valuable insurancecoverage. The yield trigger, 50 percent ofexpected yield, has been criticized as toolow to provide a benefit except in rarecases, and the maximum possible indem-nity, less than 30 percent of the expectedvalue of a crop, has been criticized asinadequate. However, CAT was neverintended to provide substantive coverage,just benefits roughly the same as thoseunder previous ad hoc disaster programs.

CAT is a basic coverage level that wasintroduced under the Federal CropInsurance Reform Act of 1994. The cropinsurance reform, which required partici-pants in farm programs to obtain cropinsurance in 1995 and which raised pre-mium subsidies for coverages above CAT,was designed to increase crop insurance

participation and reduce the need for adhoc disaster assistance. In 1995, the firstyear of reform, total insured acreage dou-bled to about 80 percent of eligible acres

(due largely to linkage with farm programbenefits), and CAT accounted for the bulkof the expansion.

Risk Management


A Brief Legislative History of Crop Insurance1980—Federal Crop Insurance Act

* Crop insurance intended to replace disaster payments as primary form of cropyield risk protection

* Insurable crops and areas greatly expanded* Premium subsidy instituted, at up to 30 percent of total premium* Private insurance companies and agents may sell and service crop insurance

1988-94—ad hoc disaster assistance

* Enacted each year partly in response to low insurance participation* Disaster assistance recipients were required to obtain crop insurance in the

subsequent year

1990—Food, Agriculture, Conservation, and Trade Act (1990 Farm Act)

* Premium rate increases mandated to reduce excess losses* Target loss ratio established for all crop insurance* Actions to control fraud are mandated * Private insurance companies to bear increased share of underwriting risk* FCIC authorized to reinsure and subsidize privately developed products

1994—Crop Insurance Reform Act

* Restrictive legislative procedures instituted for enacting disaster assistance* Participants in farm programs must obtain crop insurance* Catastrophic coverage level (CAT) introduced* Premium subsidies for coverage levels above CAT are increased* Non-insured Assistance Program (NAP) created for crops not covered

by insurance

1996—Federal Agriculture Improvement and Reform Act (1996 Farm Act)

* Requirement that participants in farm programs obtain crop insurance is ended* Pilot revenue insurance program is mandated

1998—Emergency assistance, included in 1999 Agricultural Appropriations Act

* Crop-loss disaster assistance payments to producers authorized for single-year(1998) or multiple-year (3 or more years between 1994 and 1998) crop losses;payments slightly higher for those who had obtained crop insurance

* Additional premium subsidies authorized for buy-up coverage in 1999, limited tototal of $400 million

* Recipients of emergency assistance who did not have 1998 crop insurance mustobtain crop insurance, where available, for 1999 and 2000 crop years

1999--Emergency assistance, included in the 2000 Agricultural Appropriations Act* Crop-loss disaster assistance similar to single year crop loss disaster assistance

program of 1998* Additional premium subsidies authorized for buy-up coverage for 2000, limited to

$400 million total

Since implementation of the 1996 FarmAct, which significantly changed farmprograms and eliminated the crop insur-ance requirement, CAT participation hasdropped dramatically. While overallinsured acres have declined about 15 per-cent (average net acres insured for 1997and 1998, compared with 1995 and 1996),acres insured above the CAT level haveincreased by about 7 percent, and CATacres have dropped about 40 percent.

The Value of Crop InsuranceThe current array of crop insurance prod-ucts is designed to protect against short-falls in yields or revenues that occur dur-ing a single growing season. Insuranceguarantees are set at planting, based onexpectations about the eventual levels ofyields or revenues. By reducing or elimi-nating the chances of sharply lowerincome as a result of losses from a par-ticular commodity, crop insurance can bea valuable risk management tool. Therisk protection that it provides can, forexample, facilitate access to operatingloans by offering some financial securityto a lender.

For insurance purposes, expected yieldsare based on yield histories, and the annu-al expected yield for a crop is usually cal-culated as the average yield over the pre-vious 4-10 years, depending on data avail-ability. While in most cases these actualproduction histories provide reliable indi-cations of the likely yield under normalconditions, they can produce distortedpictures.

If yields for a farm over a 4- to 10-yearperiod differ significantly from yieldsbased on a longer history, premiums willnot be consistent with long-term expectedlosses. If yields are too high due to a fewgood years, the premium will be lowerthan needed over the long term and viceversa. By the same token, if recent histor-ical yields differ from current expecta-tions of the grower, he or she may con-sider the guarantees too high or too low.

Under crop insurance rules, expectedyield, and hence insurance guarantee, canfall if a producer’s yield declines overtime. This potential for declining guaran-tees has led to questions about the effectsof repeated crop losses. In the Northern

Plains, for instance, several years of poorweather and plant diseases have hamperedcrop production for some but not all pro-ducers, reducing the historic yield andleading to complaints that insurance basedon actual production history no longeroffers effective yield guarantees.

FCIC/RMA authorized a pilot program inearly 1999 that may help some growersovercome the declining guarantee prob-lem. In exchange for a higher premium,growers can choose to use 90 or 100 per-cent of a transitional or T-yield instead ofthe recent actual yields on the farm as thebasis for the insurance guarantee. (T-yields are based on Farm Service Agencyprogram or county-level yields and otherdata and are usually used in the Federalcrop insurance program to set insuranceguarantees when a producer is unable toprovide records of farm-level actual pro-duction history.) This “Yield FloorOption” is available in 1999 for barleyand spring wheat in Minnesota and Northand South Dakota.

In addition, provisions for multiple-yearcrop loss payments are included in theCrop Loss Disaster Assistance Program,implemented under the 1999 AgriculturalAppropriations Act. Under the disasterprogram, producers could apply for pay-ments from USDA in addition to cropinsurance indemnities they may havereceived. The program allowed producersto file for payments based on either a sin-gle loss in 1998 or on multiple crop lossesbetween 1994 and 1998. Although pro-ducers who did not have crop insurancecould also receive benefits, those withcrop insurance received greater payments.And all producers receiving benefits whodid not have crop insurance in 1998 wererequired to obtain crop insurance, whereavailable, in 1999 and 2000.

Crop insurance, particularly revenueinsurance, provides protection from sharpdrops in prices over each growing season.The products provide little protectionagainst declines in prices that occurbetween growing seasons and over severalseasons. Prices, or formulas for establish-ing prices, are determined when insuranceguarantees are set at planting. In the caseof MPCI yield coverage, RMA estimatesan expected price. Revenue coverage usesprices of futures contracts with delivery

Risk Management


1992 94 96 98-0.5

0

0.5

1.0

1.5

2.0

Premium subsidy

Administrative expense reimbursements

Other administrative costs

Net underwriting costs*

Government Costs of Federal Crop Insurance Increased Following 1994 Reform

$ billion

Cropinsurancereform

Crop year

*Appears as a negative value if premiums received exceed indemnities paid (i.e., a gainrather than an expense). Other administrative costs include Risk Management Agencysalaries and operating expenses.Source: Risk Management Agency, USDA.


dates near harvest time. Both of these procedures keep the value of insuranceconsistent with the expected value of the crop in that year.

Multiple-year insurance contracts mayoffer a means of moderating the drops ininsurance coverage that can follow fromseveral losses or from declines in prices.But guarantees fixed for several years at atime would have the potential to distortproduction if they exceed the marketvalue of the crops and undermine theactuarial integrity of the insurance pro-gram. Multiple-year contracts could alsobe much more costly than annual cropinsurance contracts.

The Government-Private Crop Insurance PartnershipExpansion in the Federal crop insuranceprogram since the early 1990’s has beenaccompanied by expansion in the role ofprivate insurance companies. The compa-nies have developed new products,notably Revenue Assurance, CropRevenue Coverage, and Group RiskIncome Protection, and have borne anincreasing amount of underwriting risk.Still, the Federal government providessubstantial support and direction to theprogram. In products approved by theFCIC board of directors, it provides pre-mium subsidies to producers in order toencourage participation, expense reim-bursements to the companies to covercosts of selling and servicing policies,and underwriting risk protection to thecompanies.

Government involvement in providingcrop insurance is explained in part by sev-eral “market failure” arguments. One suchargument is that natural disasters associat-ed with crop production tend to affectmany producers in an area at the sametime, so pooling risk on a sufficient scaleis difficult for most private insurers.Another argument suggests that purelyprivate markets for crop insurance wouldfail because other producer responses torisk—diversification, borrowing, drawingon savings—reduce the value of the addi-tional protection provided by insurance,making insurance unattractive whenoffered at competitive market prices.

Risk Management


How Federal Crop Insurance Is Delivered USDA’s Risk Management Agency (RMA) is charged with the administration ofcrop insurance programs for the Federal Crop Insurance Corporation (FCIC).FCIC/RMA regulates and promotes insurance program coverage, sets standardterms—including premium rates—of insurance contracts, ensures contract compli-ance, and provides premium and operating subsidies. Crop insurance policies aredelivered—sold, serviced, and underwritten—by private insurance companies.Insurance companies also develop new insurance products that are approved forsubsidies and reinsurance by FCIC and offer private coverages (without FCIC sup-port) that supplement Federal crop insurance.

About 18 insurance companies delivered crop insurance in 1999. The companies’insurance portfolios vary in size and scope. The four companies with the largestamounts of crop insurance account for about two-thirds of the volume of total pre-mium, and each delivers insurance in about 40 states. While these companies havelarge and widely spread portfolios, other companies deliver smaller amounts of cropinsurance over smaller areas. Most of the companies with small crop insurance port-folios deliver in five or fewer states, and tend to operate in low-risk states.

Companies compete for crop insurance business through insurance agents who selland service the policies. Most of the nation’s 18,000 crop insurance agents are inde-pendent agents who may sell insurance for more than one company. Others are captive agents, selling for only one company. An agent is usually paid a sales com-mission by a company proportional to the premium of the policy sold. Lossadjusters for claims are employees or contractors of the insurance companies.

Insurance underwriting gains or losses arise as total premiums (producer premiumsand premium subsidies) are used to offset indemnities paid. In the crop insuranceprogram, private companies share the underwriting risk with FCIC by designatingtheir crop insurance policies to risk-sharing categories, called reinsurance funds.Because each of the funds allows different levels of risk sharing—potential under-writing losses when indemnities exceed premiums and gains when premiumsexceed indemnities, the proportion of losses paid or gains earned varies by govern-ment fund.

Companies that qualify to deliver crop insurance must annually submit plans ofoperation for approval by FCIC/RMA. A plan of operation provides information onthe ability of the company to pay potential underwriting losses and on the allocationof the company’s crop insurance business to the various risk sharing categories orreinsurance funds.

Based on the policies designated to each reinsurance fund, companies retain or cedeto FCIC portions of premiums and associated liability (potential indemnities). FCICassumes all the underwriting risk on the company-ceded business and variousshares of the underwriting risk on the retained business, determined by the particu-lar category and level of losses. Companies can further reduce their underwritingrisk on retained business through private reinsurance markets.

In addition to underwriting returns, the companies are paid a subsidy by FCIC foradministrative, operating, and loss adjustment costs. The rates of administrative andoperating subsidy vary by the type of crop insurance and level of coverage and areapplied to the total premium of each type of insurance sold. The levels of adminis-trative and operating subsidy and the terms of the underwriting risk-sharing arespecified in the Standard Reinsurance Agreement (SRA), which applies to all com-panies delivering FCIC-reinsured policies. The 1998 SRA specifies the subsidy forAPH-MPCI at the CAT level at 11 percent (for loss adjustment). For buy-up APH-MPCI and similar coverages, the administrative and operating subsidy is 24.5 per-cent of total premium; 22.7 percent for GRP; and 21.1 percent for most crop rev-enue products.

In order to encourage participation in cropinsurance, RMA provides subsidies toreduce producer premiums. The amountof the subsidy depends on the type ofinsurance and the coverage level. ForCAT coverage, the premium is entirelysubsidized, and the producer pays only aprocessing fee. For what has been themost popular “buy-up” (above CAT) coverage level—65 percent of yield at100 percent of price—the subsidy hasbeen about 42 percent of the total premi-um. As a further incentive to purchasecrop insurance, the Secretary of Agri-culture authorized up to an additional$400 million in premium subsidies for1999 buy-up coverage. The additionalfunds, part of the emergency assistancepackage passed by Congress in 1998,reduced producer-paid premiums by about30 percent. In addition, the 2000 agricul-tural appropriations included $400 millionin premium subsidies for buy-up coveragein 2000, which is estimated to reduce pre-miums by 25 percent.

Under most private insurance, the premi-ums include administrative costs as wellas the costs of expected indemnities.Under the crop insurance program, totalpremiums—producer-paid plus govern-ment subsidies—are designed to coveronly expected indemnities. For this rea-son, FCIC/RMA separately providesadministrative subsidies to insurancecompanies to cover the costs of sellingand underwriting policies, adjusting loss-es, and processing policy data. Becauseadministrative costs vary by type of insur-ance, the subsidy amount is designed tomatch reimbursement to differing work-loads.

The administrative subsidy, like the pro-ducer premium subsidy, is generally high-est (in dollar amount) for individual farmAPH-MPCI buy-up coverage and lowestfor GRP area-yield insurance. The APH-MPCI subsidy is high because of the costsof establishing individual farm yield his-tories and guarantees and adjusting losseson an individual basis. The GRP subsidyis low because it requires no fieldwork toadjust losses.

The underwriting exposure—potentialgains or losses—of private crop insurancecompanies has grown considerably.Underwriting gains or losses arise as pre-miums are used to offset indemnities paid.In the crop insurance program, privatecompanies share the underwriting riskwith FCIC. The companies’ crop insur-ance business is reinsured by FCIC underthe Standard Reinsurance Agreement(SRA). The companies can obtain addi-tional reinsurance in commercial markets.In 1992, the companies’ total capital atrisk—maximum possible losses afterFCIC reinsurance—was about $227 mil-lion. Since then, as risk-sharing provi-sions of the SRA have been renegotiatedand the size of the crop insurance busi-ness has grown, the companies’ total capi-tal at risk has grown to about $1.5 billion.

With the exception of 1993, growing con-ditions have been generally favorablesince 1992 and company underwritinggains have been sizable. Underwritinggains totaled approximately $1.1 billionover 1992-98, an average of about $155million per year. The average, however,masks wide variation among areas, com-panies, and years. For instance, net under-writing gains in 1997 were $352 million,

while yield losses due to floods in 1993were responsible for net underwritinglosses of $84 million. While the potentialfor underwriting gains is large, the privatecompanies are also exposed to largepotential losses. For example, had the1988 drought occurred in 1998, whenmore acres were insured and the compa-nies’ risk exposure was larger, it is esti-mated that net underwriting losses wouldhave exceeded $450 million.

Since the early 1990’s, the Federal cropinsurance program has expanded in thescope and variety of risk protectionoffered to producers. A major reformadded a low level of coverage, and com-bined with premium subsidies and linkageto other farm programs in 1995 dramati-cally increased insurance coverage.Maximum coverage levels that producerscan purchase have been raised under pilotprograms for some crops in some areas ofthe country. Revenue insurance productshave been developed and have capturedsignificant shares of the crop insurancebusiness.

At the same time, private insurance com-panies have played a larger role in deliv-ering crop insurance, developing newproducts, and sharing underwriting risk.Nonetheless, questions remain about theeffectiveness of the coverage availableunder the crop insurance program inassisting producers in managing the eco-nomic risks in farming, and crop yieldand revenue insurance are likely to be thefocus of policy decisions about strength-ening the farm safety net.

Robert Dismukes (202) [email protected]

AO

Risk Management


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Rapid expansion has occurred in thenumber of federally backed insur-ance products offered to farmers

since the 1996 farm legislation. Althoughfederally subsidized insurance has been apart of the government’s farm program forover a half century—yield-based insur-ance was available as early as 1938 forselected crops in selected locations—cropinsurance was not widely accepted byfarmers until recently. Prior to 1996, com-modity programs shielded agriculturefrom some of the risks stemming fromweather and markets, lessening the needfor crop insurance. Some researchers alsocite the frequent use of Federal ad hocdisaster assistance payments as a disin-centive to purchasing crop insurance (AO August 1999).

However, the demand for crop insuranceincreased in the last few years due tohigher Federal insurance premium subsi-dies, as well as the introduction of severalnew revenue insurance products thatincrease farmers’ choices and that someoperators find more attractive than crop-yield insurance alone. The array of insur-ance products currently available to pro-ducers is growing, and their use as a riskmanagement tool is widening.

In Iowa, for example, three revenue insur-ance products—Crop Revenue Coverage(CRC), Income Protection (IP), andRevenue Assurance (RA)—were firstoffered in 1996-97. Also available werethe more traditional yield-based prod-ucts—Multiple Peril Crop Insurance(MPCI), which includes a minimum cata-strophic coverage (CAT), and the GroupRisk Plan (GRP). (See page 28 fordescriptions of insurance products.) Afterjust 3 years, acreage covered under therevenue insurance products accounts formore than half of insured acres for cornand soybeans in Iowa.

In 1999, revenue insurance choices forU.S. farmers expanded with the introduc-tion of two new products. Group RiskIncome Protection (GRIP) adds a revenuecomponent to GRP area-yield insurance,and Adjusted Gross Revenue (AGR) offerscoverage on a whole-farm rather than crop-by-crop basis (AO May 1999).

At issue with regard to farmers’ participa-tion in insurance markets are a number ofquestions. What factors are driving farm-ers toward these new risk managementtools? How do farmers decide among dif-

ferent insurance products? Can theincrease in farmers’ demand for insur-ance, especially for the new revenueinsurance products, be sustained?Addressing such questions can be a keystep in anticipating the demand for yieldand revenue insurance products and thepotential for growth in a more market-oriented policy environment.

USDA’s Economic Research Service(ERS) has examined the demand for yieldand revenue insurance products amongcorn and soybean producers who pur-chased insurance in Iowa, where a rangeof insurance products was offered tofarmers in 1997. Using 1997 data collect-ed by USDA’s Risk Management Agency(RMA), the study analyzed the role offarmers’ risk characteristics, farm incomelevel, and the cost of insurance in makingdecisions on insurance purchases. This isthe first attempt to analyze farmers’demand for crop and revenue insurance inthe post-1996 Farm Act policy environ-ment, in which farmers are offered multi-ple insurance products.

The Risk Management Agency maintainsrecords of all individual farmers who buyfederally backed crop-yield or revenueinsurance from private insurance compa-nies. About 80,000 Iowa insurancerecords for 1997 contain 10 years of yieldhistory and information on coverageunder four insurance plans: MPCI, RA,and CRC at coverage levels of 50 through75 percent, and GRP at up to 90 percent.IP was not included in the analysis for


Risk Management

Demand for Yield & RevenueInsurance: Factoring In Risk, Income & Cost

Jac

k H

arr

ison

About the Demand ModelA Generalized Polytomous Logit(GPL) model is specified and estimat-ed to accommodate the demand forcrop insurance where the choice of aninsurance product is discrete—i.e.,farmers make a choice of one distinctproduct from among several alternativeproducts available to them. The GPLmodel specification was designed sothat all choices for the various insur-ance products are treated equally with-out assigning ranks. Further, the modelestimation accommodates all choicesto be estimated simultaneously, allow-ing every combination of the explana-tory variables to be taken into consid-eration concurrently.

lack of sufficient data; only 50 IP cornand soybeans policies were sold in Iowain 1997. GRIP and AGR did not exist in 1997.

To analyze demand for crop insurance,ERS developed a model based on threeexplanatory factors that influence a farmoperator’s decision to buy an insurancecontract (type of product and extent ofcoverage):

• Risk level measures the producer’slevel of yield or revenue risk. Yieldrisk—based on 10 years of yieldrecords—is calculated as the probabili-ty of yield falling below the insuranceproduct’s guaranteed level. Similarly,revenue risk—based on 10 years ofyield records and corresponding aver-age marketing-year prices—is calculat-ed as the probability of revenue fallingbelow the guaranteed level. The proba-bility measure is based on both themean and variance of yield or rev-enue—an indicator of volatility for anindividual farm.

• Level of income or size of operation isan indication of the amount of revenue

at risk, along with the operator’s abili-ty to pay for insurance or to self-insureagainst loss. Level of income isdefined as the cumulative sum of sav-ings over the past 10 years, using grossrevenue and an assumed savings rateof 10 percent. This variable is directlyproportional to the size of operation.

• Cost of insurance, captured by premi-um per dollar of liability (maximumpotential indemnity or value of theinsurance contract if the producer losesan entire crop), is total premium(including subsidy) divided by totalliability.

These three factors are categorized intothree ranges—low, medium, and high.The model then determines how these fac-tors influence the choice of alternativeyield and revenue insurance products.

The results reveal a strong relationshipbetween risk level and choice of insurancecontract. Farm operators with a higherrisk of yield or revenue falling below theguaranteed level are more likely than low-risk farmers to have chosen higher cover-age contracts. High-risk farmers, com-

pared with low-risk farmers, are morelikely to prefer revenue insurance (CRCand RA) over yield insurance (MPCI). Ifgiven a choice between only GRP andMPCI, high-risk farmers are more likelyto prefer MPCI, which is based on indi-vidual yield history rather than countyaverage yield.

Another way to see how risk and otherfactors relate to product choice is to cal-culate odds ratios—the odds of choosingone insurance product versus another.Comparing the odds of choosing CRC,RA, and GRP relative to MPCI for farm-ers with different risk levels indicates thathigh-risk farmers are nearly twice as like-ly as low-risk farmers to choose CRC orRA over MPCI. In general, analysis of theodds ratios indicates that high-risk farm-ers prefer revenue insurance while low-risk farmers prefer yield insurance.

The link between risk level and choice ofinsurance product was also explored bycalculating the probability of choosing aspecific insurance product given the farm-ers’ risk level. The computed probabilitiesfurther strengthen the findings that high-risk farmers are more likely to choose

Risk Management


Insurance contracts can be categorized into two types ofinsurance products: standard yield-based crop insurance andrevenue insurance products (AO April 1999). Yield insuranceproducts available in 1997 include Multiple Peril CropInsurance (MPCI) and Group Risk Plan (GRP), while rev-enue insurance products include Income Protection (IP),Revenue Assurance (RA), and Crop Revenue Coverage(CRC). Following is a brief description of how those pro-grams operated in 1997.

MPCI pays indemnities if yield falls below a guaranteedlevel—determined by a farmer’s average historical yield—but offers no price protection. MPCI provides minimum cata-strophic coverage (CAT), with premiums fully subsidized bythe government, and optional higher (or “buy-up”) levels ofcoverage with partially subsidized premiums.

GRP is tied to county yield rather than to individual farmyield. GRP policies pay indemnities when the county averageyield drops below a threshold or guaranteed level, regardlessof yield of the individual farmer. GRP buyers can insure upto 90 percent of the expected county yield at up to 150 per-cent of the expected price.

IP, RA, and CRC protect against lost revenue caused by low yields, low prices, or a combination of both. IP and RA

protect farmers against reductions in gross income wheneither prices or yields decrease during the crop year fromearly-season expectations. Indemnity amounts are determinedby individual farm yields and harvest-time futures prices. IPoffers a single insurance contract per commodity enterprisefor the farm per county—e.g., within a county, IP coveragecombines all corn fields which a farmer owns or from whichat least a share of corn crop earnings is due. RA—availableonly in selected counties and for selected crops around thenation—allows both basic and an optional field-specific cov-erage (multiple insurance contracts based on ownership,farming practices, and section of the farm’s acreage).

CRC with replacement-coverage protection (RCP) providespartial protection against both yield and price shortfalls, pay-ing an indemnity if a producer’s gross revenue falls below apredetermined guarantee level. Since CRC uses the higher ofthe planting-time price for the harvest futures contract or theactual futures contract quote at harvest in setting the guaran-tee, the producer’s revenue guarantee may actually increaseover the season because CRC with RCP allows producers topurchase “replacement” bushels if yields are low and pricesincrease during the season. Recently, farmers in Iowa wereoffered RA contracts with a harvest price option that is verysimilar to CRC except that it imposes no limits on priceincreases at harvest-time.

Insurance, in Short

revenue insurance contracts (CRC or RA),while low-risk farmers are more likely tochoose yield contracts (GRP, MPCI, orCAT). High-risk farmers, who have agreater expectation of collecting indemni-

ties, select contracts that would providegreater indemnities in the event of lossand are apparently willing to pay a higherpremium to obtain those contracts.

Level of income also influences the typeof insurance product a farmer purchases,as well as level of coverage. The resultsimply that, within the same risk class,high-income farmers are more likely toprefer revenue insurance over yield insur-ance. For example, the odds of choosingCRC over MPCI by high-income farmersrelative to low-income farmers is 1.5,indicating that, within the same risk cate-gory, high-income farmers are 1.5 timesas likely as low-income farmers to chooseCRC over MPCI. Higher income farmersshowed a preference for greater coverage,while lower income farmers showed apreference for lower coverage levels, con-trary to the initial hypothesis that high-income farmers who could afford to self-insure against some risk loss would pur-chase less insurance.

Results also indicate that cost of insur-ance affects the decision to buy and thechoice of insurance contract (regardless ofrisk class or income level), which under-scores the importance of premium subsi-dies. Under the current insurance pro-gram, nearly 40 percent of producer pre-miums on “buy-up” coverage are subsi-dized (depending on the coverage level,and excluding the added 1999 and 2000premium discounts provided in appropria-tions legislation). Since the subsidy is alarge part of the premium, changes inFederal subsidies are likely to significant-ly affect the extent of farmers’ use of cropinsurance.

Study results suggest that by incorporat-ing risk and other characteristics associat-ed with farmers who buy different con-tracts, it may be possible to structureinsurance rates to more closely reflectfarmers’ risk profiles. Even though theanalysis is limited to Iowa corn and soy-bean producers, the findings provide use-ful insights into preferences of farmers atvarious risk levels in choosing amongalternative insurance contracts, and thesubstitutability among contracts, and mayfacilitate making the agricultural insur-ance industry more self-sustaining.

Shiva S. Makki (202) 694-5316 and AgapiSomwaru (202) [email protected]@econ.ag.gov

AO

Risk Management


0 0.5 1 1.5 2 2.5

CRC over MPCI RA over MPCI

Odds ratio


Farmers’ Level of Risk and Income Affects Likelihood of Choosing Revenue Insurance Over Crop Insurance

Preference for revenue insurance over crop insurance:

Odds ratio = Probability of high-income—or high-risk—farmers choosing CRC or RA over MPCI, divided by probability of low-income—or low-risk—farmers choosing CRC or RA over MPCI. When odds ratio equals 1, probabilities (numerator and denominator) are the same. CRC=Crop revenue coverage; RA=Revenue assurance; MPCI=Multi-peril crop insurance.

High-riskfarmers(v. low-risk)

High-incomefarmers(v. low-income)

Low-risk farmers Medium-risk farmers High-risk farmers0

0.1

0.2

0.3

0.4

CAT MPCI GRP CRC RA


Probability

Risk Level Affects Choice of Insurance Product

Probability indicates the likelihood of farmers choosing a particular insurance product. For example, out of 100 low-risk farmers, 32 are likely to choose CAT and another 19 to choose MPCI above the CAT level. Crop-yield insurance: CAT = Catastrophic (minimum) crop-yield coverage; MPCI = Multi-peril crop insurance above the CAT level; GRP = Group risk protection. Revenue insurance: CRC = Crop revenue coverage; RA = Revenue assurance.

Risk management in agriculture isaimed, in general, at attaining adesired combination of risk and

return. Some producers strive to obtainthe highest possible return for an accept-able level of risk, while others may seekto minimize the risk associated with adesired level of return. The ability of dif-ferent strategies to reduce risk, and thecost of adopting different risk manage-ment strategies, varies with each individ-ual situation. But whatever approach istaken, implementation of most risk-reducing strategies involves some trade-off between expected income and riskexposure.

Federal subsidization of crop and revenueinsurance programs alters the tradeoff sothat operators may attain significant riskreduction at relatively low cost, whileactually increasing expected (i.e., long-run) returns. Yet the rate of participationin insurance programs has remained sig-nificantly less than universal, with about61 percent of eligible acres insured in1998. This may be because the potentialbenefit of insurance is largely unrecog-nized and undervalued, or other factorsmay be at work in the farm operator’sdecisionmaking process.

In agriculture, as in most other industries,the activities associated with the highestexpected returns are often associated withthe greatest level of risk. As a result, aproducer may be forced to forego thoseactivities with the most potential for profitin favor of other activities with lower butless risky returns.

For example, corn production mightpromise a farm the highest net returns peracre if favorable weather is combinedwith heavy input use. However, unfavor-able weather could result in low yieldsand large losses, and gambling on favor-able weather by putting all the farm’sacreage into corn may be a perilousundertaking for all but the most financial-ly secure operations. A risk-averse pro-ducer confronting this situation may beinclined to opt for lower potential profitby partially diversifying the acreage intosoybeans and some other grains withlower input costs (e.g., oats, wheat, orsorghum). If, instead, that risk-averse producer faces price prospects that areparticularly poor and off-farm employ-ment opportunities exist, renting out orfallowing a large portion of the acreageand devoting a share of household labortime to earning off-farm wages may be apreferred strategy.

The level of risk an individual is willingor able to bear varies with the person’sfinancial situation, attitude toward risk,availability of other opportunities, andease of transitioning to alternative activi-ties. A variety of strategies is available toenable agricultural producers to achievean acceptable balance between expectedreturn and risk.

But some risk-reducing strategies mayinvolve substantially lower expected netreturns—for example, diversifying produc-tion to grow some commodities wherereturns per acre may be lower but less vari-able. On the other hand, competitive risktransfer markets—e.g., futures and optionsexchanges or agricultural insurance pro-grams provide a means of lowering riskwith little change in expected net returns.Purchasing crop or revenue insurance is arisk transfer strategy that can be used toobtain varying degrees of revenue-riskreduction at relatively low cost. A distin-guishing feature of this strategy is theFederal subsidies available to crop and rev-enue insurance market participants.

Subsidies Lower Premiums forCrop & Revenue Insurance

Crop and revenue insurance are low-costtools to help farmers guard against risk ofrevenue losses due to yields and pricesthat fall short of planting-time expecta-tions. Crop yield insurance provides pay-ments to producers when realized yieldfalls below the producers’ insured yieldlevel, whereas crop revenue insurancepays indemnities based on revenue short-falls that result from yield or price short-falls (AO April 1999).

But unlike most other risk managementtools, crop and revenue insurance alsoprovide a special case where income riskis reduced and expected returns areincreased because of Federal governmentintervention in premiums charged to farm-ers. The Federal Crop InsuranceCorporation (FCIC) provides subsidies toprivate companies, eliminating much ofthe delivery cost and underwriting riskfrom premiums, and helping to ensurethat premiums are a close representationof longrun expected indemnities. In addi-tion, the FCIC subsidizes producer premi-ums to lower the cost of acquiring insur-ance so that, in the aggregate, total

Risk Management


Crop & Revenue Insurance: Bargain Rates but Still a Hard Sell

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expected returns over the long term aregreater than farmers’ total actual premiumcosts. In other words, a dollar’s worth ofexpected return can be purchased for lessthan a dollar of premium.

Substantial taxpayer dollars have beenexpended over the years to make insuranceavailable on a widespread basis and toincrease producer participation in insuranceprograms. Between 1981 and 1998, Federalrisk management outlays included $5.7 bil-lion in producer premium subsidies, $3.9billion in administrative reimbursements toprivate insurance deliverers (plus another$1.6 billion in other administrative costs),and $3 billion in net underwriting losseswhich, in the absence of Federal risk shar-ing, would have been borne by the privatecompanies selling the policies.

Since passage of the 1994 Federal CropInsurance Reform Act, total insurance-related outlays have averaged nearly $1.4billion per year, with premium subsidiescomprising the bulk of the transfer. Thepremium subsidy share of those outlayshas also increased. The larger outlays aredue in large part to a significant rise inparticipation. Insured acreage peaked at75 percent of eligible acres in 1995 whenparticipation in crop insurance wasmandatory for farmers to be eligible forother Federal program benefits—e.g.,deficiency payments. The mandatory par-ticipation requirement was dropped for1996 and subsequent years, and as aresult, participation has declined.

Under most private insurance policies:Total premiums = expected indemnities +administrative costs + profit margin

What makes government-subsidizedinsurance such a good deal? Under mostprivate insurance programs—e.g., auto-mobile, homeowners, health—premiumsare set to include all expected indemnities(payments made on qualifying losses),plus all the costs of administering thepolicies, plus a reasonable profit. If pre-miums fall short of this goal, the companyloses money and must either raise premi-ums or go out of business. Competitionamong private companies helps to mini-mize increases in profit margins, keepingpremium increases down.

Under FCIC-backed crop insurance:Total premiums = expected indemnities

Under the FCIC-backed crop insuranceprogram, government payments to insur-ance carriers are used to ensure that totalpremiums are set to cover expectedindemnities only, which reduces the pre-miums paid by farmers. Federal cropinsurance subsidies are designed, in largepart, to equate premium rates with thelong-term chance of loss.

To achieve this objective, USDA’s RiskManagement Agency (RMA), through the

FCIC, subsidizes private insurance com-panies that sell and deliver crop and rev-enue insurance, by reimbursing them forthe costs of selling and underwriting poli-cies, adjusting losses, and processing poli-cy data. The government also lowers therisk associated with underwriting cropand revenue insurance by sharing the riskof loss (and the possibility of gain) onpolicies sold by private companies.

To encourage producer participation inagricultural insurance markets, the gov-ernment also pays a portion of producers’premiums on FCIC-approved policies,

How Are Insurance Premium Rates Set & Subsidies Applied?An insurance premium is the amount an individual or business pays for purchase ofinsurance. For crop and revenue insurance, premiums are generally expressed on adollars-per-acre basis, but are calculated as a percent of the total liability. Total lia-bility is the maximum loss exposure of the insurer—the amount of indemnity pay-ment required if yield were to fall to zero.

Because premiums for crop and revenue insurance are designed to cover losses overtime, insurers project yield and revenue distributions to show expected losses andpayouts at different levels of insurance guarantees. Premium rates are determined byseveral factors:

• the type of crop, size of insured unit, and coverage level selected;

• the farm’s loss experience and APH (actual production history) yield; and

• the county yield and its historical variability.

For a given crop at a given price, premium rates are highest for land where risk ofproduction loss is greatest—i.e., where yields are the most variable.

USDA’s Risk Management Agency (RMA) subsidies encourage participation in cropinsurance by reducing producer premiums. The amount of the subsidy depends onthe type of insurance and the coverage level in accordance with the 1994 FederalCrop Insurance Reform Act. For minimum CAT (catastrophic) coverage—i.e., 50-percent yield coverage at 55 percent of the expected harvest-time price—the premi-um is entirely subsidized, and a policy may be purchased for a small processing fee.At higher levels of coverage—referred to as “buy-up” coverage—subsidies are calcu-lated in accordance with yield/price rules:

Calculation of “buy-up” coverage subsidy:

• Yield/price guarantees below the 65/100 level (65-percent yield coverage at a100-percent price coverage election) are subsidized at a rate equivalent to CATcoverage.

• Yield/price guarantees at or above 65/100 level are subsidized at a rate equivalentto a 50/75 guarantee.

• For each of the above two ranges the subsidy is first calculated as a fixed amount,which is then applied to the higher premiums charged for higher coverage levels.

Thus the subsidy share of the premium rate declines as coverage rises, with theexception of a kink at the 65/100 coverage break-point where the subsidy shareattains a maximum value of nearly 42 percent of the premiums. Premium subsidiesare also available for revenue insurance but are based strictly on the yield portion ofcoverage. As a result, revenue insurance subsidies are generally a lower proportion oftotal premiums than their yield-based crop insurance counterparts.

ranging from 13 to 100 percent dependingon the type of insurance and the coverageoption chosen. Premium subsidies arebased only on the yield portion of federal-ly backed insurance policies. Subsidies onrevenue insurance plans are limited to theamount payable if the producer had elect-ed the yield-based coverage. From 1981to 1994 these subsidies averaged about 25percent of total premiums. Beginning withthe Federal Crop Insurance Reform Act of1994, government subsidies have aver-aged about 50 percent of total premiumsacross all policies—comprised of a 100-percent share of premiums for minimumcatastrophic coverage (CAT) and a 40-percent share of premiums for additionalyield loss “buy-up” protection.

Under actuarially fair insurance rate set-ting—where total premiums equal indem-nities paid out, and the insurance program“breaks even”—the premium subsidiesrepresent a positive expected benefit toproducers who purchase insurance. Inother words, with the government payingpart of farmers’ insurance premiums,expected net returns per acre are greaterwith insurance than without.

How does this work? If the insurancecompany writing the policy and the pro-

ducer buying the policy have equal infor-mation about risk, and if the insurancepremium is set to correctly reflect thatrisk, then the premium should exactlyequal the expected indemnity. With nogovernment subsidy, the producer wouldpay the full premium and no expectedbenefit would ensue beyond being able totransfer some production risk. However,when the government subsidizes a portionof an actuarially fair premium, the pro-ducer pays less than the full premium butstill can expect to obtain the full indemni-ty. Thus, a dollar of a farmer’s premiumreturns more than a dollar of expectedbenefit over the long run.

A measure of the actuarial success of pre-mium rating for crop insurance is the lossratio—total indemnities paid divided bytotal premiums received. Because ratesare set to reflect the longrun chance ofloss, actuarial fairness equates to a lossratio of approximately 1.0. However, inany given year, the loss ratio for a crop ina specific area is unlikely to equal exactly1.0, due to variations in weather. In a yearwith extremely unfavorable weather, thesum of crop and revenue insurance poli-cies would be expected to show a lossratio greater than 1.0, implying net under-writing losses (although reimbursement

subsidies to private companies for admin-istrative costs could potentially make upfor the losses). In years with more normalweather, a loss ratio less than 1.0 mayresult, with net underwriting gains.

From 1981 through 1993, annual lossratios (based on total premiums, includingsubsidies to producers) exceeded unity,suggesting that ratings on subsidizedinsurance were not actuarially sound.Since 1990, many features of the FCIC-backed crop insurance program have beenimproved in an “actuarial” sense. Forexample, rates have been raised, and morestringent penalties for yield data inade-quacies have been imposed on insuredfarmers. These changes, in combinationwith several years of moderate weather,have helped to improve loss ratio per-formance significantly since 1993. Inaddition, private companies have beenasked to bear a greater share of the under-writing risk, while reimbursement foradministrative costs has declined.

From the producers’ point of view, the rel-evant ratio is based on actual premiums—the farmers’ cost after subtracting theFederal subsidy portion of the premium.The ratio based on the producer-paid pre-mium has exceeded unity in every yearsince 1981 with the exception of 1994when it dipped below unity. Since 1995the national aggregate producer-paidindemnity/premium ratio has averagednearly 1.77, implying $1 of premium hasbought $1.77 of expected indemnity bene-fit “on average,” plus additional unquanti-fied “benefit” from risk reduction.

If federally subsidized crop and revenueinsurance is such a good deal, why don’tall eligible producers take advantage of it?While the answer to this question is debat-able, there are several possible reasonswhy participation in crop and revenueinsurance programs is less then universal(in 1998 about 65 percent of acreageplanted to major field crops was insured).A key to understanding these reasons restson the premise that risk-averse farmers canbe expected to purchase correctly ratedinsurance (where the premium accuratelyreflects the true risk of loss), and bothinsurer and insured regard the premium asaccurately reflecting risk.

Risk Management



Ratio

Ratio of indemnities toproducer-paid premiums

1994 FederalCrop InsuranceReform Act

85 89 93 970.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1981

Since the 1994 Reform, Total Crop and Revenue Insurance PremiumsHave Generally Exceeded Indemnities Paid Out

Ratio of indemnities to total premiums(loss ratio)

Total premiums = Producer-paid premiums plus Federal Crop Insurance Corporation (FCIC) premium subsidy. A longrun average loss ratio of 1.0 implies actuarial soundness--i.e., an insurance program "breaks even" with regard to premiums and indemnities. Source: Risk Management Agency, USDA.

Under this premise, there are several char-acteristics of crop and revenue insuranceprograms that help explain less-than-universal participation. First and foremost,it is likely that many farmers simply donot believe expected indemnities exceedtheir producer-paid share of the premium.These farmers believe (rightly or wrong-ly) that premium rates fail to reflect theirspecific situation. In other words, manyfarmers feel that the premium rates theyface (or the processing fee in the case ofCAT coverage) overstate their risk of loss.Imperfections in the rate setting schemeprobably make this true for some, whileothers may be poorly informed about thetrue extent of farm-level risk.

There may also be some misunderstand-ing or general lack of information con-cerning how crop and revenue insuranceprograms work and the advantages theyimpart. This problem is compounded bythe growing array of available insuranceproducts, which strengthens the percep-tion that crop and revenue insurance pro-grams, like many other risk managementprograms, are too complicated to under-stand and use correctly.

Other reasons that are frequently cited ascontributing to less-than-universal partici-

pation in subsidized crop insuranceinclude:

1) An operator’s overall level of wealthcan have a strong bearing on risk decision-making. For many large commercial oper-ations with substantial equity values, thepotential magnitude of a crop loss relativeto the equity base may be very small, sothe incentive to buy insurance is low.

2) Management objectives such as profitmaximization or enterprise growth maysupersede risk management goals anddiminish the demand for insurance.

3) Many farmers have some ability toreduce yield and revenue risk through theuse of alternative strategies—stable off-farm wage opportunities or diversificationof on-farm activities—which may bemore cost-effective under some circum-stances. Some farms may reduce yieldrisk simply by altering cultivation andcrop management practices, at lower costthan the producer-paid share of the premi-um on a crop insurance policy.

Finally, many researchers have cited thefrequent use of Federal ad hoc disasterassistance payments (from 1988 through1994 and again in 1998 and 1999) as a

principal deterrent to purchasing cropinsurance. Why pay a premium for some-thing that you would likely get for free?

Do FCIC Subsidies AlterProducer & Carrier Behavior?

The goal of FCIC subsidies is to alterbehavior—namely, increase participationin crop and revenue insurance markets. Ifsuccessful, this contributes to the highergoal of encouraging farmers to reducetheir risks, thereby increasing the viabilityof agriculture and reducing the need forpublicly funded disaster assistance pro-grams. But do FCIC subsidies have otherconsequences? The answer appears to beyes, for several reasons.

First, when viewed as an increase inexpected revenue, the subsidy providesnot only an incentive to purchase insur-ance, but also to marginally expand areaunder crop production, since a producer’stotal expected return increases with everyinsured acre.

Second, since premium subsidies are calcu-lated as a percent of total premium, andpremiums are higher for production onriskier land, the subsidies are weighted infavor of production on land with the great-est yield variability. As a result, subsidiesmay encourage production on land thatmight otherwise not be planted. And to theextent that yield risk varies across bothcrops and fields, distortions are likely tooccur across both regions and commodities.

Third, in the absence of FCIC subsidies,crop insurance premiums would includemarkups for the insurance companies’administrative costs and profit margin.These added costs could make premiumrates prohibitively expensive in high-riskareas. If the higher premium rates discour-age participation, such areas would be lessattractive markets to private companiesselling the policies. To this extent, Federalsubsidies increase the likelihood of insur-ance delivery, and consequently produc-tion, in high-risk areas, such as variouslocations in the Great Plains.

Randy Schnepf (202) 694-5293 andRichard Heifner (202) [email protected]@econ.ag.gov

AO

Risk Management



85 89 93 970.0

0.5

1.0

1.5

2.0

1981

$ billion

Producer-paid

Total premiums

Premium subsidies are paid by the Federal Crop Insurance Corporation (FCIC).Source: Risk Management Agency, USDA.

Subsidy-Paid Share of Crop and Revenue Insurance PremiumsIncreased Sharply in 1995

1994 FederalCrop InsuranceReform Act

Subsidy-paid

Aprogram of tax-deferred savingsaccounts for farmers is among thealternatives currently under con-

sideration by Congress to help farm oper-ators manage their year-to-year incomevariability. Unlike the income-averagingprovision for farmers included in theTaxpayer Relief Act of 1997, whichallows farmers to spread above-averageincome to prior tax years and avoid beingpushed into a higher tax bracket, tax-deferred savings accounts would build acash reserve to be available for risk man-agement. By depositing income into spe-cial Farm and Ranch Risk Management(FARRM) accounts during years of highnet farm income, farmers could build afund to draw on during years with abnor-mally low income. Federal income taxeson eligible contributions would bedeferred until withdrawal.

Proposals for tax-deferred risk manage-ment savings accounts originally surfacedafter passage of the 1996 Farm Act, as amechanism to encourage farmers to save aportion of the 7-year transition payments.In 1998, as Congress sought to expand thefarm safety net and ease stress from recentlow prices and regional disasters, it again

considered FARRM accounts. A bill toauthorize FARRM accounts was intro-duced in the 1999 Congressional session(H.R. 957, S. 642), and is likely to gener-ate more debate in 2000.

How FARRM Accounts Would WorkUnder the current FARRM account pro-posal, farmers could take a Federalincome tax deduction for FARRMdeposits of no more than 20 percent ofeligible farm income—taxable net farmincome from IRS Form 1040, Schedule F,plus net capital gains from sale of busi-ness assets including livestock but notland. Deposits would be made into inter-est-bearing accounts at approved finan-cial institutions, and interest earningswould be distributed and taxable to thefarmer annually. Withdrawals from prin-cipal would be at the farmer’s discretion(no price or income triggers for with-drawal), and taxable in the year with-drawn. Meaningful income triggerswould be difficult to determine given thenature of taxable farm income and thefact that price levels do not necessarilycorrelate with farm-level yield or incomevariability.

Deposits could stay in the account for upto 5 years, with new amounts added on afirst-in first-out basis. Deposits not with-drawn after 5 years would incur a 10-percent penalty. FARRM funds wouldhave to be withdrawn if the account hold-er were disqualified from participating bynot farming for 2 consecutive years.Deposits and withdrawals would notaffect self-employment taxes.

FARRM account eligibility would be lim-ited to individual taxpayers—sole propri-etors, partners in farm partnerships, andshareholders in Subchapter S farm corpo-rations—who report positive net farmincome and owe Federal income tax. Theprogram should be relatively easy toadminister through the use of existingincome tax forms, with reporting require-ments similar to those of individual retire-ment accounts (IRA’s). Contributions anddistributions from the accounts could beverified by matching income tax returnswith records from banks or other financialinstitutions where the accounts are held.

Although farm sole proprietors make upthe largest share of potentially eligibleindividuals, over two-thirds either report afarm loss or have no Federal income taxliability and therefore could neither par-ticipate nor benefit from participation.And actual participation could be signifi-cantly less than the number eligible.

Using 1994 Internal Revenue Service(IRS) data, USDA’s Economic ResearchService estimates that 916,000 farmerswould be eligible to contribute as much as$2.8 billion to FARRM accounts eachyear. Farm sole proprietors account forover two-thirds of eligible participantsand three-fourths of potential contribu-tions. But about half of eligible farm soleproprietors would be limited to contribut-ing less than $1,000. Thus, each year onlyabout one of every six sole proprietorscould contribute more than $1,000.Contributions for farm partners wouldalso be small—averaging below $2,000—but subchapter S shareholders’ contribu-tions could average $4,355.

Basing eligibility for contributions onpositive net farm income would directmuch of the benefit of FARRM accountsto those relying on farming for more thanhalf their income. About two-thirds of

Risk Management


Tax-Deferred Savings AccountsFor Farmers: A Potential Risk Management Tool

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potential contributions by sole proprietorswould be concentrated among the one-third of eligible sole proprietors whoderive over half their income from farm-ing. A very small share of limitedresource farmers—gross farm sales under$100,000 and household income less than$10,000—would be eligible, and theircontributions would be rather small.

The amount of money that would bedeposited into FARRM accounts and aminimum account balance that would besufficient to provide risk protection foreither farm operations or household livingexpenses are difficult to estimate. But withover 80 percent of all farmers limited tocontributions of less than $1,000 in anygiven year, and with participation ratesexpected to be less than 100 percent, mostfarmers are not likely to accumulate sig-nificant reserves. Some producers withlow contribution limits may be able todeposit larger amounts in years when farmincome is higher. But the 5-year windowfor building reserves and the generally lowlevel of taxable net farm income combineto reduce the likelihood that most farmers

would be able to build balances adequateto self-insure risk exposure.

Although 1994 is the most recent year forwhich complete data are available, it wasnot an especially good year for farmincome. Examination of the most prof-itable year during the 1990-94 period(1990) suggests that aggregate potentialcontributions would have increased byabout 25 percent to $3.5 billion. Thus,with 100-percent participation, potential5-year contributions could range from $14to $17.5 billion. The official revenue esti-mate by the Congressional JointCommittee on Taxation suggests thataggregate account balances would be wellbelow this amount as a result of with-drawals and less than full participation.

Looking at data for 1996, a year whenboth farm prices and government programpayments were high, it appears that esti-mates of eligible participants and totalpotential contribution amount would notchange significantly. Despite a slightincrease in total taxable income fromfarming, the number of farmers with tax-

able farm income actually dropped byabout 30,000. Moreover, the number offarmers and other taxpayers who owe noFederal income tax has since increased,due largely to the child credit and othertax relief measures enacted in 1997 and1998. As a result, the number of farmerswho would be eligible to make contribu-tions if the program is implemented mayactually be lower than 1994 data suggest.

Should Benefits Be Targeted?Without a provision for targeting—speci-fying who is eligible to participate andwhere program benefits are expected tobe concentrated—most of the benefits ofFARRM accounts would go to relativelyfew farmers, and some would go to indi-viduals who do not rely on farming fortheir livelihood. The FARRM accountproposal currently on the table does notspecify a maximum annual contributionor a limit on accumulated balances. About0.5 percent of farm sole proprietors wouldbe eligible to contribute over $20,000annually, adding up to more than 25 per-cent of total sole proprietors’ potentialdeposits. Off-farm income for this groupexceeds $250,000, on average, and asmall subset of very high-income individ-uals would be eligible for contributionsaveraging $50,000. In contrast, manyfarmers with persistently low farmincomes, highly vulnerable to incomeswings, would likely be ineligible to con-tribute or unable to build sufficientFARRM account balances.

Concentrating benefits for individuals athigh income levels and excluding low-income farmers may raise concerns aboutappropriately targeting the program.Targeting could be used to reach a specif-ic group of farmers by capping annualcontributions or limiting eligibility basedon adjusted gross household income(AGI). For example, restricting eligibilityto individuals with AGI under $100,000would reduce potential contributions byabout a third and cut taxpayer cost—fromfarmers deferring taxes—nearly in half,but would reduce the number of eligiblefarmers by less than 10 percent.

The 1996 proposal for tax-deferred sav-ings had a targeting provision—a $40,000annual contribution limit and a 10-yeartime limit for withdrawals. A Canadian

Risk Management


Sole Proprietors Would Predominate Among FARRM Account Holders...

Eligible farmers Maximum potential FARRM deposits

Number (1,000) Percent $ million Percent $ meanof total deposit

All 916 100.0 2,830 100.0 3,090Sole proprietors 626 68.3 2,138 75.5 3,415Partners 242 26.5 483 17.1 1,995Subchapter S shareholders 48 5.2 209 7.4 4,355

...But Nearly Three-fourths of Them Could Not Have FARRM Accounts

Sole proprietors Maximum potential Average incomeFARRM deposits Off-farm Farm

Number (1,000) Percent $ million Percent $1,000

All sole proprietors 2,265 100.0 2,138 100.0 49 *Ineligible to deposit, due to:Negative net farm income 1,422 62.8 0 0 56 -10No Federal tax owed 217 9.6 0 0 5 8

Eligible to deposit:$1-$999 282 12.4 87 4.1 50 2$1,000-$9,999 305 13.5 1,112 52.0 35 19$10,000-$19,999 27 1.2 363 17.0 51 69$20,000 or more 12 0.5 576 26.9 263 246

Eligible farmers are those who report a positive combination of net farm income from Form 1040, Schedule F,plus capital gains from business assets other than farmland, and who owe Federal income tax. Maximumpotential deposits estimated as 20 percent of eligible farmers’ total net farm income.* Loss under $500.Source: Compiled from 1994 IRS Individual Public Use Tax File.


program for farmer tax-deferred savingslimits annual contributions and accumu-lated balances, but has no time limit.

FARRM Accounts Are IntendedTo Manage Risk, Not TaxesTo meet goals of program efficiency—benefits offsetting costs—and risk man-agement, FARRM accounts must createnew savings rather than shift assets orreplace existing risk management prac-tices. The cost of the FARRM accountprogram is primarily the decrease in gov-ernment revenue associated with taxdeferral. The benefits are mainly farmers’increased financial stability, and dimin-ished need for government farm programpayments or emergency aid payouts.

Creating new savings instead of shiftingassets could mean a gain for taxpayersand a stronger risk position for farmers.To enhance farmers’ risk managementcapabilities, new savings have to comefrom reduced household consumption orfrom funds that would have been invest-ed in the business, rather than from shift-ing existing savings, diverting futurenew savings, borrowing, or depositingtaxes deferred by making the contribu-tions. But evidence indicates that mostpotentially eligible farmers have ampleresources to shift funds into FARRMaccounts instead of creating new savings.

Information on interest earnings forpotentially eligible individuals suggeststhat contributions from existing liquidassets could fund a large portion—aboutthree-fourths of total potential contribu-tions—in the first year, and over half ofeligible farmers have sufficient existingsavings to fund FARRM account contri-butions for several years. Farmers withadjusted gross income above $100,000 aremore likely to be able to fund a largerproportion of contributions from existingsavings, while eligible farmers with AGIunder $50,000 have less existing savingsavailable and are more likely to createnew savings if they decide to participate.

USDA’s 1994-95 Agricultural ResourceManagement Study reveals that a majorityof households associated with farms thathave gross sales of $50,000 or morealready keep liquid assets to meet unex-pected expenses. If those liquid assetswere moved into FARRM accounts, thehousehold would benefit from tax deferralwithout incurring significant restrictionson availability of funds, but would notenhance their ability to manage risk.

Research on IRA’s, similar in concept toFARRM accounts, documents a signifi-cant amount of asset shifting rather thannew saving. The FARRM program provi-sion that requires a contribution to bewithdrawn within 5 years effectively lim-its the amount of income that can beaccumulated in the account and prevents aFARRM account from becoming an addi-tional retirement savings plan. But assetshifting could be even more prevalent forFARRM accounts than for IRA’s becauseFARRM accounts remain liquid and,without price or income triggers that mustbe reached to allow withdrawals, FARRMaccounts do not lock the money into long-term reserves. In addition, FARRM fundsare not required to remain on deposit for aminimum time and, like IRA’s, contribu-tions prior to April 15 would apply to the

preceding tax year, so depositing funds inFARRM accounts for a short period couldprovide a 1-year income tax deferral.

A program of tax-deferred risk manage-ment accounts has the potential toencourage farmers to provide their ownsafety net by saving money from high-income years to withdraw during low-income years. Taxpayers could benefit iffarmers’ additional financial diversifica-tion and liquidity reduce the need forcontinued income support programs or adhoc farm disaster relief. Nonetheless,there are several potential limitations tothe program’s effectiveness. Theseinclude: 1) low levels of taxable farmincome that could preclude most farmersfrom building meaningful account bal-ances—particularly those most in need ofrisk management tools, such as limitedresource and beginning farmers; 2) con-centration of program benefits amongoperators with large farms and relativelyhigh off-farm income; and 3) funding ofFARRM accounts with farmers’ existingliquid assets instead of new saving.

James Monke (202) 694-5358 and RonDurst (202) 694-5347 [email protected]@econ.ag.gov

AO

Risk Management


Canada Already Has a Savings Plan for FarmersRisk management savings accounts are not without precedent. In 1991, Canadabegan the Net Income Stabilization Account (NISA) program to encourage farmersto save for self-insurance (AO May 1995). The farmer’s contribution earns a 3-per-cent interest rate bonus and is supplemented by a matching government contribu-tion. Unlike the U.S. proposal, a farmer’s NISA contribution is not tax-deferred, but government contributions and interest earnings are not taxed until withdrawal.Annual farm contributions are limited to 20 percent of the year’s sales, and depositseligible for government matching are limited to the smaller of $7,500 or 3 percentof eligible farm sales—gross sales of most primary commodities minus purchasesof those commodities, such as seed and feed. NISA has no time limit on deposits,but account balances may not exceed 1.5 times the farm’s 5-year average sales.

Analysis of the NISA provision that allows withdrawals only when income fallsbelow an established threshold suggests that rules for withdrawal can create obsta-cles to effective use of funds. Administrative delays in availability of funds to farm-ers reduce the program’s usefulness as a source of emergency funding. This partial-ly explains why many Canadian farmers who became eligible for withdrawals didnot actually take funds from their accounts.

The U.S. Department of Agriculture (USDA) prohibits discrimination in all its programs and activities on the basis of race, color, national origin, sex, religion, age, disability, political beliefs,sexual orientation, or marital or family status. (Not all prohibited bases apply to all programs). Persons with disabilities who require alternative means for communication of program informa-tion (braille, large print, audiotape, etc.) should contact USDA’s Target Center at (202) 720-2600 (voice and TDD).

To file a complaint of discrimination, write USDA, Director, Office of Civil Rights, Room 326-W, Whitten Building, 14th and Independence Avenue, SW, Washington, DC 20250-9410 or call(202) 720-5964 (voice or TDD). USDA is an equal opportunity provider and employer.

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