Livestock Gross Margin Insurance for Dairy: Part 1
Livestock Gross Margin Insurance for Dairy (LGM-Dairy) is a subsidized insurance policy providing dairy producers protection against the loss of gross margin
Livestock Gross Margin Insurance for Dairy (LGM-Dairy) is a subsidized insurance policy providing dairy producers protection against the loss of gross margin (market value of milk minus feed costs) for specified portions of milk produced by their dairy cows. LGM-Dairy establishes a floor (minimum) on income over feed costs (IOFC), ensuring that the gross margin will not be less than the amount specified in the LGM-Dairy policy. It is a risk management tool very similar to using a bundled options strategy (see Figure 1). In a bundled options risk management strategy the producer uses Class III milk put options to create a milk revenue floor (minimum) and feed (corn, soybean meal) call options to establish a feed cost ceiling (maximum). The “bundling” of the put and call options allows the producer to establish an IOFC floor (minimum). The effect of LGM-Dairy and the bundled options strategy are identical (Figure 1).
LGM-Dairy has several advantages over traditional hedging using Class III futures contracts, a bundled options strategy, or co-op sponsored forward (fixed) price contracts: 1) hedging and forward contracts “lock in a milk price” and, unlike LGM-Dairy, provide no upside milk price potential, 2) hedging has daily margin requirements while LGM-Dairy does not, 3) the contract size in hedging and bundled options strategies are limited to increments of 200,000 lbs. of milk, 5,000 bushels of corn, and 100 tons of soybean meal while LGM-Dairy has a completely flexible contract size, 4) the cost of an LGM-Dairy policy is the policy premium, and is known before entering into the contract, 5) the cost of insurance in a LGM-Dairy policy is much cheaper than in a similar bundled options strategy because the premium is subsidized, and 6) LGM-Dairy does not require an established contract with a commodities broker or a milk marketing entity that offers forward price contracts. Very importantly, LGM-Dairy’s only cost is the cost of the insurance policy and the contract guarantees a minimum IOFC for covered milk production, but does not limit the producer from participation in higher milk prices (Figure 2) and/or lower feed (corn, soybean) prices (Figure 3).
LGM-Dairy is a program administered by the USDA’s Risk Management Agency, but LGM-Dairy policies are purchased from firms selling federal crop insurance. Crop insurance agents must be certified to sell LGM-Dairy and have an identification number on file with the Federal Crop Insurance Corporation. A list of approved agents can be obtained by going to the University of Wisconsin’s Understanding Dairy Markets website. Click on the “LGM-Dairy” tab, then on “List of LGM-Dairy Providers.”
LGM-Dairy is available for purchase each month (12 contracts offered per year) and each contract covers from one to ten months (Figure 4). Unfortunately, LGM-Dairy has a very short period each month when the product can be purchased. The LGM-Dairy purchase period starts at the end of the last business Friday of each month and ends at 9:00 p.m. ET the next day (Saturday), therefore, there is only about a 27-hour sign-up window every month. This makes it critical that producers work with their insurance agent in advance of the sign-up period.
Overview of LGM-Dairy
The purpose of LGM-Dairy is to provide insurance protecting a minimum IOFC. This is achieved by first establishing an expected gross margin (GM).
Expected Gross Margin (GM) = expected market value of milk minus expected feed costs
Feed usage in LGM-Dairy is expressed as corn and soybean meal (SBM) equivalents. The LGM-Dairy program allows the producer to select from a wide usage range for these two feed equivalents. The producer may choose any feed usage numbers desired, even if they do not accurately represent their farm’s actual feed usage, as long as they stay within the LGM-Dairy’s feed usage limits. If desired, producers may also convert the portion of their dairy rations that are not corn or SBM (for example, homegrown feeds like corn silage or haylage) to corn and SBM equivalents. The University of Wisconsin Understanding Dairy Markets website has software available to convert a wide variety of dairy feeds to corn and SBM equivalents.
Once expected milk production and feed usage are determined, the GM can be calculated. Expected milk, corn, and SBM prices are derived from futures prices on the Chicago Mercantile Exchange (CME) for the three commodities: Class III milk, corn, and SBM. Expected prices are the average of the last three days of futures settlement prices for each month and commodity including the sign-up Friday. So in our example (Figure 4), the expected prices would be the three-day futures settlement price averages for Class III milk, corn, and SBM on Sept. 28, 29 and 30, 2011. Fortunately, producers do not have to collect all of this information and make the calculations on their own. The University of Wisconsin website Understanding Dairy Markets has web-based software (LGM-Dairy Analyzer v. 2.0) available that provides these data and makes the necessary calculations.
Like most insurance, LGM-Dairy allows the producer to select a deductible. The higher the deductible selected the more risk the producer assumes, but the lower the premium becomes on the LGM-Dairy contract. Deductibles are available from $0.00/cwt of insured milk to $2.00/cwt of insured milk in $0.10/cwt increments (Table 1). As LGM-Dairy deductibles increase the amount of insurance premium subsidy also increases.The premium subsidy is expressed as the percentage the premium is reduced. For example, if a $0.50/cwt deductible is chosen, the premium for that covered month would be reduced by 28%. A producer must have targeted marketings in two or more months to qualify for the premium subsidy.
Once the deductible is selected it is possible to calculate the gross margin guarantee (GMG).
Gross Margin Guarantee (GMG) = GM minus deductible
The deductible is the portion of the GM you choose to leave unprotected.
The final calculation needed in the LGM-Dairy program is the actual gross margin:
Actual Gross Margin (AGM) = Actual market value of milk minus actual feed cost
The futures markets are also used to determine the actual milk, corn, and SBM prices. Very importantly the LGM-Dairy program uses no actual farm level prices, involves no futures market transactions, and no local basis is used to adjust commodity prices. Actual prices for Class III, corn, and SBM are the average CME futures settlement prices for the first, second, and third days prior to the futures contract last trading day. Let’s look at Oct. 2011: The last trading day for corn and SBM futures is Oct. 14, so the actual October corn and SBM prices will be the average futures settlement prices for Oct. 11, 12 and 13. The last trading day for Class III milk is Oct. 30, so the actual October Class III price will be the average futures settlement prices on Oct. 27, 28 and 29.
In LGM-Dairy an indemnity payment occurs when the total actual gross margin (AGMTotal) for an LGM-Dairy contract period is less than the total gross margin guarantee (GMGTotal). That is, an indemnity (payout) occurs if:
AGMTotal < GMGTotal
It is important to remember that there is only one AGMTotal and one GMGTotal per LGM-Dairy contract, thus, the contract is evaluated over the entire contract period. In other words, indemnity payments in months where the AGM is lower than the GMG may potentially be offset by other covered months where the AGM is greater than the GMG.
Next month we will conclude our discussion of LGM-Dairy by giving an example contract which will further illustrate the LGM-Dairy rules and concepts.
Table 1. LGM-Dairy insurance deductibles and premium subsidies.
Figure 1. Effect of LGM-Dairy insurance or bundled options strategy using Class III put options and corn and soybean meal call options.
Figure 2. LGM-Dairy insurance permits producer to participate in milk prices higher than specified in the LGM-Dairy policy (IOFC equals Income Over Feed Costs).
Figure 3. LGM-Dairy insurance permits producer to participate in feed prices lower than specified in the LGM-Dairy policy (IOFC equals Income Over Feed Costs).
Figure 4. LGM-Dairy insurance contract period for insurance purchased in the September, 2011 sales period.