Evaluating Marketing Strategies to Complement Your Crop Insurance

By David W. Bullock, Risk
Management specialist, Minnesota Department of Agriculture, david.bullock@state.mn.us ,
651-284-3705

The sales closing date for crop insurance purchases (March 15th) has passed and most spring wheat producers have locked in their insurance coverage for the 2003 crop year. Now comes the hard part – developing and implementing a preharvest marketing plan for the upcoming crop.

As the title states, my specialty is risk management, which is more that just trying to accurately forecast what the price of wheat is going to be in late August / early September. Risk management can be simply defined as balancing the best case scenarios against the likelihood of a worst case scenario. We can think of the best case scenarios as “blue sky” and the worst case scenarios as “cloudy sky.” The objective of a risk management plan is to “capture” as much of the “blue sky” as we can while maintaining a certain level of exposure to “cloudy sky.”

So, how do we determine how much “cloudy sky” exposure to have in a risk management plan? This should be determined on an individual farm basis and is related to two basic factors: (1) the financial condition of the farming operation, and (2) the farm operator’s emotional ability to bear risk.

Financial ability to bear risk can be ascertained from the financial statements and capital/credit reserves of the farming operation.  A farm with a high debt load and low credit reserves is not in a very good position to bear risk. The opposite holds true for a farm with a low debt load and strong credit reserves.

Emotional ability to bear risk varies by personality.  Counter to popular stereotypes, the “gambler” mentality does not result in a good risk manager. A good risk manager has to have discipline and be able to keep everything in perspective. A compulsive “gambler” is more likely to make rash, emotional decisions that could prove costly in the end.

So, how does one go about putting together a risk management plan? There are five basic steps:

1) determine an “acceptable” amount of risk (or “cloudy sky”) for the farming operation using the two criteria mentioned above;

2) determine what strategies are available for managing the risk such as forward contracts, futures, options, etc.;

3) conduct a numerical risk analysis of each strategy to see if it fits within the “acceptable” level of risk and to determine how much “blue sky” value can be captured;

4) write up the results into a written, formal risk management plan; and

5) evaluate the plan as it is implemented and make notes as to how the plan performed.

In conducting a numerical risk analysis, there are three basic levels of analysis that can be done based upon the level of sophistication desired.  A “Level 1” risk analysis lays out several possible scenarios for the important variables such as yield and price. So, for example, there may be a high price scenario, a baseline price scenario, and a worst case price scenario. Each of these scenarios are implemented into a spreadsheet model to determine what the strategy payoff will be under the alternate scenarios.  The Minnesota Departement of Agriculture has a free spreadsheet model, called CropRisk 1.0, that can be downloaded from the MDA risk management website at www.mda.state.mn.us/riskmgmt .  This spreadsheet program can evaluate any combination of crop insurance and preharvest marketing strategies using up to five different price and five different yield scenarios.

A “Level 2” risk analysis extends “Level 1” by adding odds to each of the scenarios. So, for example, you may assign odds of one out of four (or 25% probability) to the low and high price scenarios and odds of two out of four (or 50% probability) to the baseline price scenario. You would then do a weighted average of the results from each scenario to get an expected outcome.  Risk can be measured by taking the odds of the worst case scenarios by their outcomes or by taking what is known as the “standard deviation” of the outcomes.

A “Level 3” risk analysis uses highly sophisticated “simulation” models and is the preferred method for most professional risk analysts.  There are several publicly available computer software packages, such as @Risk and Crystal Ball, that can be used to simulate Excel spreadsheet models.

I have developed an @Risk simulation model that can be used for analyzing crop insurance and marketing strategies for a multi-enterprise cropping operation.  This model was used by Aaron Clow and George Flaskerud in a paper analyzing crop insurance and marketing decisions for a Cass County, North Dakota wheat operation. Their paper can be downloaded from the NDSU website at www.ext.nodak.edu/homepages/aedept/ and looking under “Publications.”

Simulation Analysis of Marketing Strategies For a Polk County, MN Wheat Operation
In this article, we will apply a “Level 3” risk analysis to a hypothetical wheat operation located in western Polk County, Minnesota. The operation has planted 150 acres to hard red spring wheat.  Data on this operation was generated using the FINBIN application on the Internet.  The actual production history (APH) yield for this farming operation is 39 bushels per acre. The farm budget projects that direct expenses (ie., excluding overhead costs) will be $115 per acre for 2003.  It is assumed that the farming operation will take an LDP payment at harvest if available.  The new countercyclical payment will not be considered in the analysis, since it will not be known until well after harvest. The County Loan Rate is $2.99 per bushel and the farm has a payment limitation of $75,000.  The anticipated local basis (cash minus futures) at harvest is projected to be at $0.25 per bushel under futures.

For crop insurance coverage, we will look at the coverage options in the chart below (source: USDA-RMA online premium calculator).

Coverage	Percent Yield	Percent Price	Premium	Admin Fee
Catastrophic (CAT)	50%	55%	$0/acre	$100/crop
Actual Production History (APH)	75%	100%	$6.04/acre	$30/crop
Crop Revenue Coverage (CRC)	75%	100%	$8.11/acre	$30/crop
Revenue Assurance with Harvest Option (RAH)	75%	100%	$7.63/acre	$30/crop

For 2003 spring wheat, the maximum price election for CAT and APH is $3.15 per bushel.  For CRC and RAH, the base price is calculated as the average daily close in February for the September 2003 Minneapolis spring wheat futures. As of the time of this writing, it appears that the base price will be around $3.70 per bushel.

In our risk analysis, we will compare three different marketing strategies combined with each of the crop insurance coverages (APH, CRC, and RAH). The strategies to be examined are: (1) do nothing but hold crop insurance, (2) sell one Minneapolis September 2003 futures contract to cover approximately 70% of our anticipated production, and (3) buy one Minneapolis $3.50 (strike price) put to cover approximately 70% of our anticipated production.

As of 2/25/03, the Minneapolis September 2003 spring wheat futures was trading at approximately $3.59 per bushel. The $3.50 put option was trading at a premium of approximately 19 cents per bushel.  It will be assumed that the hedge cost (brokerage and interest) for a futures round turn is 2 cents per bushel and one cent per bushel for option round turns.

This data was incorporated into the @Risk computer model. Figure 1 below shows a summary of the simulation results for each strategy. Buying CAT coverage alone was also included in the strategy list for comparison purposes.

Figure 1. Risk-Return Profile 150-Acre Polk County Wheat Operation

The net revenue over direct costs is plotted on the y-axis while each strategy is listed on the x-axis.  The solid bar represents the average net revenue per acre for each strategy. This represents the most likely result from each strategy. The striped bar represents the total loss per acre that could occur 5 percent of the time (i.e., one out of 20 years). This is used to measure the risk for each strategy. 

So, for example, when looking at the CAT coverage only strategy, we see that the most likely return is around $24.00 per acre.  However, there is a one out of 20 chance of incurring a loss of around $26.00 per acre (before overhead costs).

For the APH coverage, the simulation results indicate that buying the put option provides the best average return; however, the risk is about $3.00 per acre higher than placing the futures hedge.  Purchasing APH coverage only, without any marketing coverage, has the highest risk of any of the strategies listed.

For those that have purchased Crop Revenue Coverage (CRC) coverage, the put option provides the best average return and doesn’t add much risk over the futures hedge. The futures hedge does nothing to improve upon the CRC only strategy.  The same comparison holds true for the Revenue Assurance with the harvest option (RAH) insurance coverage.

These results show the value of using a risk management approach to evaluating marketing and crop insurance strategies. Often, the strategy with the highest average return also has the highest risk.  This positive correlation between average return and risk is sometimes referred to as the “free lunch rule.” In other words, you cannot increase return without increasing risk.  Likewise, you cannot reduce risk without reducing expected return. It is managing this tradeoff between risk and return that encompasses what true risk management is all about.