Managing Farm Risks with Crop Marketing and Insurance
Article By: Silva Gaku, UW-Madison, Division of Extension
Today's agricultural producers face no shortage of uncertainty. Commodity prices can change quickly, weather conditions are increasingly unpredictable, and production costs remain high. As no single strategy can protect against all these risks, producers often benefit from using several risk management tools together. Crop insurance and crop marketing are two important tools that can complement one another and help improve income stability.
Forward Contracting
Grain marketing encompasses many different possible techniques and tools, including some fairly complex opportunities. The most commonly utilized marketing tool by producers is forward contracting. A forward contract allows producers to lock in a price for a portion of their expected production before harvest. This can help capture profitable prices and reduce exposure to falling markets or increasing local basis. Despite their effectiveness in managing price risk, forward contracts do not address production risk. If drought, flooding, or other adverse weather conditions reduce yields, producers may not have enough grain to fulfill their contracts. In these situations, they may need to buy grain to meet delivery obligations or pay contract cancellation fees.
Revenue Protection
Crop insurance does help manage the production risk. Revenue Protection (RP), the most widely used crop insurance product, protects against losses caused by lower yields, declining grain prices, or any combination of the two. The revenue guarantees within an RP policy are based on futures market prices. Thus, producers purchasing this coverage are indirectly using a grain marketing technique to establish their revenue guarantees. Additionally, farms automatically receive two pricing opportunities through an RP policy. The base price sets the dollar value of coverage using the average futures price during the February price discovery period, while the harvest price is determined using the average futures price during the harvest price discovery period. The greater of the two is used to calculate potential indemnity payments. Examples of how this product works are shown below.
Example One: Corncob Farms has an Actual Production History (APH) yield of 150 bushels per acre and purchases an 80% Revenue Protection (RP) policy. The announced base price is $4 per bushel. The guaranteed bushels are 120 (150x0.8) bushels/acre. The $4 base price provides an initial revenue guarantee of $480 per acre. Suppose a drought reduces actual production to 90 bushels per acre, and the harvest price rises to $5 per bushel. Actual crop revenue is calculated to be: $5 per bushel x 90 bushels per acre = $450 per acre. Harvest price increased, thus the RP guarantee increases to $600 per acre (120 bushels/acre x $5/bushel). Since actual revenue ($450/acre) falls below the guarantee ($600/acre), the farm receives a crop insurance indemnity of $150 per acre ($600/acre-$450/acre).
Example Two: Using the same APH yield of 150 bushels per acre and an 80% RP policy, suppose actual yield falls to 90 bushels per acre and the harvest price is $3.50 per bushel. The actual revenue is $315 per acre (90 bushels/acre x $3.50). Because the harvest price is lower than the base price of $4 per bushel, the revenue guarantee remains at $480 per acre. Since actual revenue is below the guarantee, the producer receives an indemnity payment of $165 per acre ($480-$315).
Example Three: Corncob Farms harvests 150 bushels per acre but the harvest price declines to $3 per bushel for an actual revenue of $450 per acre (150 bushels/acre x $3 per bushel). With a revenue guarantee of $480, Corncob Farms receives an indemnity payment of $30 per acre.
The examples above illustrate how crop insurance can work to manage risk. Crop insurance can also help manage production risk in certain marketing scenarios. In the examples, Corncob Farms could have forward contracted 60% of their APH yield (90 bushels/acre) and always met their delivery requirements with in-field production. The farm benefits from the contracted price while the crop insurance indemnity helps offset revenue losses resulting from lower yields or adverse price movements. However, farms must keep their marketing efforts grounded in reality or financial problems can arise. If Corncob had forward contracted 90% of APH yield (135 bushels per acre), they would have harvested insufficient grain in scenarios one and two to fully satisfy the contract obligations. As a result, the producer may face non-delivery penalties or be forced to purchase grain at prevailing market prices to fulfill the contract for the remaining 45 bushels per acre. Although crop insurance indemnity can help offset some of these costs, it may not fully eliminate the financial burden.
For this reason, producers should carefully align pre-harvest sales with their crop insurance coverage and production risk. To reduce the risk of delivery shortfalls, producers can keep initial forward contract below their crop insurance coverage level and expand marketing commitments as yield prospects become clearer during the season. This approach allows producers to capture favorable pricing opportunities while reducing the risk of contract delivery shortfalls.
RP insurance provides valuable protection against revenue losses and provides security to be able to utilize forward contracting and other grain marketing techniques, but it comes at a cost. Fortunately, producers pay only a portion of the total premium, as the federal government subsidizes a significant portion of the premium cost. Farms that are considering adding new risk management techniques are urged to work with trusted professionals (Extension educators, bankers, crop insurance providers, commodity brokers, and others) to make sure they understand the costs associated with a particular tool, as well as the full risks and opportunities involved.
Silva Gaku is the Statewide Farm Financial Management Outreach Specialist with the University of Wisconsin-Madison Division of Extension. In this role, he develops and delivers educational programs that help farmers and agricultural stakeholders strengthen financial risk management and make informed business decisions.
