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Dairy-RP & Dairy Margin Coverage—new risk management options

Mark Stephenson, Director of Dairy Policy Analysis

Risk Management Options

Do nothing—self insure

Futures & options

Cash contract with coop or plant

Swaps

LGM-Dairy

Dairy-Revenue Protection

Dairy Margin Coverage—(Revised MPP-Dairy)

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Does Contracting Work?USDA-AMS Study

$10.00

$12.00

$14.00

$16.00

$18.00

$20.00

$22.00

Aug-9

6

Oct-9

6

Dec-9

6

Feb-

97

Apr-9

7

Jun-

97

Aug-9

7

Oct-9

7

Dec-9

7

Feb-

98

Apr-9

8

Jun-

98

Aug-9

8

Oct-9

8

Dec-9

8

Feb-

99

Apr-9

9

Jun-

99

Aug-9

9

Oct-9

9

Dec-9

9

Feb-

00

Apr-0

0

Jun-

00

Aug-0

0

Oct-0

0

Contract—Averaged $14.25

No Contract—Averaged $14.33

Futures Markets

A clearing house for information relevant to marketsBig sponge for weather, politics, general economy, production reports, etc.They are trying to find agreement at a point in time about a future value of a productThey transfer risk for hedgersThey provide profit motive for speculators to accept riskProvide price discovery for the rest of us

Futures markets will be wrong about the priceWe have no evidence that they are biasedThe closer we are to the expiration date, the more accurate a futures price is

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Futures Markets

Options provide the right to own the underlying futures contract at a specified price

Cost of option premium reflects the likelihood of having to supply the underlying contract at the specified price

If the commodity is harder to predict future prices, the option costs more

If the expiration date is further away (we are less certain about the market conditions) the option costs more

We can used options prices to calculate the future risk of a price forecast

MPP Forecast Margin

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RMA Insurance ProductsThe RMA insurance products, like LGM-Dairy or the new Dairy-Revenue Protection calculate the probability that they will have to pay an indemnity using futures and options.

You get to choose some coverage level that is less than the expected price (maybe like 70-90%). This is like your deductible.

They will calculate something like 5,000 “states of the world” based on current futures and options prices and then determine what is “actually fair,” given your coverage level, plus a small return. I.e., what is the expected value of the indemnities over all the states of the world.

Then they subsidize the premium by some amount. This is the gift from Congress.

RMA does not try to offset their risk in the futures markets.

Dairy RP OverviewDairy Revenue Protection (Dairy-RP) provides protection against an unexpected decline in revenue (price and/or yield) on the milk produced from dairy cows.

Covers the difference between your final revenue guarantee and actual milk revenue during each quarter of the year

Basket of milk price options with payment trigger also dependent on milk production level compared to a state

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Two Pricing Options

Class Pricing Option: Uses an insured’s election of a combination of Class III and Class IV milk prices as a basis for determining coverage and indemnities.

Component Pricing Option: Uses the component milk prices for butterfat, protein, and other solids as a basis for determining coverage and indemnities. The insured selects the declared butterfat test and declared protein test and the other solids test is fixed at 5.7 to establish the milk price.

Can insure using both the component pricing option and the class pricing option at the same time on separate quarterly coverage endorsement provided not covering the same milk.

Class Pricing Example

Note: Declare the Class III weight and Class IV weight is the residual

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Yield Adjustment FactorUses USDA quarterly milk production data to calculate an expected milk yield and a yield adjustment factor.

Once quarterly state-level milk production data has been announced by USDA, yield adjustment factor are calculated for policyholders.

The yield adjustment factor is determined by dividing actual milk production per cow by expected milk production per cow

Yield adjustment factors are calculated for the major 23 dairy states. Farmers outside the major 23 state are grouped into pooled production regions.

Yield Adjustment Factor (continued)

Example:Expected quarterly milk production=5,000 lb/cow

USDA publishes an actual milk per cow at 5,100 pounds

The yield adjustment factor would be 1.02 = 5,100 ÷ 5,000.

Yield adjustment factors greater than one increase the actual milk revenue and reduce any indemnity due to the dairy farmer.

Yield adjustment factor of less than one will decrease the actual milk revenue and result in a greater indemnity.

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Protection FactorMeant to “inflate” coverage to help adjust for costs, efficiency, and basis issues

Choose between 1.0 and 1.5 in 0.05 increments

Higher protection factor will increase potential indemnity and premium cost proportionally

May choose a different protection factor for each type and practice indicated on the quarterly coverage endorsement.

Final Revenue Guarantee

The final revenue guarantee is expected yield multiplied by expected price along with the coverage level selected.

Expected milk yields are based on state-level National Agricultural Statistics Service (NASS) estimates of milk production per cow in the pooled production region.

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Insurance Payment = Indemnity

Dairy-RP insures the difference between the final revenue guarantee and actual milk revenue multiplied by actual share and protection factor

Payment = [(final revenue guarantee – actual milk revenue) x protected milk quantity x protection factor] if that value is greater than zero

Actual Milk RevenueActual milk revenue calculated for class pricing option is determined by multiplying the actual Class III and Class IV prices x the declared pricing elections x covered milk production x yield adjustment factor ÷ 100 lbs.

Actual milk revenue for the component pricing options is determined by multiplying the actual butterfat, protein and other solids prices x the final component tests x covered milk production x yield adjustment factor ÷ 100 lbs.

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Quarterly CoverageThe quarterly insurance period is the three-month period starting with the quarter one-out

Can purchase up to five consecutive quarters (if they are offered)

Multiple Quarterly Coverage Endorsements can be purchased for the same quarterly insurance period

The producer can elect different coverage levels and pricing methods for each Quarterly Coverage Endorsement.

The premium is payable at the end of the Quarterly Insurance Period.

Insurance Sales Periods

Available for five consecutive quarters beginning one quarter out.

Initially available for first quarter of 2019 on October 9.

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Subsidy and Coverage Levels

Coverage Level 70% 75% 80% 85% 90% 95%

Premium Subsidy 59% 55% 55% 49% 44% 44%

Note: Beginning farmers are eligible for an additional 10% premium subsidy

Estimated Premiums as of 8/21/18

Note the component example here uses very high fat and protein levels.

Summary: $0.02-$0.16/cwt in nearby quarter; $0.18-$0.44/cwt five quarters out

Source: Marin Bozic, University of Minnesota

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Farmer Specifies

Declared covered milk production

Declared share of milk check

Expected milk production per cow

Coverage level (between 70-95%)

Protection factor (between 1.0-1.5)

Example: Producer Declarations

Declared covered milk production 1,000,000 pounds

Declared share 100%

Expected milk production per cow 5,000 lbs/cow/quarter

Coverage level 95%

Protection factor 1.10

Subsidy rate 44%

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Example: Class pricing system

Declared class price weighting factor

50%

Expected class III milk price

$18/cwt

Expected class IV milk price

$17/cwt

Example: Actual values

Actual class III milk price $15/cwt

Actual class IV milk price $16/cwt

Actual milk production per cow 5,100 lb/cow/qtr

Milk marketings 900,000

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Premium CalculationStep 1: determine the liability used to calculate premium

((expected class III price x declared class price weighting factor) + (expected class IV price x (1 – declared class price weighting factor)) x declared covered milk production/100 x coverage level x declared share x protection factor

$182,875 = ($18x0.5)+($17x(1– 0.5))x1,000,000/100x0.95x1.00x1.10

Premium Calculation: Step 2Step 2: determine the premium

Premium rate is based on the simulated losses under the class pricing option

In this example, the premium rate is $0.013 per dollar of liability

Gross premium $2,377 = $182,875 x $0.013

Subsidy $1,046 = $2,377 x 0.44

Producer premium $1,331 = $2,377 - $1.046

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Indemnity Calculation

Step 1: determine covered milk production

Determine if total milk marketings are greater than 85% of the declared covered milk production summed over all quarterly coverage endorsements for the applicable quarter

1,000,000 x 0.85 = 850,000 pounds

900,000 lbs. > 850,000 lbs. so covered milk production is 1,000,000 lbs.

Indemnity Calculation: Step 2

Step 2: calculate the final class pricing milk revenue

((expected class III price x declared class price weighting factor) + (expected class IV price x (1 – declared class price weighting factor)) x covered milk production/100

$175,000 = (($18x0.5)+($17x(1-0.5))x1,000,000/100

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Indemnity Calculation: Step 3Step 3: Calculate the final revenue guarantee for the class pricing option

Final class pricing milk revenue x your coverage level

$166,250 = $175,000 x 0.95

Indemnity Calculation: Step 4

Step 4: Calculate the yield adjustment factor

Actual milk production per cow/expected milk production per cow

1.02 = 5,100/5,000

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Indemnity Calculation: Step 5

Step 5: Calculate the class pricing actual milk revenue

((actual class III price x declared class price weighting factor) + (actual class IV price x (1 – declared class price weighting factor)) x covered milk production x yield adjustment factor/100

$158,100 = (($15 x 0.5) + ($16 x (1-0.5)) x 1,000,000 x 1.02 / 100

Indemnity Calculation: Step 6

Step 6: Calculate the indemnity on class pricing policy.

Indemnity = (final revenue guarantee – actual milk revenue) x actual share x protection factor

If the final revenue guarantee is less than the actual milk revenue, then no indemnity is due.

If the final revenue guarantee is greater than the actual milk revenue, then an indemnity is due.

In the example:

$8,965 = ($166,250 - $158,100) x 1.00 x 1.10

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In case of a lossA notice of probable loss is used to notify the insured of a probable loss approximately ten days after all Dairy Revenue Protection data applicable for the quarterly insurance period are released.

To receive an indemnity, the insured must submit a claim and include all required documents, including the milk production worksheet, within sixty days (60) days following the date the notice of probable loss is issued.

The insured should return the notice of probable loss to the AIP along with the milk production worksheet and milk marketing records.

Milk Production Worksheet

If there is a loss, then the milk production worksheet is due

The milk production worksheet must be accompanied by milk marketing records corresponding to the insured quarter from the insured dairy operation’s milk cooperative or handler that provides records of actual milk deliveries and, if applicable, component levels in the milk sold

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Purchasing Dairy-RPDairy-RP is available for purchase every business day when the coverage prices and rates are validated and published on RMA’s website.

Dairy-RP insurance must be purchased through an authorized crop insurance agent (must be livestock certified)

Can only change insurance agent annually

Producers can fill out an application at any time.

Insurance does not attach until a quarterly coverage endorsement is purchased.

Multiple quarterly coverage endorsements can be purchased with one application.

Dairy LGM and Dairy RPYou may have LGM-Dairy and Dairy-RP policies in effect for the same crop year, but only one policy, either LGM-Dairy or Dairy-RP can have endorsements in effect for the quarterly insurance period.

For example: One policy is Dairy RP and the other is a LGM-Dairy policy insuring the same milk for the quarterly insurance period, the policy with the earliest date of endorsement for the quarterly insurance period will be in force and the other endorsement will be void.

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When can Dairy RP be purchased?Every day that coverage prices and rates are published

Premiums published on USDA-RMA website after 4 pm on trade days

Premiums then good until 9 am the following day

Not traded on days when USDA Milk Production, Cold Storage, or Dairy Products reports are released

Where can Dairy RP be purchased?

Dairy-RP is available for purchase from your local livestock insurance agent.

The Agent Locator tool is on the Risk Management Agency (RMA) website at:

www.rma.usda.gov/tools/agent.html

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Class Price Cost Example 9/24/183rd quarter 2019 (Jul-Sep 2019)

1,000,000 pounds

Class III price $16.44/cwt; Class IV $16.25/cwt

50/50 weight on class prices

So calculated price is $16.345/cwt

Protection Factor

CoverageLevel

%

GuaranteePrice$/cwt

Prem.

$/cwt

Total Coverage

$

Total Prem.

$

Producer Premium

$

1.00 90 14.7105 0.1057 147,105 1,887 1,057

1.00 95 15.5278 0.2387 155,278 4,262 2,387

1.25 90 14.7105 0.1322 183,881 2,360 1,322

1.25 95 15.5278 0.2983 194,098 5,326 2,983

Component Example 9/24/183rd quarter 2019 (Jul-Sep 2019)

1,000,000 pounds

Fat price $2.6098/lb; Protein $2.0917/lb; Other $0.1941/lb

Coverage factor is 1.00 in all examples

Calculated value per cwt is $21.0081/cwt

Protection Factor

CoverageLevel

%

GuaranteePrice$/cwt

Prem.

$/cwt

TotalCoverage

$

Total Prem.

$

Producer Premium

$

3.8% fat3.1% prot

5.7% other

90 15.7571 0.1196 157,751 2,135 1,198

95 16.6325 0.2627 166,325 4,691 2,627

4.5% fat3.9% prot5.7% other

90 18.9073 0.1509 189,073 2,694 1,509

95 19.9577 0.3248 199,577 5,800 3,248

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Advantages of Dairy RPSubsidy means Dairy-RP significantly cheaper than using puts

Can account for some degree of production risk

Can tailor to class price mix or component pricing to account for some basis risk

Can get more than a year out to capture mean reverting nature of milk futures

Can use Dairy-RP simultaneously with the new DMC

Conclusions

Fits farms of all sizes and premium prices do not differ.

Dairy-RP is very customizable and may help alleviate basis risk issues

A degree of production risk is accounted for in milk/cow compared to state production

Dairy-RP should be much less expensive than individual futures and options contracts

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Dairy-RP Questions?

Dairy Margin Coverage

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The Agriculture Improvement Act of 2018

Title I contains the commodity titles which have temporary authority. They will expire at the end of a Farm Bill’s life.

Title XI contains Crop Insurance which has permanent authority and doesn’t need to be reauthorized

That’s why Dairy-RP could be introduced before a Farm Bill was passed

Margin Protection Program

Introduced in the last (2014) Farm Bill

Insurance-like programBetter aligns with the crop and other programs

Altered at the last minute in the Senate to score betterLowered feed cost calculations to account for 90 lbs of milk production—not 100Also lowered the sensitivity of when it triggersProducers were angered that the program did not provide payments when they felt payments were neededProducers paid more in premiums than were paid out in indemnities

Temporary change in 2018 to lower premiums and re-enroll

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Dairy Margin Coverage

New Name, same basic concept—based on margin between milk and feed prices

Farms must choose coverage level and pay premium—higher coverage requires higher premiums

Can only cover a percentage of historic production

Most of the parameters of the program were tweaked in some way to make it more farmer-friendly

Production History

You keep your same production history that you last had if you participated in the program

You get all of the “bumps” that were accumulated

If you didn’t participate previously, your production history will be established in the same way:

Highest annual production in 2011, 2012 or 2013

If you have a new operation since 2013, you can estimate production

If you got “caught” with a partial year’s production in 2013, there will be a means to establish a full year’s history

There will be no more “bumps” in production history

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Amount of Milk Covered

Tier 1 coverage is increased from 4 million pounds to 5 million pounds of historic production

You can elect to cover a percentage of production history from 5% to 95% (previously 25% to 90%)

New Premiums and Coverage Levels

CoverageLevelThreshold

Tier1MPP-Dairy,2016to2017

Tier1MPP-Dairy,

2018Tier2

MPP-DairyTier1DMC

Tier2DMC

QualifyingProduction 4Mlbs.orless 5Mlbs.orless above5Mlbs. 5Mlbs.orless above5Mlbs.

$4.00 $- $- $- $- $-$4.50 $0.0080 $- $0.0200 $0.0025 $0.0025$5.00 $0.0190 $- $0.0400 $0.0050 $0.0050$5.50 $0.0300 $0.0090 $0.1000 $0.0300 $0.1000$6.00 $0.0410 $0.0160 $0.1550 $0.0500 $0.3100$6.50 $0.0680 $0.0400 $0.2900 $0.0700 $0.6500$7.00 $0.1630 $0.0630 $0.8300 $0.0800 $1.1070$7.50 $0.2250 $0.0870 $1.0300 $0.0900 $1.4130$8.00 $0.4750 $0.1420 $1.3600 $0.1000 $1.8130$8.50 n.a. n.a. n.a. $0.1050 n.a.$9.00 n.a. n.a. n.a. $0.1100 n.a.$9.50 n.a. n.a. n.a. $0.1500 n.a.

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Tier 1 Comparison

$-

$0.0500

$0.1000

$0.1500

$0.2000

$0.2500

$0.3000

$0.3500

$0.4000

$0.4500

$0.5000

$4.00 $4.50 $5.00 $5.50 $6.00 $6.50 $7.00 $7.50 $8.00 $8.50 $9.00 $9.50

MPP Dairy 2014 MPP Dairy 2018 DMC

Tier 2 Comparison

$-

$0.0025 $0.005

$0.100 $0.310

$0.650

$1.107

$1.413

$1.813

$-$0.0200

$0.0400

$0.1000 $0.1550

$0.2900

$0.8300

$1.0300

$1.3600

$0.00

$0.20

$0.40

$0.60

$0.80

$1.00

$1.20

$1.40

$1.60

$1.80

$2.00

$4.00 $4.50 $5.00 $5.50 $6.00 $6.50 $7.00 $7.50 $8.00

DMC MPP-D

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Objective: Avoid Tier 2 Coverage

For farms with more than 5 million pounds of historic production, choose the percentage coverage that gets you closest to 5 million pounds.

Example: 10 million HP, choose 50% = 5 millionExample: 23 million HP, choose 20% = 4.6 million

If you have more than 100 million pounds of HP, choose 5%, but you will have to buy some Tier 2 coverage

If a farmer elects $8.00 coverage or less, then he/she mustselect the same coverage level in Tier 2

If a farmer elects $8.50 coverage or more, then he/she mayselect any different coverage level in Tier 2

Strategy

Tier 1 coverage is cheap at any level

If you are a larger farm (more then 5 million lbs PH), always pick $8.50 or above

Cover as much Tier 2 as you want at $5.00—it’s cheap catastrophic coverage

CoverageLevelThreshold

Tier1DMC

Tier2DMC

QualifyingProduction 5Mlbs.orless above5Mlbs.

$4.00 $- $-$4.50 $0.0025 $0.0025$5.00 $0.0050 $0.0050$5.50 $0.0300 $0.1000$6.00 $0.0500 $0.3100$6.50 $0.0700 $0.6500$7.00 $0.0800 $1.1070$7.50 $0.0900 $1.4130$8.00 $0.1000 $1.8130$8.50 $0.1050 n.a.$9.00 $0.1100 n.a.$9.50 $0.1500 n.a.

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Discount

Option #1: You can elect coverage each year at signup

Option #2: You can elect coverage once for the entire 5 years of the Farm Bill and receive a 25% discount on premiums

Coverage at $9.50

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$14.00

$16.00

Jan-

14

Mar

-14

May

-14

Jul-1

4

Sep-

14

Nov-

14

Jan-

15

Mar

-15

May

-15

Jul-1

5

Sep-

15

Nov-

15

Jan-

16

Mar

-16

May

-16

Jul-1

6

Sep-

16

Nov-

16

Jan-

17

Mar

-17

May

-17

Jul-1

7

Sep-

17

Nov-

17

Jan-

18

Mar

-18

May

-18

Jul-1

8

Sep-

18

Nov-

18

Historic Margin

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Historic Benefit at Different Coverage

CoverageLevel

MonthsBelow

PercentofMonthsBelow

ExpectedPayout Premia NetBenefit

NetwithDiscount

6.00$ 2 3% 0.01$ 0.050$ (0.04)$ (0.03)$6.50$ 2 3% 0.02$ 0.070$ (0.05)$ (0.03)$7.00$ 8 13% 0.06$ 0.080$ (0.02)$ 0.00$7.50$ 13 22% 0.14$ 0.090$ 0.05$ 0.07$8.00$ 19 32% 0.27$ 0.100$ 0.17$ 0.20$8.50$ 26 43% 0.47$ 0.105$ 0.36$ 0.39$9.00$ 31 52% 0.71$ 0.110$ 0.60$ 0.63$9.50$ 39 65% 1.00$ 0.150$ 0.85$ 0.89$

ForFirst5MillionPoundsofMilk

Net Benefit with Annual Choice

Threshold

5-Year Commitment with Discount

Annual Choice Using Futures

Forecast Difference6.00$ (0.105)$ (0.082)$ 0.023$ 6.50$ (0.088)$ (0.065)$ 0.023$ 7.00$ (0.048)$ (0.025)$ 0.023$ 7.50$ 0.024$ 0.046$ 0.023$ 8.00$ 0.158$ 0.180$ 0.023$ 8.50$ 0.355$ 0.378$ 0.023$ 9.00$ 0.597$ 0.606$ 0.009$ 9.50$ 0.886$ 0.863$ (0.023)$

Net Benefit per cwt.

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What Would I Do?

Sign up for 5 year coverage with discountIt’s a small benefit, but use a “set it and forget it” mentality

If I’m a small farm (less than 225 cows), buy as much production history as I can at $9.50. It’s inexpensive risk management, and it offers good coverage for all your milk production.

If I’m a medium to large sized farm, buy as much $9.50 coverage as you can and put the Tier 2 at $5.00 coverage. You will maximize your Tier 1 payments and you get low cost catastrophic coverage.

Consider your additional risk management needs with Dairy-RP, LGM-Dairy, futures or cash forward contracts.There are no restrictions with DMC and other coverages

A Couple of Other Items…

If you couldn’t take advantage of MPP last year because you had LGM coverage, the Farm Bill let’s you have a do-over.

If you paid more money into premiums under MPP than you received in indemnity payments, then you can:

Apply 75% of the difference toward DMC purchase

Receive rebate of 50% of the difference in cash

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Observations

DMC offers coverage regardless of market sentiment

Futures, options, cash forward contracts, LGM-Dairy and Dairy RP, are all tied to futures market sentiment

May not be able to get coverage you need

Requires active management of your marketing and risk management plans

Have a marketing plan in place to take the emotion out of choices

Observations

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Questions?