AgDM newsletter article, December 2001

Gross margin insurance for hog producers

by William Edwards, extension economist, 515-294-6161, wedwards@iastate.edu

After many months of review, a revenue insurance plan for hog producers has been approved by the U.S. Department of Agriculture. The new product is called Livestock Gross Margin, (LGM). It will probably be available to producers beginning the second half of 2002.

How does LGM work?

The revenue that will be insured is actually the return over feed costs. The guarantee is based on projections for three risky variables: the price of market hogs, the price of corn, and the price of soybean meal. These are the most important determinants of gross margin that are beyond the producer's control. LGM does not provide any guarantee against production risks, such as disease or infertility.

There are several steps involved in determining the guarantee and possible indemnity payments.

By multiplying the projected gross revenue per pig in each month by the number of pigs to be marketed in that month, a total gross revenue value for the six-month period is estimated. The producer can then choose to insure from 80 percent up to 100 percent of that amount. Naturally, a higher level of coverage will result in a higher premium. The premium will also depend on how soon the hogs will be marketed. If more production will be sold early in the six-month period, the premium will be lower. This is because the risk of both hog and feed prices changing is less for the closer months.

Actual revenue

When the marketing period is over, the actual revenue will be calculated in the same manner as the guarantee. The only difference is that actual prices will be used, that is, the prices for the same contracts used to set the guarantee averaged over the last three days they are traded. If the actual revenue turns out to be less that the guaranteed value, the producer will receive a payment for the difference.

Who will benefit most from LGM? Producers who depend on the daily cash market price or a formula based on it to sell their hogs is the obvious targets. Secondly, smaller producers who do not have enough volume to practically use futures contracts can accomplish similar risk protection with LGM. Larger scale producers can buy put options on lean hog contracts and call options on corn and soybean meal contracts, but there are minimum contract sizes to deal with. LGM can be tailored to any scale of production. Plus, LGM offers a more straightforward transaction than managing multiple futures contracts.

Producers who purchase all or most of their feed will achieve the most risk reduction. Farmers who produce their own corn and soybeans have less feed cost risk (prices for soybean meal and soybeans are closely correlated), but can still benefit from reducing risk from declining hog prices.

Livestock Price Insurance Available

The USDA has approved a second insurance product for hog producers called Livestock Risk Protection (LRP). It protects against declining hog prices, only. Policies can be purchased at any time, beginning in April 2002. Coverage levels of approximately 70 to 95 percent of daily hog prices can be fixed for 90, 120, 150 or 180 into the future.