All cattle producers face multiple types of risk, including sale price, due to long production periods. The average-sized herd in the U.S. was about 44 beef cows, according to the latest Census of Agriculture (2017 data). In the prior Census (2012), the national average was about 40 head. Many beef cow herds are enterprises that complement other farm resources, like grazing corn stocks and land not suitable to crop production.
In those operations, the cow herd often is a way to use labor resources year-round. Also, many cow herds are part-time, supplementing off-farm income. U.S. beef cow herds are often, in a broad sense, part of an overall risk management plan because they involve diversification of enterprises and income sources.
LRP is designed to help offset lower prices producers may receive due to market declines.
Many operations with small- and medium-sized cow herds increase their income beyond selling calves and cull cows by growing animals to yearlings. Other producers buy calves for their stocker enterprise. If close enough to population centers, some raise animals to harvest and sell beef direct to customers. Regardless, smaller scale operations face price risk that can be expensive to manage.
Livestock Risk Protection (LRP) insurance is a tool administered by the USDA’s Risk Management Agency (RMA) to help protect cattle producers from downside price risk in the cattle market. This tool is similar to other insurance products in that a premium is paid to obtain coverage against the possibility of a detrimental loss. In the case of LRP, the potential damage is a decline in cattle market prices. It is available nationwide.
LRP sells more policies for feeder cattle than those for fed cattle. In the 2020 marketing year (through June 30, 2020), there was a year-over-year increase in the number of fed cattle covered nationally, but it still only totaled 8,098 head across 62 paid policies. One reason for the low usage is fed cattle operations are typically larger and have more risk management tools available.
There appears to be potential for more LRP use by small producers. There were 393 paid policies for feeder cattle covering 79,846 head in the 2020 marketing year. That was a decline from the previous year. Producers in some states make use of LRP; others do not.
How does LRP work?
LRP is designed to help offset lower prices producers may receive due to market declines. Pragmatically, it is like buying a “put” in the futures market. For cattle contracts, LRP is a derivative of the options contracts traded on cattle futures. But it is different; it is a stand-alone insurance policy. Additionally, the LRP policy only triggers at the end of the coverage period and cannot be “exercised” sooner.
The cost of the insurance (insurance premium) is fixed at the time of purchase and is incurred no matter what happens to cattle prices after purchase. It is not intended to boost profits by “speculating.”
Compared to a futures market put option, one key advantage of LRP is that it can be purchased on as few as one head while the minimum quantity for a feeder cattle put option is 50,000 pounds. Also, LRP is sold by crop insurance agents and does not involve having a commodities brokerage account and maintaining required cash balances to cover margin requirements.
Like options prices, LRP premium rates are impacted by market volatility. The high market volatility in 2020 has resulted in sharply higher LRP premium levels. Price risk protection is more expensive when there is increased uncertainty about prices in the future. Since premiums fluctuate with market volatility, each producer’s risk preferences will impact their potential enrollment decisions.
The LRP subsidy levels were substantially increased a year ago from a constant 13 percent level.
Every business day, expected ending prices and premiums are posted to the USDA-RMA website for LRP policy periods (available at www.rma.usda.gov). These expected prices are derived from CME feeder cattle contracts. A producer would pay a premium for their chosen coverage level of the expected price.
If at the end of the policy period the index price turns out to be lower than the coverage level selected, the enrolled producer will collect an indemnity payment.
Similar to crop insurance, the federal government subsidizes a portion of the premium. Table 1 shows the LRP insurance premium subsidy levels, including recent increases. The premium is tied to coverage level (100 percent of expected price, 95 percent, etc.). Insurance at 70 percent of the expected price has a lower cost than at the 95 percent coverage level. Table 2 shows some of the details for feeder cattle.
[inline_image file=”a87105574e9be3c6b7e383ac7eb487d0.png” caption=”Table 1″]
[inline_image file=”584ea09b1dbc989a1e40bc3df2d69464.png” caption=”Table 2″]
A key point to consider, LRP does not guarantee the price for cattle at any local auction. Instead, the program is designed to protect against declines in a national feeder cattle cash price index (the Feeder Cattle Index calculated and published by the CME). That index is for feeder steers weighing 600-900 pounds.
The feeder cattle policy provides adjustment factors for cattle type and weight. For example, calves that will weigh less than 600 pounds at sale time have a 10 percent premium to the index. LRP also includes adjustment factors for heifers, Brahman, and dairy-type cattle.
A producer needs to decide the marketing date for their animals, which shows how long insurance coverage is needed. The shortest duration is 13 weeks. The producer can then review the LRP quotes to determine if a policy is being offered (typically within 30 days of when the animals are to be sold) and consider the insurance premiums (there are several options), which are per cwt. To purchase LRP, a producer needs to find a crop insurance agent that also sells LRP. RMA has an agent locator tool on their website to assist with this step.
Recent changes to LRP and “costs”
July 1, 2020, marked the beginning of a new commodity year for LRP. With the new year came two significant changes to LRP—the premium subsidy was again increased, and the premium payment due date was moved from the time of purchase to the end of the coverage period.
The new subsidy levels range from 25-35 percent of the premium cost, depending on the coverage level chosen, as shown in Table 1. The LRP subsidy levels were substantially increased a year ago from a constant 13 percent level.
A common question is how costs compare if considering buying LRP versus a put option. Before the recent subsidy changes, costs were often similar when comparing the alternatives on a per cwt basis. Consider a cost comparison from July 2, 2020, under the current subsidy structure.
LRP on feeder cattle for the standard weight class had premium quotes for an Oct. 29, 2020, end date. The highest coverage level available was $136/cwt at a full premium cost of $6.82/cwt. The subsidy (25 percent for this coverage level) would reduce the cost to $5.12/cwt. A $136 strike price October put option on the same date settled at a premium of $6.00/cwt. The option premium would not include any commission costs, which could add $0.15/cwt. Thus, the subsidy would provide a cost advantage to LRP.
Note the fixed size of option contracts may give LRP an additional cost advantage as it is purchased on a per-head level. If a producer were to market 40 head weighing 625 pounds, the cost of LRP would be $32 per head. A put option would cost $3,000 (as its size is fixed at 50,000 pounds), making the effective cost $75 per head. LRP provides some serious cost savings for this example.
It is a federal government program, as such is subject to the politics of farm bills, budget shortfalls, and government shutdowns.
Changing the time the LRP premium is payable is more subtle, but still relevant. When buying options, having to pay the premium can use a substantial amount of financial capital. Lenders are often willing to lend the necessary capital, but then interest will add to the expense. In some cases, borrowing may use valuable credit reserves.
Interest rates are generally low currently, so explicit interest expense or the opportunity cost of capital is currently low. Regardless, the change would again give a cost advantage to LRP compared to buying put options.
Some wrap-up observations
Every farm or ranch is different, and LRP will not be the best fit for every producer. There are some disadvantages, including the national index may not match up with actual prices received by producers. In particular, it may not work perfectly for calves sold weighing significantly less than 600 pounds.
It often works well for stocker operations, including those grazing fall/winter small grains (e.g., wheat) and summer-long yearlings. It also fits with finishing for harvest a few animals.
The length of insurance periods and availability have changed periodically. It is a federal government program, as such is subject to the politics of farm bills, budget shortfalls, and government shutdowns.
There are few price risk management tools available to cattle producers, especially smaller operations. But given the recent increases in LRP subsidy levels, it may be worth considering, especially for producers wanting to build in some level of protection against potential price drops given the recent ups and downs in the market.
It takes some time and effort to get the jargon of LRP, but the key point to remember is that it is an insurance policy.
