Livestock Risk Protection (LRP) insurance is a good tool to manage price risk and has been made much more attractive over the last several years through increased subsidy levels and other changes in how it operates. As a result, usage has greatly increased, and odds are high that continues.
One of the areas that producers tend to find confusing about LRP is how adjustments are made for different cattle types. This article will focus specifically on the adjustment that is made for heifers as that is one that a large number of producers are likely to encounter.
LRP coverage and indemnities are based on changes in the CME Feeder Cattle Index. The CME Feeder Cattle Index is a seven-day weighted average price for 700-900-pound Medium and Large Frame #1-2 steers in 12 major cattle-producing states.
A producer covering heavy steers will choose a coverage level when they purchase LRP and if the actual ending value for the CME index is below that coverage level on the ending date of the policy, they will receive compensation in the amount of that difference on each pound they covered.
For the sake of illustration, let’s assume a producer purchases an LRP policy with an ending date in August and an expected ending value of $250/cwt. This $250 can be thought of as the expectation for the CME index on that ending date. For simplicity, let’s further assume they purchase 100% coverage, meaning they have a coverage level of exactly $250/cwt.
If the CME Feeder Cattle Index is $240 on the ending date in August, they would receive an indemnity of $10 for every 100 lbs. covered. This is the simplest way to think about LRP and generally works if one is covering steers in the higher weight category (600-1,000 lbs.).
If this producer were instead purchasing coverage on heifers in the same heavyweight category, the relevant index would be adjusted downward by 10%. This means the expected ending value of $250 on the steers is reduced to $225 ($250 x 90%) for the heifers.
Let’s again assume 100% coverage—a coverage level of $225/cwt on the heifers. If the CME index is $240 on the ending date as it was in the previous steer scenario, that is adjusted downward by 10% for the heifers for an actual ending value of $216 ($240 x 90%). With a coverage level of $225 and an ending value of $216, the producer receives an indemnity of $9 for every 100 lbs. covered on those heifers.
LRP has a “built-in basis” on heavy heifers at 10% below the steer price. This is important because it means that the heifer adjustment moves with the market. If the CME index is $250/cwt, that heifer discount is $25/cwt, and if the CME index is $150/cwt, the heifer discount is $15/cwt.
If a cattle producer in the South was utilizing LRP, they would want to ask themselves how the prices of the cattle they plan to sell will differ from the LRP expected ending value. If they are protecting steers, that expected ending value will essentially be the market expectation of the CME index on the ending date. In the case of heifers, the expected ending value will be discounted by 10%.
This is important because it means that LRP basis can be very different for steers and heifers because of this heifer adjustment. For example, consider a producer that sells loads of both steers and heifers. Perhaps they expect their steers to sell $5 back of the CME index, which implies an expected LRP basis of -$5.
If they typically sell heifers for $15 back of steers at the same weight, this would imply a $20 heifer discount to the actual CME index. But with the 10% heifer adjustment (-$25/cwt in the previous discussion), the LRP heifer basis could actually be positive. The key point here is that steers and heifers need to be considered separately, and the producer needs to fully understand the expected ending value and coverage levels for each.
It is important to understand LRP basis because it paints a picture of the true price floor set by LRP coverage, but people can get so focused on the absolute numbers that they miss the impact of price changes. The price an individual producer receives for their cattle is irrelevant to the price floor that is set through LRP and any indemnity that is received. However, this concept works from a risk management perspective because the prices of cattle in a given location should move similar to the prices of cattle in those 12 states.
A simple way to look at LRP insurance is just to compare the expected ending value to a selected coverage level. If the expected ending value is $250/cwt, that means that I have to self-insure the first $8/cwt drop in the market if I purchase a $242 coverage level. One can think of this as an $8 deductible. And with respect to heifer coverage, one just needs to understand that the movement in the index is slightly truncated by the 90% adjustment factor. — Dr. Kenny Burdine, University of Kentucky Extension livestock marketing professor
