Making Informed Crop Insurance Decisions Rochester NY June

Making Informed Crop Insurance Decisions… Rochester, NY June 18, 2002 1 Brent Gloy Cornell University

Overview of Presentation q NY Field Crop Production q Why buy crop insurance? q Crop Insurance Products q Crop Insurance Decisions q Case-Farm Break-out 2

NY Field Crop Production 3

NY Grain Production Statistics q Corn is # 1 field crop… § In total acres planted and harvested 4

NY Corn Production q Grain vs. Silage § 50% of corn acres are harvested for grain and 50% for silage 5

NY Corn for Grain Production Top 10 Corn Acre Counties q Top 10 corn counties are located in central ‘Upstate’ New York #6 #7 #8 #4 #10 #3 #5 #1 #2 #9 6

NY Corn Production Top 10 Corn Acre Counties q Top 10 NY Corn Counties § § 7 Total Corn Acres Planted 39% Total Corn Acres Harvested for Grain Total Grain Corn Production 61% % of Corn Acres Harvested for Grain Compared to State Average of 51% ü‘ 59% ü‘ ü‘ 78% ü‘ Higher % to grain

Is there a need/role for crop insurance in NYS? Some facts: q Not all corn in NYS is harvested for silage q In top counties nearly 80% harvested for grain q Value of corn for grain production in top 10 counties approaches $70 million 8

Some Corn Trivia q In 2001, Mc. Lean County IL (#1 county in U. S. ) produced 50, 180, 80 bu of corn q IL had the top 6 producing counties in the U. S. q NY state produced 56, 700, 000 bu of corn in 2001 q NY ranked 20 th in corn production in 2001 q The highest yielding county (with at least 20, 000 bu produced was Phelps County NE, South Central (194 bpa) q The top 10 counties in the U. S. produce 4% of U. S. corn production q There were 115 counties in the U. S. that produced over 20 million bushels of corn. Of these the highest average yeild was 194 bpa and the lowest was 111 bpa Nobles county MN q # of these counties by state IA = 41, IL = 35, IN = 3, KS = 1, MN = 12, ND = 1, NE = 19, TX = 1, WI = 1 q These counties produce 31% of U. S. corn q Top 4 states are IA 1. 66 bb, IL 1. 65 bb, NE 1. 1 bb, IN 884 mb and account for 54% of production 9

Why buy crop insurance? 10

Why buy crop insurance? It’s about Profit! § Profit = Total Revenue – Total Cost grain price * grain produced - input costs * inputs - other costs profit price uncertainty input price uncertainty production uncertainty § Risk = variability in profits and cash flow ü If you are committed to certain cash flows, debt service, 11 family living, etc. , how can you manage the risk of failing to achieve cash flow?

Risk Means Something to Everyone q Usually it’s different to everyone q We will view risk as a financial phenomena q Care because it has financial consequences § Ability to pay bills § Ability to maintain lifestyle § Ability to meet business goals and objectives 12

Sources of Risk On the cost side… § input price variability § unplanned input needs § liability On the revenue side… § grain price variability § grain yield variability 13 Tools to manage… § hedging § planning/maintenance § insurance/management § practices Tools to manage… § hedging/marketing § timeliness § Insurance § Management practices Crop Insurance tools… Production and/or Revenue Insurance

How prevalent are price and yield risks in NY? 14

Production Uncertainty q Uncertain yields § County average yields ranged from - 84 bu/ac to 132 bu/ac § A 40 bu/ac yield difference was observed in 2001 between Cayuga § 15 and Livingston County Farm or even field yields are much more variable! Sources: Select NY county yields: NASS county yields

Production Uncertainty q Uncertain yields § For Lewis County, yields over the past 12 year typically ranged from 75 § § 16 to 125 bu/acre 4 out of these 12 years, yields varied out-side of one standard deviation Farm or even field yields are much more variable! Sources: Cayuga county yield: NASS Cayuga county yield

Price Uncertainty q Uncertain prices are another source of risk § National average corn prices have varied around $2. 40 (’ 90 -’ 01) $2. 40 avg. Oct. Corn Dec. Futures Price 17 Source: Harvest futures price: October average daily close price of the December CBOT futures contract

The Natural Hedge q When production is down; prices go up High Prices Low Production Principles of Supply and Demand Revenue Balances 18

Harvest Price – Harvest Yield Relationship q National yields and harvest futures prices exhibit a relatively weak negative relationship § Beginning stocks and corn demand also factor into the equation § This weak relationship reflects the ‘double whammy’ of low prices and low yields in the same year! 19 Sources: Harvest futures price: October average daily close price of the December CBOT futures contract National yield: NASS US National yield

U. S. Corn Production and Harvest Futures Prices 20

NY and National Price/Yield Relationships: an Example q Cayuga County yields do not tend to follow to National Yields § NY low yields do not affect national yield averages § This increases the risk of low yields with not price response – ‘double whammy’ of low yields low prices q As a result, Cayuga County yields have a very weak relationship with National Prices § In the past 10 years, 1992, 1999, and 2000 were years of low yields and low prices 21 Low yields & low prices

Basis for Considering Crop Insurance q Grain production is relatively important in many counties q Natural hedge tends to be weak in NYS q Some variability in prices and yields q Individual producer need for insurance is also (highly) dependent upon their financial situation 22

Risk Management is an Expense High Risk (very uncertain profits) Low Risk (future profits with relative certainty) Amount of risk The trade off: reducing risk vs. the cost of risk reduction Cost of risk management 23

Crop Insurance Expense Provides a Safety Net q Crop Insurance Places a Safety Net Beneath Cash Flow § Various crop insurance products provide a safety net by paying producers § when yields or revenue falls. Protect against the down-side potential of yields and/or prices. Low Yields Low Prices Farm Revenue 24

Crop Insurance Expense Provides a Safety Net q Crop Insurance Places a Safety Net Beneath Cash Flow § Various crop insurance products provide a safety net by paying producers § when yields or revenue falls. Protect against the down-side potential of yields and/or prices. Low Prices 25 Low Yields

Crop Insurance Products 26

Crop Insurance Products and Coverage Levels High Risk (very uncertain profits) Low Risk (future profits with relative certainty) Production Risk… Price Risk… q Yield Insurance Products q Revenue Insurance Products Catastrophic Coverage (CAT) Actual Production History (APH) Indexed Income Protection (IIP) Crop Revenue Coverage (CRC) q Income Insurance Product Adjusted Gross Revenue (AGR) Coverage Levels Cost of risk management 27

What product & coverage level should grain producers choose? ü Identify cash flow needs ü Factor in risk tolerance ü Establish a cost effective safety net 28 Sounds Complicated

What product and coverage level are NY corn producers choosing? q The minimum – CAT 29

Making Informed Crop Insurance Decisions 30

Multi-Peril Insurance Products – NY Grain Crops q Corn and Soybeans § Actual Production History (APH) ü Includes: Catastrophic Coverage (CAT) § Indexed Income Insurance (IIP) § Crop Revenue Insurance (CRC) § Adjusted Gross Revenue (AGR) ü Pilot Program in select NY counties q Small Grains – Wheat, Barley, Oats, & Rye § Actual Production History (APH) ü Includes: Catastrophic Coverage (CAT) 31

Farm Insurance Products q Yield Insurance § Catastrophic Coverage (CAT) § Actual Production History (APH) q Revenue Insurance without Guarantee Increase § Indexed Income Protection (IIP) § Crop Revenue Coverage (CRC) q Income Insurance § Adjusted Gross Revenue (AGR) 32

Catastrophic Coverage (CAT) Type of product: § Basic multi-peril crop insurance product Available for the following Field Crops: § Corn § Soybean § Wheat § Barley § Oats § Rye § Flax Producer choices: § No insured unit choices § No coverage level choices Protection provided against: § Low yields Indemnity Trigger = Actual yield < 50% of APH yield NY Sales Closing Date § March 15 33

Actual Production History (APH) Type of product: § Multiple peril crop insurance product at the selected level of coverage Available for the following Field Crops: § Corn § Soybean § Wheat § Barley § Oats § Rye § Flax Producer choices: § Insured unit § Yield election: % of AHP yield § Price election: % of MPCI price Protection provided against: § Low yields Indemnity Trigger = Actual yield < Yield election*APH yield NY Sales Closing Date § March 15 34

Indexed Income Protection (IIP) Type of product: § A multiple peril crop insurance product with a revenue insurance component Available for the following Field Crops: § Corn § Soybean Producer choices: § No insured unit choice § Coverage level: % of revenue Protection provided against: § Low yields § Low prices Indemnity Trigger = Actual yield * Harvest Price < Coverage level * APH yield * Higher of HP/BP NY Sales Closing Date § March 15 35

Crop Revenue Coverage (CRC) Type of product: § A multiple peril crop insurance product with a revenue insurance component Available for the following Field Crops: § Corn § Soybean Producer choices: § Insured unit § Coverage level: % of revenue Protection provided against: § Low yields § Low prices Indemnity Trigger = Actual yield * Harvest Price < Coverage level * APH yield * Higher of HP/BP NY Sales Closing Date § March 15 36

Adjusted Gross Revenue (AGR) – Pilot Program Type of product: § Whole farm revenue insurance § Multiple commodities under Producer choices: § % of Coverage § % of Payment one insurance product Producer eligibility: § If more than 50% of § 37 expected income will be derived from a crop or combination of crops No more than 35% of expected allowable income can be from animals or animal products Protection provided against: § Low yields § Low prices NY Sales Closing Date § January 31

Practical Approaches to Making Crop Insurance Decisions 38

Making the Crop Insurance Decision q Could dedicate the rest of your life to this one decision q Let’s balance costs and returns q What do you need? q What should be considered? q What is the goal? 39

Cost of Coverage ($/acre)– Premiums Only* Cayuga County - Corn CAT § § 50% Yield 55% Price $0 APH Yield = 100 bu/acre 2002 MPCI Price = $2. 00 CRC Yield = 100 bu/acre 2002 CRC Base Price = $2. 32 55% 65% 70% 75% APH $2. 31 $2. 81 $3. 96 $5. 18 $7. 71 IIP 40 60% $2. 07 $2. 61 $3. 71 $4. 66 $6. 50 CRC IIP Yield & Base Price = CRC Base Price & Yield $3. 28 $4. 04 $5. 73 $7. 51 $11. 13 * Premium only, does not include the administrative fee

Costs versus Returns q Although not trivial the cost of these products are not overwhelming § Likely means the returns won’t be either § Should dedicate an amount of time to this decision that is appropriate q The major amount of time lost to these decisions involves trying to find the “profit maximizing” product and coverage level q The real benefit to crop insurance is not in profit maximization q The benefit is that the products can help avoid financial stress 41

Avoiding Financial Stress q If the benefit is in risk reduction let’s evaluate these products ability to reduce risk q Let’s answer these questions, “To what extent do crop insurance products… § help maintain liquidity? § help maintain solvency? § help keep future plans on track? q Then consider how much this protection costs q Let’s not waste time on whether they increase expected profitability – maybe they do but we’re not going to get rich 42

Costs of Products q Increases substantially with coverage level q Increases with the types of risk they guard against q Are difficult to evaluate from a profit standpoint without solid data q One way to examine is to look at the marginal costs of additional protection 43

Marginal Cost of Additional Coverage Levels q Marginal cost of coverage generally increases as coverage level increases q Marginal costs have fallen due to higher subsidy rates CRC APH IIP 44

Our Approach to Crop Insurance Decisions We seek to answer these fundamental questions: 1. What are the consequences if the operation experiences a revenue shortfall? 2. How likely is it that a shortfall will occur? 3. How willing is the producer to accept these risks? 4. Including their costs, how do various crop insurance products alter the likelihood of such a shortfall? 45

A Three Step Process to Answer these Questions 1. Assess cash flow and financial situation 2. Perform a sensitivity analysis on cash flow and financial situation 3. Evaluate the types of risk and protection provided by the crop insurance products 46

Information Needs q Coordinated financial statements q Crop budgets q Yield and price history and projections q Insurance product information including mechanics and premium information q Ideally in spreadsheet format – we’ll help with that 47

Practical Approach to Making Crop Insurance Decisions Assess Cash Flow Needs Goal: To determine your operation’s level of critical cash flow… Sources of Cash… § Additional borrowing § Savings § From business earnings § Others 48 Uses of Cash… § Debt service § Operating needs § Family living § Special needs § Health Insurance § Others

Assessing Critical Cash Flow q Develop a crop budget q Cost and return information are critical q So is financial information q Where to get information § Historical records § CBOT § USDA § RMA q Once a budget and pro-forma finanicals are developed can begin to assess critical cash flow 49

Build the Budget q What costs must be paid what could be put off q How much borrowing capacity is available q How willing are they to use it – retirement, expansion, etc. q Come up with a bottom line # q How likely is it that the number will be hit? q What can be done to avoid hitting the number 50

What is Critical Cash Flow q Cash flow not profitability should be first concern q Monitor things like: § Credit reserves § Liquidity § Solvency § Family living draw q Concentrate on cash flows not economic costs – for now q What is necessary and what is not 51

Practical Approach to Making Crop Insurance Decisions Perform a sensitivity on your cash flow Goal: To determine the likelihood of not achieving your critical level of cash flow The Bottom Line Low Prices 52 Low Yields

Performing a Sensitivity Analysis q Computerization is helpful, but not mandatory § Can lead to information overload § How to summarize q The key is to account for variability in prices and yields § What about covariance? q Historical data is useful but not absolutely necessary § Consider deviations from budget values § Perils of relying too heavily on historical information 53

Historical Price and Yield Information 54

An Approach to Sensitivity Analysis Construct several “scenarios” 55

An Approach to Sensitivity Analysis q Apply various yield and price combinations to the budget and pro-forma financial statements q Monitor key cash flow and financial variables q What to look for: try to isolate key variables that you need to act upon q Apply various crop insurance products 56

Practical Approach to Making Crop Insurance Decisions Examine the types of risks that crop insurance products cover Goal: To determine the appropriate crop insurance product and coverage level 57

Some Intuition on the Products q Harvest prices matter for comparing across products q CRC revenue guarantee increases with price increases q APH pays back at the MCPI price q Take a look at some alternative assumptions on ending prices q Examine the protection provided by different products and different coverage levels 58

Premiums for APH and CRC: Cayuga County 100 bpa APH Yield 59

Effect of APH on Revenue per Acre 60

Effect of APH on Revenue per Acre 61

Effect of CRC on Revenue per Acre Harvest Price = MPCI Price = 2. 00 62

Effect of CRC on Revenue per Acre Notice Guarantee Increases 63

CRC vs. APH 75% Coverage Level 64

Adding in CRC 65% 65

Things get more complicated when price assumptions change… 66

because it depends on who is paying -- market or insurance product 67

It is also possible to look at -revenue curves iso q Allows you to examine various price and yield assumptions q Contours represent areas of equal revenue q The following graphs are for return above direct costs, not just revenue q They incorporate some additional assumptions and NO Government Payments q Revenue on a per acre basis 68

No Crop Insurance 69

65% APH Insurance 70

75% APH 71

CRC 65% 72

CRC 75% 73

Case-Farm Break-out 74

The G. W. Shrub Farm q Background – the Shrub farm q Choice between APH, CRC, or no insurance q If insuring, choice of coverage level q Discussion of recommendations 75

Assignments q Task 1: Assess financial situation § Is there a need for crop insurance? q Task 2: What are key risks? § What insurance product is likely to work best q Task 3: Assess ability of insurance to protect against risk 76

Questions 77