Effects of Crop Insurance and Government Payments on

Annual Financial Risk

Bruce A. BabcockCenter for Agricultural and Rural Development

www.card.iastate.edu

Presented March 8, 2005

Talk Outline

• How are option premiums determined?• Effects of hedges, puts, and insurance on

risk• How do commodity programs affect risk?• How much risk is left over to reward

management?• Discussion

Per-Bushel Cost of a Call Option on December Corn Futures (Futures price = 234.75)

0

5

10

15

20

25

220 230 240 250 260 270 280 290 300

cents/bu

cent

s/bu

Distribution of December Futures Prices as of March 7, 2005

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.10

cents/bu

prob

abili

ty

$2.30 What is the probability of a particular price outcome?

What is the option payoff if that price occurs?

Multiply the probability by the payoff at that price.

What is the strike price?

5.2% chance that price is between $1.70 and $1.80

$0.55

.045 x .55 = $0.023

Repeat for all outcomes

Determining a Put Option Premium

0.00

0.02

0.04

0.06

0.08

0.10

0.12

cents/bu

prob

abili

ty

Summing up all outcomes: $0.17 for a $2.30 put option

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.10

220 -230

210 -220

200 -210

190 -200

180 -190

170 -180

160 -170

150 -160

140 -150

< 140

Price Range

Prob

abili

ty

0

0.2

0.4

0.6

0.8

1

1.2

Opt

ion

payo

ut (c

ents

/bu)

Powesheik County Corn Yields: 1957 to 2004

0

20

40

60

80

100

120

140

160

180

200

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Year

bu/a

c

Powesheik County Soybean Yields: 1957 to 2004

0

10

20

30

40

50

60

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Year

bu/a

c

Distribution of Farm (not field) Yields for an Average Powesheik County Farmer

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

bu/ac

prob

abili

ty

Per-Acre Yield Option Premiums for Alternatve Strike Yield Amounts (Price = $2.30/bu)

0

5

10

15

20

25

30

100 110 120 130 140 150 160

bu/ac

$/ac

re

Crop Insurance Premiums for Different Coverage Levels (Price = $2.30/bu)

0

5

10

15

20

25

30

60% 65% 70% 75% 80% 85% 90% 95% 100%

Coverage level

$/ac

re

Unsubsidized Crop Insurance Premiums for Different Coverage Levels (Price = $2.30/bu)

0

5

10

15

20

25

60% 65% 70% 75% 80% 85% 90%

Coverage level

$/ac

re

"Best" Estimate atEnterprise Unit

Basic Units

Crop Insurance Premiums for Different Coverage Levels (Price = $2.30/bu)

0

5

10

15

20

25

60% 65% 70% 75% 80% 85% 90%

Coverage level

$/ac

re "Best" Estimate at Enterprise UnitBasic UnitsEnterprise units

Crop Insurance Premiums for Different Coverage Levels (Price = $2.30/bu)

0

2

4

6

8

10

12

14

16

60% 65% 70% 75% 80% 85% 90%

Coverage level

$/ac

re "Best" Estimate at Enterprise UnitProducer-Paid basic unitProducer paid enterprise unit

Distribution of Corn Harvest Revenue Less $180 Variable Cost

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution of Net Revenue Hedging 75% of Expected Production

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution of Net Revenue Hedging 75% of Expected Production

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution Hedging 75% of Expected Production with Put options

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Corn Acres Insured in Powesheik County in 2004

0

5,000

10,000

15,000

20,000

25,000

30,000

50 55 60 65 70 75 80 85

Coverage Level

Acr

es

Actual Production HistoryCrop Revenue CoverageGroup Risk Income ProtectionGroup Risk PlanRevenue Assurance

Soybean Acres Insured in Powesheik County in 2004

0

5,000

10,000

15,000

20,000

25,000

50 60 65 70 75 80 85 90

Coverage Level

Acr

es

Actual Production HistoryCrop Revenue CoverageGroup Risk Income ProtectionGroup Risk PlanRevenue Assurance

Distribution of Net Revenue with 75% Yield Insurance (APH)

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution with Yield Insurance and 75% Hedge

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution Using Yield Insurance and Put Options

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution of Net Revenue with 75% RA

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution with 75% RA-HPO

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution with 75% RA and Hedge

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

$/acre

prob

abili

ty

Distribution with 75% RA-HPO and Hedge

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

$/acre

prob

abili

ty

Structure of Program Paymentsfor Corn

Target PriceFixed Payment

Loan Rate

Counter-CyclicalPayment

Loan DeficiencyPayment

NotTiedTo

Prod

ProdReq.

$2.63

$0.28

$2.35

$1.95

RegardlessOf Market

Only If…

Distribution of Net Revenue Plus Direct Payments

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution of Net Revenue Plus LDPs

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution of Net Revenue Plus CCPs

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution with DP, LDP, CCP

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Risk Free Farming?

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Reduced Risk

• With no insurance or government programs:– Average return over variable cost = $117/ac– 5.2% probability of not covering $180 variable cost

• With all government programs and insurance:– Average returns over variable cost = $207/ac– 5.9% probability that returns are less than $117/ac

Costs of Benefits of Crop Insurance Decisions

• What product to buy?– APH, RA, RA-HPO, CRC, GRP, GRIP, GRIP-HRO

• What coverage level to buy?– CAT, 65%, 70%, 75%, 80%, 85%

• What unit structure to use? – (optional, basic, enterprise, whole-farm)

Effects of Coverage and Unit Structure on Premium

Coverage Level 65% 75% 85%

Total Premium Optional 6,749 16,594 32,478 Enterprise 4,545 12,425 24,610 Whole-Farm 2,440 10,270 21,870 Producer Premium Optional 2,767 7,452 20,136 Enterprise 1,863 5,591 15,258 Whole-Farm 1,000 4,621 13,559

Change in Expected Indemnity  65% to 75% 75% to 85% Optional 9,845 15,884 Enterprise 7,880 12,185 Whole-Farm 7,830 11,600

Change in Producer Premium Optional 4,685 12,684 Enterprise 3,728 9,667 Whole-Farm 3,621 8,938

Expected rate of return from increasing coverage

65% to 75% 75% to 85% Optional 110% 25% Enterprise 111% 26% Whole-Farm 116% 30%

Expected rate of return to changing unit structure

  Whole-Farm to Enterprise Enterprise to Optional

65% 144% 144%

75% 122% 124%

85% 61% 61%

Distribution of Returns by Unit Structure

GRIP and GRIP-HRO

• GRIP guarantee = Factor*CBOT Springtime Price*Expected

County Yield• GRIP-HRO guarantee =

Factor*CBOT Fall or Spring Price*Expected County Yield

Factor lies between 0.6 and 1.5.

Who Should Buy GRIP?

• Farmers who do not have a representative APH yield

• Farmers who are lower risk than that assumed in APH program

• Farmers with yields that are highly correlated with county yields

GRIP and GRIP-HRO in Poweshiek County

(Expected Yield = 154.9 bu/ac)

Maximum Coverage Total Producer Per Acre Premium Premium ($/acre) ($/acre) ($/acre)

GRIP $553 $32.30 $14.53 HRO $553 $47.28 $21.28

Historical Indemnities that Would Have Been Paid Out Under GRIP and GRIP-HRO in Powesheik County

0

50

100

150

200

250

$/ac

re GRIPHRO

Payoff from GRIP and GRIP-HRO

• Total payout = 6.2% of liability for GRIP and 7.6% of liability for HRO from 1975 to 2004.

• Premium rate = 5.84% of liability from GRIP and 8.55% of liability from GRIP-HRO.

• Since 1975, rate of return = 6% for GRIP and -12%% for HRO.

Subsidized rate of return for GRIP and GRIP-HRO

• 2005 Premium = $14/acre for GRIP and $21 for GRIP-HRO

• Expected Payout from 1975 to 2004: $34 for GRIP and $42 for HRO

• Expected Payout from 1957 to 2004: $27 and $39.

• Expected return = $20 or $13 per acre for GRIP, $21 or $18 per acre for HRO.

Distribution with 90% GRIP

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

Distribution with 90% GRIP-HRO

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

How Does GRIP-HRO Perform Relative to the Gold Standard?

0.00

0.02

0.04

0.06

0.08

0.10

0.12

$/acre

prob

abili

ty

RA + DP, LDP, CCPGRIP + DP, LDP, CCP

www.card.iastate.edu

• Discussion