This summer, corn futures repeatedly set and broke price records — and it’s hard to say where prices ultimately will land. Soybean meal prices face a similar fate. Higher and significantly more volatile feed prices, combined with a lean-hog market that’s traded mostly sideways in a whipsaw fashion in 2008, generated $40-per-head losses for many finishing operations. Prospects of returning to profitability look bleak. So, managing risks to protect whatever opportunities might surface is important.

Traditionally, producers have managed price risks with marketing contracts or the futures market. To the extent that they can anticipate their basis risk, futures have worked well. However, many hedgers, particularly in other agricultural commodity markets, are having more difficulty maintaining their futures positions given the increased margin requirements and potentially large margin calls associated with growing market volatility.  It’s particularly problematic for short hedgers during rapid price increases. So, producers hedging market hogs by selling futures contracts and those using marketing contracts with packers (who take short positions in futures to offset their risk) may need to consider risk-management alternatives that don’t carry the possibility of large margin calls. 

Purchasing put options, in the case of short-hedging lean hogs, or call options for future corn or soybean meal purchases, can establish a minimum selling price or maximum purchase price without margin calls. However, option premiums tend to increase when market price volatility grows. As a result, they have become an expensive risk-management alternative. To reduce premium costs from buying puts or calls, you can sell other options to create either a fence or spread.  While this does recover some of the premium cost, it can establish maximum selling prices or minimum purchase prices, or remove favorable protection during large price moves.

There are new alternatives

USDA’s Risk Management Agency now offers two types of livestock insurance to give producers more hedging alternatives that do not require margin accounts or margin calls. Livestock Risk Protection insurance, available in 37 states, protects pork producers from a decline in lean-hog prices. 

Livestock Gross Margin insurance, available in 20 states, protects against declines in the hog-finishing margin or the spread between the lean-hog price, corn price and soybean meal price. You can purchase both LRP and LGM insurance through licensed crop insurance agents, and they both require only that you pay the premium cost.  There is no performance bond to post and no margin calls to pay for livestock insurance because you do not take a position in the futures market. However, the protection provided is similar to that available in the futures market, and the insurable prices are based on that market.

When you use LRP insurance, you select a lean-hog coverage price that’s based on an expected price set forth by the Risk Management Agency. That price is related to the futures price around the time that the finished hogs will be marketed.  When the policy expires and the hogs are marketed, an indemnity is paid if the CME Lean-hog Cash Index (a two-day, volume-weighted average of negotiated price and hog or pork market formula national net price) is below the insured coverage price.  You can select insurance periods of 13, 17, 21 or 26 weeks that correspond to the hog marketing date, and you can insure up to 32,000 head per crop year. (The insurance year runs from July 1 to June 30.)

LRP insurance price protection is similar to purchasing CME lean-hog put options. A floor price is established at the coverage price level selected and you retain the upside potential. Although LRP premiums are subsidized, the net cost that you pay is similar to put options, so there isn’t a cost advantage to LRP. However, it does provide the flexibility to insure any size lots (up to the program maximums).  Different from CME put options, LRP functions as a European-style option and only has value on the policy’s end date. Its value cannot be captured earlier by selling it back.

LGM: A package deal

The Livestock Gross Margin insurance alternative is worth considering given this year’s unexpected corn and soybean meal price increases. LGM creates finishing margin protection by hedging corn and soybean meal costs and the market-hog selling price as a bundled option. LGM provides insured producers an indemnity when the spread between the market-hog selling price and corn and soybean meal input prices narrow due to changing market conditions. This could be due to lean-hog prices declining or corn and soybean meal prices increasing, or some combination thereof. As the margin narrows, the insurance indemnity payment becomes larger to offset lower revenues or increased costs.

The protection that LGM offers is similar to purchasing lean-hog put options and corn and soybean meal call options.  However, an advantage to LGM is that you don’t need to decide on the options mix, the strike price or the entry date for the various option contracts. This is particularly important for small lot sizes because of futures contracts' fixed sizes. LGM policies are available for farrow-to-finish, feeder-pig finishing and wean-to-finish operations.

LGM has a six-month insurance-coverage period that lets you insure the hogs that you expect to market during the insurance period in any of the next successive six months, except the first month.  Indemnity payments are based on a gross-margin guarantee and a total-actual-gross margin. The gross-margin guarantee is the total swine feeding margin expected for the six months of hog marketings that you insure when you purchase the policy. The total-actual-gross margin is the swine feeding margin that actually occurs once the six-month coverage period ends. At the end of the six-month insurance period, an indemnity is paid if the total gross-margin guarantee exceeds the total-actual-gross margin. Thus, LGM becomes a margin-averaging tool because large losses in one month may be offset by gains in another. If that’s the case, no indemnity is paid. Furthermore, LGM generally does come at a considerable premium cost.

LGM is sold on only the second-to-last business day of each month. The sales period commences once the Risk Management Agency validates the futures price data that is used to calculate the gross-margin guarantee. The sales period ends at on the next business day. You can insure any number of hogs up to the program’s limit of 15,000 head for any six-month insurance period and there is a 30,000-head limit per crop year.

Both have a place

Both types of insurance provide useful risk protection at a time when using the futures and options market is challenging. The greatest drawback, however, is likely to be the premium cost. That, combined with the programs’ relative newness, has resulted in relatively low insurance policy sales.  For the year July 1, 2007 to June 30, 2008, the Federal State Insurance Corporation reports sales of only 174 LRP policies and 240 LGM policies. Although atypical, the loss payout ratios have been quite high this year because of market conditions.

Of course, past payout ratios are no indicator of future indemnities to be paid from these programs. For hog finishers, it’s easy to get caught on the wrong side of a volatile market, and risk-management tools need to be used to hedge against adverse price moves. LRP and LGM insurance can be used effectively, but at a cost, to protect against the large market changes that still appear on the horizon.

What Insurance Does Your State Have to Offer?