The last twelve months is a period most of us would just as soon move past. While much attention was focused on a global pandemic, a summer of civil unrest, and a November election, USDA was revamping a livestock insurance product that can significantly bolster producers’ ability to manage risk today and for years to come.
Livestock Risk Protection (LRP) is an insurance product designed to protect against a decline in market price. First introduced in 2003, LRP protects pig farmers against declines in the CME Lean Hog Index in exchange for a premium paid by the producer. Policyholders make customizable selections to match their farm’s risk profile, including the length of the endorsement and coverage levels of an expected ending value, ranging from 70 to 100 percent.
Three rounds of program modifications approved by the Federal Crop Insurance Corporation (FCIC) over the past year have made LRP a valuable component to producers’ toolbox to manage risk. In June 2020, revisions included allowing premiums to be paid at the end of the endorsement period and an increase in premium subsidies. Moving the premium due date to after the policy ends could provide a cash flow advantage over traditional put options at the CME, which require premium costs to be in a brokerage account upfront at the time of purchase. September 2020 modifications included further additional subsidy rate increases. The net impact of these two rounds of subsidy rate increases are summarized below.
The most recent round of revisions, which went into effect in January 2021, increased head limits to 40,000 swine per endorsement and 150,000 head annually. It also lengthened the sales window from 30 to 60 days. This will allow for a larger swath of producers to use the program and allow for greater flexibility in marketing decisions than the program traditionally offered. The most recent revisions also made coverage available for unborn swine and increased the insurance endorsement lengths, extending coverage from 26 to 52 weeks in 4-week increments. These changes more closely align to how many pork producers are already managing their risk through time and ensure LRP can be used in conjunction with traditional derivatives.
LRP offers several advantages over exchange-traded futures and options products. With no minimum head limit per endorsement, the program is fully customizable and does not require units to be priced in 40,000 carcass pound increments. At times, premiums for LRP may offer a potential discount to put options due to the recently revamped subsidy levels. Over the past year, the highest coverage level of a 26-week LRP policy has averaged $1.10 less than the CIH board estimate for an equivalent level of protection. Because LRP is offered nearly every day, it also allows for the ability to protect animals against adverse price movements marketed between option expiration dates.
The past year has been tough for hog farmers to navigate. Tightening crop balance sheets, supply chain bottlenecks, and the COVID-19 pandemic introduced a spike in volatility and a reduction in profit margins. Looking at forward price curves through the end of the year, open market margins have slowly moved higher to positive levels. This is in part due to expected lighter supplies in the second half of the year, a reopening of local economies, and is a testament to strong demand for U.S. pork, both domestically and internationally. From a historical perspective, margins are above average, as you can see below. According to the data, 3rd quarter open market margins currently rank at about the 77th percentile of historical profitability over the past decade. In other words, 3rd quarter margins have been lower than they are currently trading 77 percent of the time over the past decade. Hog producers may want to engage in a flexible strategy that provides protection to lower price levels and opportunity to participate should the market move higher, such as LRP or put options.
We have created several tools to help producers navigate the LRP decision-making process. One such tool helps determine when LRP prices are more or less expensive than equivalent put options and can be viewed below. At the time of this writing, October lean hogs are trading near $79 per hundredweight. An LRP policy may be purchased to protect a coverage price of $77.11 in mid-October for a net premium of $4.42 ($6.80 minus the 35% subsidy). In this case, the premium would not be due until the end of November. An equivalent put option in the same timeframe would be valued at $5.43. This premium would be due at the time of purchase. Both strategies would provide protection on animals if the market moved below $77.11, but LRP comes at a lower cost.
The most straightforward use of LRP is for outright, at-the-money protection such as the example outlined above. It is important to note, however, that the decision to use LRP is not an either/or decision with exchange-traded instruments. Many producers have also found utility in pairing the LRP coverage as the root of more advanced futures and options strategies, such as collars and position adjustments. Producers who use LRP also have the opportunity to layer into relatively cheap coverage below where the market is currently trading. This allows for major market disruption insurance at a subsidized price level should a catastrophic event send the hog market tumbling lower.
LRP could be an excellent tool for someone who is looking to establish cash flow-friendly, cost effective coverage. Much like a put option, the endorsements establish some level of protection while maintaining opportunity to the upside should the market move higher. The sign-up process is simple and program costs are uniform across all agencies. The value the agent brings is their expertise, tools, and analysis. Contact us with any questions how LRP may fit into your risk management approach.
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