Cheaper Than Puts LGM-Dairy insurance could save you big bucks

January 14, 2009 06:00 PM

University of Wisconsin research shows LGM-Dairy insurance is cheaper than buying puts and calls on the futures market.
Livestock gross margin for dairy (LGM-Dairy) insurance got off to a slow start when it debuted last August, and it hasn't picked up any steam since.

Yet analysis by Brian Gould, an agricultural economist, and Victor Cabrera, a dairy scientist, both with the University of Wisconsin–Madison, shows the insurance does what it says and could cost you a fraction of locking in similar margins with put and call options on the futures market.

"Through our analysis, we've been able to get $480,000 worth of gross margin protection for a 250-cow herd for 27¢/cwt. with a $1.50 deductible,” Gould says. If you scale that up to a 750-cow herd, you could protect $1.8 million of gross margin, depending on the deductible and month, for 27¢/cwt. to 55¢/cwt.

For example, if you try buying any kind of Class III put option to floor a milk price for 27¢/cwt., that put will only protect the Class III milk price, not rising corn and soybean meal prices on the feed side. The LGM-Dairy policy does both.

"With LGM-Dairy insurance, you can lock in a gross margin and not be penalized by an upswing in a market, like you would be with forward pricing contracting through your milk plant,” says Willard Lemaster, a dairy risk management specialist with Pennsylvania's Center for Dairy Excellence.

"You don't have to worry about margin calls, strike prices or setting up hedge funds,” he adds. "And you can insure as little production as you want up to 24 million pounds of milk over a 10-month contract.

"The only thing you're out, if the actual gross margins are greater than the expected gross margins, are the premiums,” he says.

Lemaster, Gould and Cabrera all acknowledge that the premiums can be a substantial upfront cost—running from $25,000 to $30,000 or even $50,000, depending on the volume of milk you are insuring and the deductible amount that you choose. And the premiums are due at the time the policy is written.

In addition, unlike crop insurance, there are no government subsidies on the premiums (though USDA does pay an overhead/management fee to the insurance agents who offer the insurance).

Another obstacle to the program is the short time period when policies can be purchased. They're only available once a month, on the third to last business day of the month. The producer must sign the policy after market close on that day and before the market reopens at 9 a.m. CDT the following day, a window of approximately 17 hours.

LGM-Dairy policies can seem complex, at least the first few times you go through them. Coverage is available in 31 states where federally subsidized crop insurance has been traditionally offered. (Notable dairy states not covered include California, New Mexico, Oregon, Washington and much of the Southeast.)

"There are 12 insurance periods each year,” Gould explains. Each period covers 11 months, but no milk can be insured in the first month of any insurance period. The producer can insure gross margin in any or all of the remaining 10 months of the policy.

To purchase a policy, producers must provide the amount of milk in hundredweight that they intend to market in each covered calendar month and the amount of corn equivalent and soybean meal (SBM) equivalent to be fed in each month. Once these months are declared in the policy, they cannot be changed even if the actual milk production or feed amounts change during the year.

The expected gross margin is the difference between each month's milk revenue—evaluated using the futures milk price—and the value of corn and SBM equivalents using corn and SBM futures settlement prices at insurance sign-up. (The producer's actual prices are not used.) For milk and corn, the producer's state basis is used to adjust prices. SBM is not adjusted since limited data is available to determine a state basis.

The policy pays an indemnity when the actual gross margin in the 10-month insurance period is less than the total expected gross margin for the 10 months determined at the time the policy was written. The indemnities are paid as a lump sum at the end of the 11-month policy period. Premiums are tax-deductible as a business expense.

So how do you evaluate whether LGM-Dairy insurance is right for you? First, learn everything you can about the program. Gould and Cabrera have developed simulation software on their Web site to complement the USDA Risk Management Agency's (RMA) premium calculator.

To obtain RMA premium amounts, you'll first need to set up an account at the RMA Web site (follow the Dairy Today dot for easy access). Then log on to the RMA site after 4 p.m. on the day policies are available.

"It's pretty quick to do. Once your account is set up, all you need is your production per month and your feed requirement per month,” Gould says.

If the premium is acceptable, you then need to contact your insurance agent and get him or her a premium check by 9 a.m. CDT the next day. It's as simple—and difficult—as that.

2009 LGM-Dairy sign-up dates

LGM-Dairy policies are only available on the third to last business day of each month. For 2009, those dates are:

January 28
February 25
March 27
April 28
May 27
June 26
July 29
August 27
September 28
October 28
November 25
December 29

Bonus content:

Click here for frequently asked questions.

Click here for the LGM hand book.

Click here for the LGM dairy policy.

Click here for the University of Wisconsin LGM-Dairy resource site.

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