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

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

3 NY Field Crop Production

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

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

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

7 NY Corn Production Top 10 Corn Acre Counties  Top 10 NY Corn Counties  Total Corn Acres Planted39%  Total Corn Acres Harvested for Grain59%  Total Grain Corn Production61%  % of Corn Acres Harvested for Grain78% Compared to State Average of 51% ‘ ‘ ‘ ‘ Higher % to grain

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

9 Some Corn Trivia  In 2001, McLean County IL (#1 county in U.S.) produced 50,180,80 bu of corn  IL had the top 6 producing counties in the U.S.  NY state produced 56,700,000 bu of corn in 2001  NY ranked 20 th in corn production in 2001  The highest yielding county (with at least 20,000,000 bu produced was Phelps County NE, South Central (194 bpa)  The top 10 counties in the U.S. produce 4% of U.S. corn production  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  # of these counties by state IA = 41, IL = 35, IN = 3, KS = 1, MN = 12, ND = 1, NE = 19, TX = 1, WI = 1  These counties produce 31% of U.S. corn  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

10 Why buy crop insurance?

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

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

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

14 How prevalent are price and yield risks in NY?

15 Production Uncertainty  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 and Livingston County  Farm or even field yields are much more variable! Sources: Select NY county yields: NASS county yields

16 Production Uncertainty  Uncertain yields  For Lewis County, yields over the past 12 year typically ranged from 75 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

17 Price Uncertainty  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 Source: Harvest futures price: October average daily close price of the December CBOT futures contract

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

19 Harvest Price – Harvest Yield Relationship  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! Sources: Harvest futures price: October average daily close price of the December CBOT futures contract National yield: NASS US National yield

20 U.S. Corn Production and Harvest Futures Prices

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

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

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

24 Crop Insurance Expense Provides a Safety Net  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 YieldsLow Prices Farm Revenue

25 Crop Insurance Expense Provides a Safety Net  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 Crop Insurance Indemnity Payments

26 Crop Insurance Products

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

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

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

30 Making Informed Crop Insurance Decisions

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

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

33 Catastrophic Coverage (CAT) 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 Type of product:  Basic multi-peril crop insurance product

34 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 Type of product:  Multiple peril crop insurance product at the selected level of coverage Actual Production History (APH)

35 Available for the following Field Crops:  Corn  Soybean 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 Type of product:  A multiple peril crop insurance product with a revenue insurance component Indexed Income Protection (IIP) Producer choices:  No insured unit choice  Coverage level: % of revenue

36 Available for the following Field Crops:  Corn  Soybean 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 Type of product:  A multiple peril crop insurance product with a revenue insurance component Crop Revenue Coverage (CRC) Producer choices:  Insured unit  Coverage level: % of revenue

37 Producer eligibility:  If more than 50% of 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 Type of product:  Whole farm revenue insurance  Multiple commodities under one insurance product Adjusted Gross Revenue (AGR) – Pilot Program Producer choices:  % of Coverage  % of Payment

38 Practical Approaches to Making Crop Insurance Decisions

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

40 Cost of Coverage ($/acre)– Premiums Only* CAT $0 50% Yield 55% Price Cayuga County - Corn  APH Yield = 100 bu/acre  2002 MPCI Price = $2.00  CRC Yield = 100 bu/acre  2002 CRC Base Price = $2.32 IIP Yield & Base Price = CRC Base Price & Yield * Premium only, does not include the administrative fee $5.73$7.51$11.13$3.28 CRC $4.04 APH 55%65% $2.31$3.96$5.18$ %75%60% $2.81 IIP $3.71$4.66$6.50$2.07$2.61

41 Costs versus Returns  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  The major amount of time lost to these decisions involves trying to find the “profit maximizing” product and coverage level  The real benefit to crop insurance is not in profit maximization  The benefit is that the products can help avoid financial stress

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

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

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

45 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?

46 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

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

48 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 Uses of Cash…  Debt service  Operating needs  Family living  Special needs  Health Insurance  Others

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

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

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

52 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 Low Yields

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

54 Historical Price and Yield Information

55 An Approach to Sensitivity Analysis Construct several “scenarios”

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

57 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

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

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

60 Effect of APH on Revenue per Acre

61 Effect of APH on Revenue per Acre

62 Effect of CRC on Revenue per Acre Harvest Price = MPCI Price = 2.00

63 Effect of CRC on Revenue per Acre Notice Guarantee Increases

64 CRC vs. APH 75% Coverage Level

65 Adding in CRC 65%

66 Things get more complicated when price assumptions change…

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

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

69 No Crop Insurance

70 65% APH Insurance

71 75% APH

72 CRC 65%

73 CRC 75%

74 Case-Farm Break-out

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

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

77 Questions

78 APPENDIX: Crop Insurance Products

79 Insurance Product Examples  Catastrophic Coverage (CAT)  Actual Production History (APH)  Indexed Income Protection (IIP)  Crop Revenue Coverage (CRC)  Adjusted Gross Revenue (AGR) Catastrophic Coverage (CAT) YIELD PRODUCTS REVENUE PRODUCTS

80 Prices for Yield Products  Established Price  Price set by FCIC  Price Election  Coverage level chosen by the producer and applied to the FCIC price to determine the Indemnity Price  Indemnity Price  FCIC Price * Price Election FCIC Established Prices CornSoybeansWheatBarleyOatsRye $2.00$4.92$3.05$1.75$1.20$2.40

81 Catastrophic Coverage (CAT) Yield Guarantee APH Yield100 bu. Fixed Yield Election50% Fixed Price Election55% Established Price$2.00 Yield Guarantee50 bu. (100 bu. X 0.50) Indemnity Price$1.10 ($2.00 X 0.55) Corn Example:

82 Catastrophic Coverage (CAT) Indemnity Payment Yield Guarantee50 bu. Indemnity Price$1.10 ($2.00 x 55% fixed price election = $1.10) Actual Yield40 bu. Indemnity Payment$ bu. yield guarantee – 40 bu. actual yield ’ 10 bu. yield difference $1.10 per bu. indemnity price $11.00 indemnity payment Corn Example:

83  Catastrophic Coverage (CAT)  Actual Production History (APH)  Indexed Income Protection (IIP)  Crop Revenue Coverage (CRC)  Adjusted Gross Revenue (AGR) Insurance Product Examples YIELD PRODUCTS REVENUE PRODUCTS Catastrophic Coverage (CAT) Actual Production History (APH)

84 Actual Production History (APH) Yield Guarantee APH Yield100 bu. Established Price$2.00 Yield Election (chosen) 75% Price Election (chosen) 100% Yield Guarantee75 bu. (100 bu. X 0.75) Corn Example:

85 Actual Production History (APH) Indemnity Payment Yield Guarantee75 bu. Indemnity Price$2.00 ($2.00 x 100% = $2.00) Actual Yield40 bu. Indemnity Payment$ bu. yield guarantee – 40 bu. actual yield ’ 35 bu. yield difference $2.00 per bu. indemnity price $75.00 indemnity payment Corn Example:

86  Catastrophic Coverage (CAT)  Actual Production History (APH)  Indexed Income Protection (IIP)  Crop Revenue Coverage (CRC)  Adjusted Gross Revenue (AGR) Insurance Product Examples YIELD PRODUCTS REVENUE PRODUCTS Catastrophic Coverage (CAT) Actual Production History (APH) Indexed Income Protection (IIP)

87 Prices for Revenue Products  “Base” Prices  Corn CBOT – Dec. contract average in Feb.  Soybeans CBOT – Nov. contract average in Feb.  “Harvest” Prices  Corn CBOT – Dec. contract average in Nov.  Soybeans CBOT – Nov. contract average in Oct.

88 IIP Approved Yield*100 bu. Base Price$2.46 Coverage Level (chosen) 75% Price Election (chosen) 100% Revenue Guarantee$ (100 bu. x $2.46 x 0.75) Indexed Income Protection (IIP) Revenue Guarantee Corn Example: Year Avg.Diff County Avg. Yield Individual Avg. Yield *IIP Approved Yield = Expected County Yield – Yield Difference Example: 100=

89 Indexed Income Protection (IIP) Indemnity Payment Harvest Price $2.00 Actual Yield40 bu. Revenue Guarantee$ Gross Revenue$80.00 ($2.00 x 40 bu. = $80.00) Indemnity Payment$ ($ $80.00 = $104.50) Corn Example:

90  Catastrophic Coverage (CAT)  Actual Production History (APH)  Indexed Income Protection (IIP)  Crop Revenue Coverage (CRC)  Adjusted Gross Revenue (AGR) Insurance Product Examples YIELD PRODUCTS REVENUE PRODUCTS Catastrophic Coverage (CAT) Actual Production History (APH) Indexed Income Protection (IIP) Crop Revenue Coverage (CRC)

91 Crop Revenue Coverage (CRC) Harvest Price  Revenue Insurance  Pays when below revenue guarantee  Increase in crop price  Results in an increase in revenue guarantee  Increase in guarantee  Is “good” for aggressive users of forward contracts or futures contracts

92 APH Yield100 bu. Base Price$2.46 Coverage Level (chosen) 75% If prices fall below base price… Revenue guarantee (Harvest Price=$2.00 < Base Price =$2.46) $ = 100 bu. x $2.46 x 0.75 If price rises above base price… Revenue Guarantee (Harvest Price=$2.80 < Base Price =$2.46) $ = 100 bu. x $2.80 x 0.75 Crop Revenue Protection (CRC) Revenue Guarantee Corn Example:

93 Harvest Price $2.00 Actual Yield40 bu. Revenue Guarantee$ (100 bu. x $2.46 x 75% = $184.50) Gross Revenue$80.00 ($2.00 x 40 bu. = $120.00) Indemnity Payment$ ($ $80.00 = $104.50) Corn Example (price decline): Crop Revenue Protection (CRC) Indemnity Payment

94 Harvest Price $2.80 Actual Yield40 bu. Revenue Guarantee$ (100 bu. x $2.80 x 75% = $210.00) Gross Revenue$ ($2.80 x 40 bu. = $112.00) Indemnity Payment$98.00 ($ $ = $98.00) Corn Example (price increase): Crop Revenue Protection (CRC) Indemnity Payment

95  Catastrophic Coverage (CAT)  Actual Production History (APH)  Indexed Income Protection (IIP)  Crop Revenue Coverage (CRC)  Adjusted Gross Revenue (AGR) Insurance Product Examples YIELD PRODUCTS REVENUE PRODUCTS Catastrophic Coverage (CAT) Actual Production History (APH) Indexed Income Protection (IIP) Crop Revenue Coverage (CRC) Adjusted Gross Revenue (AGR)

96 Adjusted Gross Revenue (AGR) Pilot Program  Revenue Insurance  Coverage of multiple agricultural commodities under one insurance product  Uses income tax information from the producer’s agricultural operations as a basis to provide a level of guaranteed revenue for the insurance period  Provides protection against low revenue due to unavoidable causes  Loss Payments  Triggered when the adjusted gross income for the insured year is less than the loss inception point  Loss Inception Point  Calculated by averaging the approved AGR times the selected coverage level  Once a loss is triggered, the producer is paid an indemnity equal to the revenue shortfall times the payment rate

97 Adjusted Gross Revenue (AGR) Pilot Program Approved AGR$94,900* Coverage Level (chosen)80% Payment Rate (chosen)90% Inception Point$75,920 ($75,920 = $94,900 x 0.80) Farm Example: Year Income$91,500$119,00$89,000$90,000$85,000 Average$94,900 *Approved AGR = 5 year average of adjusted gross income

98 Actual AGR$21,000 Loss Inception Point$75,920 ($75,920= $94,900 x 0.80 Coverage Level) Revenue-to-count($54,920) (-$54,920 = $21,000 - $75,920) Indemnity Payment$49,428 ($49,428 = $54,920 x 0.90 Payment Rate) Adjusted Gross Revenue (AGR) Pilot Program Farm Example: