Introduction to Risk Management

Understanding Production Risks

Agricultural production implies an expected outcome or yield. Variability in outcomes from those that are expected poses risks to your ability to achieve financial goals.

The major sources of production risks are weather, pests, diseases, the interaction of technology with other farm and management characteristics, genetics, machinery efficiency, and the quality of inputs. Following are some risk management strategies you can consider to lower productions risks.

Diversification is an effective way of reducing income variability. It is the combining of different production processes. For instance, diversification can include different crops, combinations of crops and livestock, different end points in the same production processes. For instance, diversification can include different crops, combinations of crops and livestock, different end points in the same production process (such as different selling weights), or different types of the same crop (such as yellow, white, waxy, or high-protein corns). Diversification can also be achieved through different income sources, such as off-farm employment for smaller farms.

Effective diversification occurs when low income from one enterprise is simultaneously offset by satisfactory or high incomes from other enterprises. It typically reduces large year-to-year variations in income. However, diversification is becoming increasingly costly, as capital investment requirements become greater. Diversification can ensure adequate cash flow for meeting production costs, debt obligations, and family living needs.

Management of yield or price risk through the purchase of crop insurance transfers risk from you to others for a price which is stated as an insurance premium. Crop insurance is an example of a risk management tool that not only protects against losses but also offers the opportunity for more consistent gains. When used with a sound marketing program, crop insurance can stabilize revenues and potentially increase average annual profits.

Crop insurance provides two important benefits. It ensures a reliable level of cash flow and allows more flexibility in your marketing plans; if you can insure some part of your expected production, that level of production can be forward-priced with greater certainty, creating a more predictable level of revenue.

With the elimination of ad hoc disaster payments and deficiency payments, crop producers will no longer receive government aid during years of crop disasters or price support payments during low price years. Crop insurance provides partial replacement for the Federal safety net.

Insurance companies offer a wide variety of crop insurance protection and coverage levels. The basic Multiple-Peril Crop Insurance (MPCI) program protects against yield shortfall by providing coverage against most natural disasters. The level of protection can be selected as a percentage of your historic yield.

Crop Revenue Coverage (CRC) protects against yield and price losses. It is currently offered for corn, soybeans, grain sorghum, cotton, and wheat in selected states and counties. Its combined price and yield feature assures producers that they will earn a minimum revenue. The yield guarantee is set using each producer's Actual Production History (APH), just as it is in MPCI policies.

Group Risk Protection (GRP) is similar to the basic MPCI program, except that the yield guarantees and indemnity payments are based on county yields rather than on individual farm yields. This program is attractive to producers whose farm yields closely track county yields and where crop disasters, such as drought, affect a wide area.

Other programs are currently being offered on a pilot basis in limited geographical areas. These include Income Protection (IP) and Revenue Assurance (RA). These revenue programs offer protection against those combinations of yields and prices which are below a guaranteed minimum.

The premiums for all of these crop insurance policies are subsidized by the Federal government. Subsidies tend to benefit those producers most who invest in higher levels of coverage.

Examples of private, non-subsidized crop insurance programs include crop-hail insurance, which offers protection for one specific peril (hail), and various products that supplement federally subsidized insurance.

Part of a crop damaged by hail might be less than the deductible on an MPCI policy. In this instance, crop-hail insurance can fill the coverage gap. An MPCI policy protects against losses severe enough to significantly drop the whole farm's yield average. Crop-hail insurance, on the other hand, gives supplemental, acre-by-acre protection that more accurately reflects the actual cash value of damage from the hail.

Crop insurance is available only through private crop insurance agents. Coverage for a crop must be arranged before its sales closing date.

Catastrophic Risk Protection (CAT) is the lowest level of MPCI coverage. Premiums for the CAT portion of all crop insurance policies are fully subsidized by the Federal government, although most farmers will pay an administrative fee. Farmers with limited resources may be eligible for a waiver of the fee for CAT coverage. Any crop insurance agent can assist producers in determining if they are eligible for a fee waiver.

Crop insurance is currently available on over 76 crops. For those crops which are not insurable, or for which insurance is not available in an area, producers can apply for the Noninsured Assistance Program (NAP). NAP provides coverage roughly similar to the CAT level of crop insurance. Although NAP requires no administrative fee, it must be applied for prior to planting. Producers should file an annual acreage and production report with the local USDA Farm Service Agency (FSA) office.

Contract production is normally associated with vertical integration, where an agribusiness firm coordinates all aspects of a producer from protection to the consumer's table. Contract production is commonly in poultry and livestock production. The agribusiness firm provides feed and other inputs to the producer, who manages the grow-out process.

Through production contracts, the agribusiness firm commits the producer to deliver a specific quality and quantity of final product. The producer must comply with the firm's quality specifications and must manage yield risk with insurance and sound management practices.

Before you agree to a production contract, you need to consider the major trade-offs. A major advantage for the producer is that a market for the output and, very often, a favorable price are guaranteed. A disadvantage is that the producer loses the opportunity of benefiting from upside price potential, since the sale of the product is fixed by conditions of the contract.

The loss of the flexibility and profit opportunities is the cost of receiving a predictable cash flow. The challenge associated with contract production is to find contracts that are consistent with the producer's goals and risk tolerance.

The challenge of evaluating new technologies is best illustrated by the two newest crop technologies: genetically altered seeds and precision farming.

For instance, some seeds are being genetically altered to provide resistance to specific herbicides, with the goal of improved weed control. Other seeds are being engineered to provide resistance to diseases or insects.

Precision farming controls the rate of application of crop inputs such as seed, fertilizer, and pesticides on each acre of a field. By contrast, the conventional approach applies the same rate across an entire field. Precision farming allows yields to be measured for each acre so that output can be strictly measured against crop inputs.

As with all new technologies, farmers who adopt these new innovations try to capture a range of potential benefits, including lower input costs and environmental quality. Benefits can include higher crop yields due to improved pest control and more cost-effective use of crop inputs.

It's a Whole New Ball Game
Understanding Goals and Risk Tolerance
Understanding Production Risks
Understanding Marketing Risks
Understanding Financial Risks
Legal Issues Associated With Agriculture
Human Resources Issues