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Livestock Gross Margin Insurance for Dairy: Pt.1                                         

Craig Thomas
Extension Dairy Educator

Introduction
Livestock Gross Margin Insurance for Dairy (LGM-Dairy) is a subsidized insurance policy that provides protection to dairy producers against the loss of gross margin (market value of milk minus feed costs) for specified portions of milk produced by their dairy cows. Livestock Gross Margin Insurance for Dairy establishes a floor (minimum) on income over feed costs (IOFC), ensuring that the gross margin will not be less than the amount specified in the LGM-Dairy policy. It is a risk management tool very similar to using a bundled options strategy (see Figure 1 on page 23). In a bundled options risk management strategy the producer uses Class III milk put options to create a milk revenue floor (minimum) and feed (corn, soybean meal) call options to establish a feed cost ceiling (maximum). The “bundling” of the put and call options allows the producer to establish an IOFC floor (minimum). The effect of LGM-Dairy and the bundled options strategy are identical (Figure 1).

Benefits of LGM-Dairy
Livestock Gross Margin Insurance for Dairy has several advantages over traditional hedging using Class III futures contracts; a bundled options strategy; or co-op sponsored forward (fixed) price contracts: 
1.  Hedging and forward contracts “lock in a milk price” and, unlike LGM-Dairy, provide no upside milk price potential;
2.  Hedging has daily margin requirements while LGM-Dairy does not;
3.  Contract size in hedging and bundled options strategies is limited to increments of 200,000 lb of milk, 5,000 bushels of corn, and 100 tons of soybean meal while LGM-Dairy has a completely flexible contract size;
4.  Cost of an LGM-Dairy policy is the policy premium, and is known before entering into the contract;
5.  The cost of insurance in an LGM-Dairy policy is much cheaper than in a similar bundled options strategy because the premium is subsidized; and,
6.  Livestock Gross Margin Insurance for Dairy does not require an established contract with a commodities broker or a milk marketing entity that offers forward price contracts. Very importantly, LGM-Dairy’s only cost is the cost of the insurance policy and the contract guarantees a minimum IOFC for covered milk production, but does not limit the producer from participation in higher milk prices (Figure 2 on page 23) and/or lower feed (corn, soybean) prices (Figure 3 on page 23).

LGM-Dairy is a program administered by the USDA’s Risk Management Agency, but LGM-Dairy policies are purchased from firms selling federal crop insurance. Crop insurance agents must be certified to sell LGM-Dairy and have an identification number on file with the Federal Crop Insurance Corporation. A list of approved agents can be obtained from a University of Wisconsin website -- http://future.aae.wisc.edu; click on the “LGM-Dairy” tab, then click on the “List of LGM-Dairy Providers.”

Livestock Gross Margin Insurance for Dairy is available for purchase each month (12 contracts/year) and each contract covers from 1 to 10 months (Figure 4 on page 23). Unfortunately, LGM-Dairy has a very short period each month when the product can be purchased. The LGM-Dairy purchase period starts at the end of the last business Friday of each month and ends at 9:00 p.m. ET the next day (Saturday); therefore, there is only about a 27-hour sign-up window every month. This makes it critical that producers work with their insurance agent in advance of the sign-up period.

Overview of LGM-Dairy
The purpose of LGM-Dairy is to provide insurance protecting a minimum IOFC. This is achieved by first establishing an expected gross margin (GM).
Expected Gross Margin (GM) = expected market value of milk minus expected feed costs.

Feed usage in LGM-Dairy is expressed as corn and soybean meal (SBM) equivalents. The LGM-Dairy program allows the producer to select from a wide usage range for these two feed equivalents. The producer may choose any feed usage numbers desired, even if they do not accurately represent their farm’s actual feed usage, as long as they stay within the LGM-Dairy’s feed usage limits. If desired, producers may also convert the portion of their dairy rations that are not corn or SBM (for example, homegrown feeds like corn silage or haylage) to corn and SBM equivalents. The University of Wisconsin “Understanding Dairy Markets” website has software available to convert a wide variety of dairy feeds to corn and SBM equivalents.

Doing the Calculations
Once expected milk production and feed usage are determined, the GM can be calculated. Expected milk, corn, and SBM prices are derived from futures prices on the Chicago Mercantile Exchange (CME) for the three commodities: Class III milk, corn, and SBM. Expected prices are the average of the last three days of futures settlement prices for each month and commodity including the sign-up Friday. In the example (Figure 4), the expected prices would be the three-day futures settlement price averages for Class III milk, corn, and SBM on Sept. 28, 29, and 30, 2011. Fortunately, producers do not have to collect this information and make the calculations on their own. The University of Wisconsin web page has a web-based software (LGM-Dairy Analyzer v. 2.0) available that provides these data and makes all the necessary calculations.

Like most insurance, LGM-Dairy allows the producer to select a deductible. The higher the deductible selected the more risk the producer assumes, but the lower the premium becomes on the LGM-Dairy contract. Deductibles are available from $0.00/cwt of insured milk to $2.00/cwt of insured milk in $0.10/cwt increments. As LGM-Dairy deductibles increase the amount of insurance premium subsidy also increases (Table 1). The premium subsidy is expressed as the percentage the premium is reduced to. For example, if a $0.50/cwt deductible is chosen, the premium for that covered month would be reduced by 28%. A producer must have targeted marketings in 2 or more months to qualify for the premium subsidy.

Once the deductible is selected it is possible to calculate the gross margin guarantee (GMG). Gross Margin Guarantee = GM minus deductible. The deductable is the portion of the GM you choose to leave unprotected. The final calculation needed in the LGM-Dairy program is the actual gross margin:
Actual Gross Margin (AGM) = Actual market value of milk minus actual feed cost.

The futures markets also are used to determine the actual milk, corn, and SBM prices. Very importantly the LGM-Dairy program uses no actual farm level prices, involves no futures market transactions, and no local basis is used to adjust commodity prices. Actual prices for Class III, corn, and SBM are the average CME futures settlement prices for the first, second, and third days prior to the futures contract last trading day. 

Let us use October, 2011as an example: The last trading day for corn and SBM futures is Oct. 14, so the actual October corn and SBM prices will be the average futures settlement prices for Oct. 11, 12, and 13. The last trading day for Class III milk is Oct. 30, so the actual October Class III price will be the average futures settlement prices on Oct. 27, 28, and 29.

In LGM-Dairy an indemnity payment occurs when the total actual gross margin (AGMTotal) for an LGM-Dairy contract period is less than the total gross margin guarantee (GMGTotal). That is, an indemnity (payout) occurs if: AGMTotal < GMGTotal.

It is important to remember that there is only one AGMTotal and one GMGTotal per LGM-Dairy contract, thus, the contract is evaluated over the entire contract period. In other words, indemnity payments in months where the AGM is less than the GMG may potentially be offset by other covered months where the AGM is greater than the GMG.

Table 1: LGM-Dairy insurance deductibles and premium subsidies.
insurance

Click image below to enlarge

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References

Gould, B. W. and V. E. Cabrera.  2011.  LGM-Dairy:  A Risk Management Tool for Small and Large Dairy Farms.  Univ. of Wis. Understanding Dairy Markets website (http://future.aae.wisc.edu/lgm-dairy/ppt_files/generic_pt1.ppt ).

Gould, B. W. and V. E. Cabrera.  2011.  LGM-Dairy Analyzer:  An Integrated Software System for Use with LGM-Dairy.  Univ. of Wis. Understanding Dairy Markets website (http://future.aae.wisc.edu/lgm-dairy/ppt_files/generic_pt2.ppt ).

Valvekar, M., V. E. Cabrera and B.W. Gould.  2008.  LGM-Dairy:  Livestock Gross Margin Insurance for Dairy, a New Risk Management Tool Available for Wisconsin Dairy Producers.  Univ. of Wis. Dairy Management White Paper.  August 2008.

United States Department of Agriculture.  2010.  Livestock Gross Margin Insurance:  Dairy Cattle.  A Risk Management Agency Fact Sheet.  Program Aid Number 2021.  June 2010.

 

 

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