Livestock Gross Margin Insurance for Dairy [Part 2]

Craig Thomas
Extension Dairy Educator

The first part of this series (Michigan Dairy Review, October 2011) discussed the basic concepts of Livestock Gross Margin Insurance for Dairy (LGM-Dairy) program and gave an overview of the program’s rules and regulations. This concluding part examines an LGM-Dairy example that illustrates many of the concepts introduced in Part 1.

LGM-Dairy Example
To better understand the rules of LGM-Dairy and how the program works we will consider an example. Let’s assume a producer is going to purchase a contract during the purchase period at the end of September, 2011. The Example Acres Dairy consists of 500 cows averaging 25,200 lb milk sold per cow per year. Using the LGM-Dairy Analyzer v. 2.0 software (available at the University of Wisconsin website – http://future.aae.wisc.edu), feed usage was determined to be 170.4 tons of corn equivalent and 42.6 tons of soybean meal (SBM) equivalent per month. Total monthly milk production was assumed to be evenly distributed across all 12 months with 15% of the herd dry in any 1 month. This results in a total of 8,925 hundred weights (cwts) of milk sold per month.

Let’s evaluate the Gross Margin Guarantee (GMG) for the month of November, 2011. Only 50% of targeted marketings were selected for coverage with a \$1.00/cwt deductible. Expected milk price is \$17.27/cwt, expected corn price is \$7.08/bu, and expected SBM price is \$358.90/ton. Recall:
Expected Gross Margin (GM) = expected market value of milk minus expected feed costs.

Then,
GM = (8,925 cwts milk X \$17.27/cwt X 50% covered) minus [50% covered
X ((170.4 tons corn X \$7.08/bu X 35.71 bu/ton) plus (42.6 tons SBM X \$358.90/ton))]
GM = \$77,067 - [(\$21,541) + (\$7,645)]
GM = \$47,881
Now, the GMG must be calculated:
Gross Margin Guarantee (GMG) = GM minus deductible.
In our example, we chose a deductible of \$1.00/cwt; therefore,
GMG = \$47,881 – (8,925 cwts milk X \$1.00/cwt X 50% covered)
GMG = \$47,881 - \$4,463
GMG = \$43,418.

This same process is used to calculate the GMG for each month for targeted marketings. Keep in mind that a potential indemnity payment exists when Average(AGM) < GMG; therefore, for November, 2011 a potential indemnity payment would exist if the AGMNovember, 2011 is less than \$43,418.  Also, remember that there is only one GMG and one AGM per contract because contracts are evaluated over the entire contract period. Thus, the producer would have to wait until after the actual prices are available for the last month of targeted marketings (March, 2011 in Figure 1, see page 15) to know if the AGMTotal is less than GMGTotal. In the example (Figure 1), the last month of targeted marketings will be February, 2012 and actual prices for that month will be available in March, 2012.

Alternative to Billings and Payments
Dairy producers have alternatives when it comes to premium billings and indemnity payments. In the month following the last month with targeted marketings (March, 2012 in Figure 1) the producer may choose to receive an indemnity payment if it is due. (In the example, the month following the last month with targeting marketings is March, 2012.) If the total indemnity payment is less than the total premium, the net premium payment can be made at this time and no indemnity payment is received. Even if the producer owes a net premium payment he/she may still choose to receive the indemnity payment in the month following the last month with targeted marketings (March, 2012 in Figure 1) and then wait to pay the entire premium the month following the last month in the contract period (In the example, the last month of the contract is August, 2012 and the entire premium could be paid in September, 2012 in Figure 1).

Producers must file a marketing report to receive an indemnity payment. This report must be filed within 15 days of a notice of a probable loss from their insurance agent. The marketing report also must be supported by milk sales receipts showing evidence of actual marketings in each month with targeted marketings. In the event total actual marketings are less than 75% of the total of targeted marketings for the insurance period, indemnities will be reduced by the percentage by which the total actual marketings for the insurance period fall below the total of target marketings for the period. There are no limits to milk production covered per year, but annual indemnities are limited to a maximum of 240,000 cwts.

The example contract period (Figure 1) was available for purchase beginning from about 6:00 p.m. Eastern Time (ET) on the last business Friday of September (Sept. 30) until 9:00 p.m. ET the following day (Saturday, Oct. 1). Figure 1 shows that the LGM-Dairy insurance period extends for 10 months, from November, 2011 to August, 2012. Program rules do not allow coverage in the month after purchase (i.e., October, 2011). The producer does not have to insure each of the 10 months, but can vary the coverage to the months desired and also vary the percentage of milk production covered within the months with targeted marketings. In this example, only 4 months have covered or targeted marketings (November and December, 2011; January and February, 2012). Also, in the example the covered months are covered at less than 100%.

The producer in this example chose not to cover March through August of 2012. Because LGM-Dairy contracts can be purchased every month; he could choose to purchase coverage for the months without targeted marketings in the September contract using subsequent LGM-Dairy contracts in the following month(s).

When the rules of the LGM-Dairy program were changed during the first half of 2011, allowing premium payments to be made at the end of the insurance contract period, the program became very popular. Its popularity increased even more when market conditions in the spring of 2011 made LGM-Dairy a very attractive risk management tool. The LGM-Dairy plan was allocated \$16.2 million in underwriting capacity for fiscal year 2011 (10/1/2010 to 9/30/2011) and that amount was exhausted during the March, 2011 sales period. The program resumed sales when the fiscal year 2012 began in October, 2011. With the current budget woes in the U.S. it remains to be seen how much and how long this program will be funded.

Conclusion
The LGM-Dairy program is a flexible insurance program all dairy producers should investigate. It guarantees a minimum Income Over Feed Costs by establishing a milk price floor (minimum) and feed (corn, SBM equivalents) cost ceiling (maximum). It does not require all milk production and feed usage to be insured; it allows overlapping of contracts; contracts can be purchased every month for up to 10 months into the future; and it provides substantial premium subsidies and a variable deductible. LGM-Dairy is similar to the bundled options strategy which employs milk put options and feed call options, but is much cheaper and more flexible in regards to amounts of milk and feed covered. Its major drawbacks are the short sign-up window, producers must wait for an indemnity payment for a given contract until the month following the last month with targeted marketings in that contract, and a subsidy in any given year disappears when program funds are exhausted prior to the end of a fiscal year.

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.

# The MDR is the primary communications vehicle for research findings, extension programming, and teaching between faculty and staff in MSU dairy programs and the dairy industry. The MDR web site is paid for by the C. E. Meadows Endowment.

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