MarketView…Livestock Gross Market Insurance Product and Price Forcasts

Dr. Cameron Thraen, State Extension Specialist, The Ohio State University

If you have been looking for the Ohio Dairy 2011 website and are unable to connect, this is because it is on the move.  Recent changes to the College of Food, Agriculture and Environmental Sciences (CFAES) and Agricultural, Environmental, and Development Economics (AEDE) website addresses have necessitated a new address for my Ohio dairy website.  The most reliable link to reach the dairy website is to bookmark the AEDE department’s new web address and then link to the dairy website by selecting ‘Programs and Research / Ohio Dairy Web.  The new AEDE website address is:  http://aede.osu.edu.   The direct link to Ohio Dairy Web 2011 is currently http://aede.ag.ohio-state.edu/programs/OhioDairy/  (note this direct link may change in the coming weeks).

Dairy Margin Management and the Livestock Gross Margin Insurance Product

Many of you are aware that the Livestock Gross Margin (LGM) Insurance program, after modifications to provide a premium subsidy up to 50%, exhausted all of its allocated underwriting funds with the sale of contracts at the March 2011 offering.  If this underwriting authorization is renewed, and there is an expectation that this will happen, the LGM-Dairy contracts will again be available for purchase beginning October 2011.  This product is also being put forth as an integral part of the next dairy title in the 2012 farm bill.  If you would like more information on the LGM program, you can find two papers on the Ohio Dairy website:  http://aede.ag.ohio-state.edu/programs/OhioDairy/LGM_Dairy.htm

In this edition, I will cover two topics.  First will be a review of what we know about the premiums paid, payouts, and income distribution for the LGM - Dairy Insurance product.  Second, I will review a price forecast for the coming 6 months.

A review of the LGM – Dairy program activity measures shows some interesting points. 

  1. During the 2011 insurance year, which runs from July 1, 2010 to June 30, 2011, 1,409 policies where purchased, covering 46.2 million cwt.  This represents approximately 2.4% of the total quantity of milk marketed by U.S. dairy farmers during the insurance year.
  2. The gross margin insured was $770.2 million for an equivalent of $16.66 per cwt.  The gross margin insured per cwt for the 2010 insurance year was $13.33.
  3. The total actuarial premium cost was $25 million for a per cwt cost of $0.54.
  4. The taxpayer funded subsidy on the premium cost was $10.7 million for a per cwt. subsidy of $0.23.
  5. The total indemnity paid back to LGM contract owners to date has been $58,000.  This represents $0.00125 per dollar of premium paid.  The loss ratio, total indemnity divided by total premium, equals 0.0023 or just over 0.2%.
  6. Breaking down the 2011 LGM insurance year, 48.9% of the total contracts were purchased during the months of July 2010 through January 2011.  These contracts generated 9.1 million in premiums and paid out zero in indemnity.
  7. For LGM contracts purchased at the February 2011 sales period, 28% of the total contracts were purchased, generating $9.1 million in premiums and incurring an indemnity of only $18,000.
  8. The last sales period, March 2011, sold 22.5% of the total contracts and incurred an indemnity of $40,000 on a total premium of $6.8 million.  This indemnity represents 68.9% of the total indemnity for the 2010-2011 contract year.
  9. Combining the insurance years 2010 and 2011, the total cost of the LGM-Dairy program comes to 31.5 million dollars.  Of this contract buyers premium obligation is 15.1 million, taxpayer premium subsidy is 10.7 million and taxpayer funded Administration and Overhead is 5.7 million dollars.

A review of these points leads one to ask the following question.  Where do all the premium dollars paid in go?  If I include the 2010 insurance year, the surplus was $25.4 million.  As you can see from points 3, and 5, the net premium surplus for 2011 is $24,983,000.  What happens to all of this money?  According to the LGM documents, the program is designed, from a statistical position, to pay out as indemnities exactly what is paid in by way of premiums, plus cover the expense of the subsidy.  In the current 2011 insurance year, contract buyers paid in $15 million and taxpayers kicked in $10 million.  If a gross margin calamity did occur, contract owners would be paid back the full $25 million as an indemnity, in effect transferring the taxpayer contribution of $10 million to themselves.  This is not a bad bargain by any definition.  In effect, on average, LGM contract owners bought one dollar worth of insurance for 58 cents.  Also, keep in mind that the concept of ‘actuarially fair’ applies only to the existing contracts.  The general idea is that the statistical models show that given the current slate of futures-based milk prices, feed prices, and price volatility, it could happen, over the life of the contracts, that the indemnity would reach $25 million dollars.  If that happens, then the payout equals the pay in.  If it does not happen, and the existing contracts expire without a payout, then the $25 million is kept by the insurance companies and others in the insurance game.  Each new contract starts a new game.  There is no ‘carry-over’ of premium dollars.  Remember that the 2011 gross margin insured was $770 million, so if the actual loss exceeded the $25 million paid in, then the insurance underwriters would have to dig into their pockets for the balance.

How much of this surplus $24.9 million dollars is used to pay the sellers commissions, plus some unspecified return to the owners of this LGM product, Iowa Agricultural Insurance Innovations Consortium, L.L.C. (mainly academics at Iowa State University)?  Read on for the answer.

When the LGM premium is calculated, 3% is added to the cost.  This 3% is held in reserve by the Federal Crop Insurance Agency as a contingency fund.  In addition to this fee, a 22.2% fee is charged against the actuarial premium to cover administrative and operating expenses.  For the combined 2010-2011 insurance period, this A&O amounts to $5.7 million.  Contract buyers do not pay any portion of the A&O, which is funded entirely by the taxpayer.  This money is collected by the insurance companies, their underwriters, and their reinsurers to cover the cost of doing business.  Iowa Agricultural Innovators Consortium, LLC., the creators and owners of the LGM insurance product, earn an additional return based on a percentage of the gross actuarial premium.  This fee is negotiated with the Federal Crop Insurance Board of Directors and is not disclosed.  The Iowa Agricultural Innovators, LLC likewise earns money from both contract buyers and the taxpayer.

I am supportive of the LGM contract concept; however, I do believe it is reasonable to ask substantive questions about the contract design and operation.  From our experience with LGM to date, and it is a short time span, it appears that this contract design is generating a substantial cash surplus.  The idea that over the long term premium pay-in and indemnity pay-out will just match is based on statistical computing models, and we all know that these can be wrong, sometimes very wrong.  Combining both insurance years 2010 and 2011, this premium plus subsidy equals $25,823,000.  Conceivably, there could be a disastrous turn of events, e.g. rapid rise in feed costs accompanied by a substantial fall in the Class 3 milk price, which would absorb this surplus as indemnity payouts.  As we move forward in 2011 and looking into 2012, this does not appear to be likely.  Therefore, a legitimate question can be raised.  In the event that there is no payout on the current contracts, what happens to the $25.8 million?  The answer is these dollars are kept by the insurance industry.  This is called Underwriter Gain and the $25.8 million plus the 5.7 million in A&O and fees earned by Iowa Agricultural Innovators, LLC. are retained by the insurance and underwriting companies.

Now you have a better understanding of where your LGM premium dollar goes, the taxpayer contribution to this product, and what fees are earned in providing this product.  If this product becomes part of the dairy title in the next farm legislation, you will hear much more about LGM.

Dairy Commodity and Milk Price Forecast for July 24 – December 17, 2011.

My forecast for dairy commodity prices, milk component values, and the Class 3 price is:

 

Commodity ($/lb)

 

Milk Component Values ($/lb)

 

Milk

2011 Forecast

Butter

NDM1

Cheese

Whey

 

Butterfat

Protein

Other Solids

Nonfat Solids

 

Class 3 ($/cwt)

August

1.986

1.673

1.952

0.551

 

2.218

3.372

0.365

1.493

 

19.927

September

1.917

1.669

1.901

0.530

 

2.134

3.265

0.347

1.488

 

19.208

October

1.870

1.661

1.882

0.508

 

2.069

3.251

0.323

1.480

 

18.803

November

1.829

1.652

1.849

0.490

 

2.018

3.227

0.303

1.472

 

18.444

December

1.846

1.678

1.877

0.493

 

1.985

3.157

0.292

1.460

 

18.053


1NDM = Non-fat dry milk.