Last year, USDA’s Risk Management Agency announced the emergence of a new insurance product called the Livestock Gross Margin for Dairy Cattle Insurance Policy. This relatively new insurance product is available to dairy producers in many states as a risk management tool. LGM-Dairy is now available for sale to Utah dairy producers, but many producers may have a few questions about what the LGM Dairy insurance policy is and how it works.
The Livestock Gross Margin Dairy insurance policy is an insurance product designed to protect dairy farmers from a loss of a gross margin between the revenue from milk produced and the cost of feed over the eleven-month insurance period. If purchased, LGM promises an indemnity payment to the dairy producer if the actual gross margin (difference between actual milk revenue and actual feed costs) is different than the gross margin guarantee for the insurance period. The gross margin guarantee is the expected gross margin minus a deductible, where the deductible can range from zero to $1.50 per hundredweight of milk. Thus, if the deductible is zero, the gross margin guarantee is the same as the expected gross margin.
The expected gross margin is calculated using futures prices for milk, corn, and soybean meal and state-specific basis information for milk and corn. Expected prices to be used in this calculation are published on the RMA website for each insurance period available.[i] To calculate the expected gross margin, the producer must submit a “Target Marketings” and “Target Feed” report. These are simply the quantity of milk to be sold each month and the amount of feed to be fed each month. The expected milk revenue is calculated by multiplying the expected price given for each month by the quantity of milk to be sold each month. The expected costs of feed are calculated by adding the amount of corn to be fed multiplied by the expected corn price and the amount of soybean meal to be fed multiplied by the expected soybean meal price. Other types of feed can be converted to corn and soybean meal equivalents to calculate feed costs.[ii] The expected gross margin is then calculated by subtracting the expected feed costs from the expected milk revenue. (Using the RMA-published expected prices, expected gross margin information for an example dairy marketing 1560 cwt of milk and feeding 20.5 tons of corn and 6 tons of soybean meal is shown in the associated graph).
The actual gross margin is calculated using the same target feed values used to calculate the expected gross margin. However, the actual milk marketings for each month are used instead of the expected milk marketings. The actual prices used for each month are also based on futures contract prices for milk, corn, and soybean meal and basis information for milk and corn. These prices are published by RMA along with the expected prices. The actual gross margin is calculated the same way as the expected gross margin, only using the actual prices instead of the expected prices and the actual marketings instead of the expected marketings for milk.
If the dairy producer chooses a deductible value above zero, the gross margin guarantee is calculated by subtracting the deductible amount from the expected gross margin. If the actual gross margin is less than the gross margin guarantee, the producer would receive an indemnity payment equal to that difference.
The LGM insurance policy is very similar to market options. Both use futures prices for commodities to protect the producer from losses, but do not limit the producer from benefitting from a gain. However, there are some key differences. While a producer would need to purchase both put and call options to protect against adverse changes in the prices of both milk and feed, LGM insurance bundles these together. Thus, a producer does not have to worry about everything associated with purchasing a put option for milk and separate call options for different types of feed to ensure his revenue exceeds his costs; he can purchase an LGM Dairy insurance policy that insures that difference. In addition, the producer is not bound to the fixed amounts of options, but can insure any amount of milk to better represent his actual dairy production.
LGM Dairy insurance policies can be purchased on the third to last business day of each month. To purchase an LGM policy, the producer must complete an application, including a target marketing and feed report.[iii] These, along with premium payment, must be submitted with a USDA-authorized insurance agent[iv] by the sales closing date-third to last business day-of the month for coverage to begin one month later. For example, if a farmer wanted to begin coverage in June, his application and premium payment needs to be filed with an insurance agent by the third to last business day of April. The premium is calculated using a premium calculator and based on the target marketings, expected gross margins and deductibles values. Step-by-step instructions for premium calculation are available through the RMA website.[v]
In the end, LGM Dairy insurance is another tool that dairy producers can use to manage the many risks they face. As always, it is important for each producer to determine the benefits and costs of available risk management tools and determine which tools are best for his own unique dairy. For some producers, the safety net resulting from an LGM Dairy insurance policy may provide the peace of mind needed during these volatile times.
[ii] Not all feeds can be converted to corn and soybean equivalents; hay cannot be added into the feeds costs calculation. Information on feed conversion is available in the LGM-Dairy Commodity Exchange Endorsement, page 8, which can be accessed at the following web address: http://www.rma.usda.gov/policies/2009/lgm/09lgmdairycee.pdf