RISK MANAGEMENT

 

RISK MANAGEMENT - FARMERS

It's A Whole New Ball Game

Risk has always been a part of agriculture. But farming is a ball game that has changed dramatically over the past few years. Increasingly, farmers are learning that it is now a game with new rules, new stakes, and, most of all, new risks.

The most successful farmers are now looking at a deliberate and knowledgeable approach to risk management as a vital part of their game plan. For them, risk management means farming with confidence in a rapidly changing world. It is the ability to deal with risks that come with, attractive farming opportunities.

This handbook is part of a campaign to improve the risk management skills of farmers. The urgent need for this campaign stems from many changes in producers' business environment. In this environment, opportunities have increased, but so have the risks. Some of the more important changes affecting producers' risks includes:

A changing government role. Increasingly, government policy markers are placing greater confidence in the ability of producers to make sound business decisions. They have passed market-oriented farm legislation and crop insurance reforms that allow producers to be more active in managing their profit opportunities and risks.
Outside forces. Many factors are forcing producers to make risky, but potentially profitable, decisions regarding their businesses. These factors include increased global competition, rapid changes in the structure of production agriculture, changes in the marketing of agricultural products in the farm supply sector, new technology, and more volatile weather patterns.
Risks connections. Increasingly, decision in certain risk areas are affecting the riskiness and profitability of other aspects of farming. For instance, more lenders are now requiring sound business plans can lower borrowing costs and result in long-run financial stability. As farmers become more aware of the many such connections between their risks, the need for effective risk management will increase.

A broad array of established risk management tools are there, ready to be used. At the same time, a growing interest in agricultural risk management is encouraging the development of exciting new tools and services. By learning about and using these tools, farmers can build the confidence they need to deal with both the risks and the exciting opportunities of the future.

How To Use This Handbook

How can you better manage risk? Well, for starters, you can assess your risk management skills by conducting an annual Risk Management Checkup-one that identifies the interactions between one source of risk and another and causes you to take action.

We have identified five primary sources of risk: Production, Marketing, Finance, Legal and Human Resources.

Since risk management should be driven by your goals, this handbook first reviews goal setting and risk tolerance. Succeeding chapters will then give you insights into the benefits of improved risk management in each specific area. As you review these chapters, look for instance of the connections between the various areas of risk. Also, consider questions to ask yourself or the professionals whose help you may need.

Remember, you are not competing by yourself. You have a whole team of professional players prepared to help you win. Who are your teammates? They are grain elevator operators, commodity brokers, crop insurance agents, loan officers, extension educators, commodity organisations, cooperatives, lawyers, accountants, and the people in local government offices.

Your teammates are currently mastering new skills, identifying new opportunities, and learning how to play as a team. Remember, it's a new ball game for them, too. But, each of them has unique strengths, skills, and experiences. The most effective way for you to use them is to make them part of your team. Share your game plan with them. Then, use their strengths to help your plan succeed.

Start now to think about risk management as a key element of the new ball game of agriculture-a game that you can win. Learn the fundamentals, use your teammates, then act on what you learn. Make risk management an important part of your game plan!

UNDERSTANDING GOALS AND RISK TOLERANCE

While no two people share the same goals in life, all of the people involved in a family business must share some common goals. Identifying those shared goals, involving everyone in the goal-setting process, and then acting together to achieve those goals should be a serious effect that focuses both the individual and the organisation. After all, a family business cannot be successful it if does not help fulfil the individual dreams of everyone involved.

Many times, the hardest thing about setting risk management goals is reconciling different views about risk. People have different answers for the same fundamental questions.....What are my risks? What are our risks? What is an acceptable level of risk? What should we do about the risks? Recognizing and acting on opportunities as well as trying to minimize losses can help shape agreement on fundamental risk management goals.

Benefits of Goal Setting

Reflects your values, interests, resources and capabilities. An honest goal-setting session for yourself, your family, and your business will cause you to take inventory of those things.
Provides a basis for your decisions and a focal point for everyone involved. Well-understood organisational goals allows every individual in the organisation to set realistic personal goals.
Establishes priorities for the allocation of scarce resources. What things will you do today and what things will you do in the future? For example, what priorities have you established for using net farm income? Buy land, pay for education, pay down debt?
Provides a means for measuring progress. Which decisions made progress towards your goal and which decisions need to be re-evaluated?

Some Questions for Your Risk Management Check-Up

Are my goals written, reasonable and measurable?
Are my goals attainable in my lifetime?
Have I shared my goals with everyone involved in the business and have they shared their goals with me?


What is Your Risk Tolerance?

Your risk tolerance is reflected in the ways you choose to manage risks. Understanding your choices and considering each of them may cause you to change your management style to more closely reflect your tolerance for risk.

Risks can be handled in one of five ways, or in certain combinations of the five:
1. Retain-With no protection from downside risk, as in holding an unpriced commodity.
2. Shift-A contractural arrangement where someone else takes on some of the chance of a negative occurrence in exchange for a premium. The more risk you shift, the higher the cost.
3. Reduce-Keeping fences in good repair to keep livestock off the highway and a marketing plan that locks in some level of guaranteed return are examples of reducing risk.
4. Self-insure-Emergency reserves funded from previous years'profits.
5. Avoid-Not selecting a particular enterprise...not pushing either end of planting windows...not increasing your debt-to-asset ratio beyond your comfort level.

Any risk must be evaluated for its frequency of occurrence and its possible negative consequences. As a general rule, formal insurance strategies are available for risks with low occurrences but with severe negative consequences. Examples include disability insurance, health insurance, crop insurance and life insurance.

Benefits of Identifying Your Risk Tolerance and Assessing Your Risks

Allow you to identify and exclude those alternatives that expose you to unacceptable risk.
Help guide providers of risk management services to the best options for you.
Ensure that your insurance dollars will be spent wisely.
Increase the likelihood that you will select the best combination of risk management strategies.

Some Questions for Your Risk Management Check-Up

Have I identified my risk tolerance?
Have I communicated my tolerance for risk to the professionals who provide me with risk management services?
Which risks can keep me from attaining my goals?
Which risks am I comfortable retaining and managing with my own resources? Which risks will I shift to others? Which will I avoid? 
When was my last insurance check-up for health, life casualty, property, disability, long-term care, medicare and crop insurance?
Have I established a confident relationship with my risk management advisers so that they can help me assess my business and personal risk exposure?

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 source 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.

Enterprise Diversification

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 or different types of the same crop. 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.

Some Questions for Your Risk Management Check-Up

Where are the new markets?
What is the income relationship between a prospective new enterprise and my existing enterprise(s)? Will the new enterprise provide effective diversification?

Crop Insurance (developed countries, mainly U.S.)

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 programme, crop insurance can stabilise 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) programme 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 countries. Its combined price and yield features 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 programme, except that the yield guarantees and indemnity payments are based on country yields rather than on individual farm yields. This programme is attractive to producers whose farm yields closely track country yields and where crop disasters, such as drought, affect a wide area.

Other programmes are currently being offered on a pilot basis in limited geographical areas. These include Income Protection (IP) and Revenue Assurance (RA). These revenue programmes 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 subsidised by the Federal Government. Subsidies tend to benefit those producers most who invest in higher levels of coverage.

Example of private, non-subsidised crop insurance programmes include crop-hail insurance, which offers protection for one specific peril (hail), and various products that supplement federally subsidised 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 he 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 CAP portion of all crop insurance policies are fully subsidised by some governments, 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 Programme (NAP). NAP provides coverage roughly similar to the CAT level of crop insurance. Although NPA requires no administrative fee, it must be applied for prior to planing. Producers must file an annual acreage and production report with the local Farm Service Agency (FSA) office.

Some Questions for Your Risk Management Check-Up

How much coverage do I need for adequate cash flow?
Which crop insurance product will best compliment my marketing plan?
What are the implications of a crop loss on my ability to meet my debt obligations?
What are the major sources of production risk and what type of crop insurance coverage do I need to protect against those risks?
What are the costs of the various types of coverage and which offers the best protection for the level of coverage I need?

Contract Production

Contract production is normally associated with vertical integration, where an agribusiness firm co-ordinates 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 favourable 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 producers goals and risk tolerance.

Some Questions for Your Risk Management Check-Up

Which benefits will a production contract provide?
What flexibility will I give up?
Do I understand the conditions of the contract? Do I need legal advice?

Evaluating New Technologies

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.





Some Questions for Your Risk Management Check-Up

What are the economic trade-offs between more aggressive pest control and minimal control?
Are my pest management strategies consistent with my management philosophy a bout environmental quality?
Will more intensive monitoring of pests be an economical strategy?


Some More Questions for Your Risk Management Check-Up

What is the economic benefit of adopting new technology? 
You should compare each aspect of the new technology with the current technology to determine the desirability of adoption. For example, consider the evaluation of costs and benefits for corn seed that is resistant to the European corn borer. For this, you must estimate the probability of infestation by corn borers in a particular year, the cost and effectiveness of chemical treatment for borers, and the change in field scouting costs.

These costs must be weighed against the additional $25 or $30 per bushel for borer-resistant seed and any increase or decrease in yield associated with the new seed.

Does the adoption of a new technology reduce my risk?
New technology can provide only a narrow "insurance policy" if it protects against only one pest. Other insects, diseases, and weather conditions will influence yield, too.

Would it be more profitable to manage risk by purchasing seed that is resistant to a specific pest or by diversifying production over several crops?
For instance, would diversification encourage the spread of natural predators of the corn borer?....Or would it give the borer sanctuary?

UNDERSTANDING MARKETING RISKS

Marketing is that part of your business that transforms production activities into financial success.

Unanticipated forces, such as weather or government action, can lead to dramatic changes in crop and livestock prices. As agriculture moves towards a more global market, these forces stem increasingly from world factors. Other farmers' weather and other governments can affect your prices. When these forces are understood, they can become important considerations for the skilled marketer.

To be successful, you should take an informed and balanced approach to making marketing decisions. Focus on long-term profitability, not short-term windfalls. Academic studies indicate that marketing strategies that depend on price chasing or speculation have not been shown to be consistently profitable. Also, those strategies that do not consider financial and production risks will likely prove to be poor.

Personal Considerations in Marketing

Marketing agricultural products involves information, objectivity, attitude, and skill. You should develop marketing plans and strategies that work for you. Here are three important considerations in developing a marketing plan:

1. Know what level of risk you are comfortable with.

Inability to control market forces and difficulty in predicting those forces make marketing an inexact science. A better understanding of your financial situation and the possible consequences of your decisions will remove some of the uncertainty marketing decisions. Obviously, marketing involves understanding your level of risk tolerance. It also involves a good understanding of your current financial position.

2. Be willing to increase the number of skills in your marketing toolbox. You may need to pay for professional help in developing your marketing plan.

Successful marketers are continually updating their abilities by learning new skills. Such efforts should be undertaken without the exception of an immediate payoff. There are many professionals who can help you. These include future brokers, elevator operators, financial planners and farm consultants.



3. Develop an integrated management approach to your business.

Marketing decisions should not be made independent of other farm business decisions. They should be planned according to the impact they will have on the production, financial, legal and human resource aspects of your business. Marketing decisions often involve contractual agreements that have important legal consequences. These contracts can significantly affect financial plans.

Some Questions for Your Risk Management Check-Up

* Am I financially able to "shoot for the top price" and withstand the potential downside consequences of missing it?
* Can I afford to store a crop, hoping the price will increase, or are my cash flow needs such that I must sell directly at harvest?
* Will my lender understand my plan and help me achieve my goals?
* When cattle prices are moving downward, am I financially able to retain ownership of feeder calves and sell them at higher weights later?
* What are the potential costs and returns associated with alternative strategies?
* Should I seek professional marketing services?
* Would a 'marketing club' fit my need for current information and help in developing a marketing plan?

Developing a Marketing Plan

Managing marketing risk begins with a marketing plan. The goals and objectives of your business should drive the marketing plan.

An accurate understanding of production costs is a critical part of a sound marketing plan...for you and the professionals who work for you. There may be times when the market price fails to cover all of the costs associated with production. A break-even price should serve as an important reference, even though it is not usually your desired prices.

An analysis of supply and demand is important in developing targets for your marketing plan. Supply and demand projections are published by many Departments of Agriculture and by private firms. Early in the growing season, expectations are highly uncertain. However, commodity markets respond decisively to these projections, so you should be aware of them.




You should also be aware of prices received in your area and know the average prices received in previous years. Again, you have a choice of learning these skills and monitoring this information yourself, or hiring a professional to help you.

Financial considerations such as cash flow requirements, including family living needs, should be incorporated in your marketing plan. Financial circumstances and other personal factors help determine your ability and willingness to tolerate market risks. Marketing plans should be as unique as the financial, production, and management characteristics of each individual producer. What works well for a neighbor may not be appropriate for you and your family.

Some Questions for Your Risk Management Check-Up

* Does my marketing plan cover the entire calendar or crop year?
* Are all crop and livestock enterprises covered in my plan?
* Have I checked my marketing plan against my financial plan to make sure that income from marketing covers cash-flow needs?
* Have I calculated production costs and estimated my yield to determine my breakeven price?

Marketing Plan Discipline

Marketing involves emotion, science, discipline and analysis. The best marketing plan will fail without the self-discipline to stay on track. Unfortunately, letting emotions rule is easy when prices are moving. When prices rise, it is hard to resist trying to squeeze an extra few cents from the market. And, it is easy to panic when prices fall. In marketing, not making a decision is a decision. A marketing plan is of little or no value if actual decisions deviate form the plan. Having a written marketing plan will help ensure discipline.

Contingency plans, as part of the basic marketing plan, will also help. What to do if the price doesn't reach the desired level and what to do if the crop is not as large as expected are important contingency actions when the market does not develop according to your general expectations.

Marketing Tools

Learning about the full range of risk management tools will allow you to become a better marketer and risk manager. Selecting the right tool to use at the right time will not only reduce risk, it could increase your profit. Following are a basic overview of more commonly used pricing strategies and guidelines for determining when to use each.

Storage (with no protection). Storage is a way if avoiding seasonally low prices. When prices are below the level anticipated in the marketing plan, storage may be justified, assuming that you have adequate financial resources. Storage may be warranted when there is a realistic expectation of a market price increase. Historical data indicate that the market is often willing to pay your storage costs. However, stored gain can go out of condition and is subject to theft.


Cash Sale. When prices are favourable and at levels anticipated in the marketing plan, direct cash sale is warranted.


Deferred Payment Contracts. Deferred payment contracts allow for the current pricing and delivery of the crop, but can delay the receipt of payment. They are often used as an income management tool for tax planning purposes. A deferred payment contract makes the seller an unsecured creditor of the elevator. This has implications both for legal and for financial risk exposure.

Fixed Price Contract for Deferred Delivery. This contract allows producers to establish a price for later delivery. A fixed price contract, also know as cash forward contract, may allow you to schedule deliveries at times of the year that better fit with labour, grain quality, and logistics. Having an adequate amount of crop insurance allows you to comfortably contract the insured portion of your crop. These contracts often work well when crops are large, when storage is tight, or when the market price reached the objective in your marketing plan.

Basis Contract. Basis is the difference between the local cash price and a futures contract price. Basis is typically more stable and predictable then either the underlying futures contract or the local cash price. However, basis does change in response to local supply and demand factors. A basis contract allows you to fix the basis, but allows the final cash selling price to be determined at a later date by subtracting the fixed basis from the futures price. This strategy works well when the basis is strong (cash prices are high relative to futures) and there is some potential for an increase in future prices. MPCI or revenue insurance can give you the confidence to enter into basis contracts without the concern of not having a crop to deliver.
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Deferred or Delayed Price Contract. A deferred or delayed price contract transfers title of a crop to the buyer at delivery, but allows the seller to set the price later. It is commonly used when storage is tight. At these times the local elevator wants to move more grain into the marketing channel, but the seller may not be satisfied with current prices. When producers have crop insurance, they have a guaranteed, minimum production level. They can, therefore, safely used deferred price contracts early in the growing season.

Minimum Price Contract. A minimum price contract established a floor price for the duration of the contract. The floor price is typically several cents below the cash price at the beginning of the contract. A producer could net less with a minimum price contract than with a fixed price contract if prices fall, but will benefit from a rise in market prices. This contract eliminates much downside price risk.

Hedge-to Arrive (HTA) Contract. This contract has risk management properties similar to a short futures market position. It is the opposite of a basis contract. It permits the seller to set the futures price level by the delivery date, but the basis is determined later. The seller is responsible for delivering the contracted amount on the delivery date.

Short Futures Hedge. Selling futures contracts to protect the value of grain or livestock in inventory or the value of expected production is a short futures hedge. A short futures hedge reduces downside price risk. On the other hand, it also reduces the ability to capture upside price movements.

Put Option Purchase. This tool is similar to a minimum price contract. It sets a floor on the crop or livestock price throughout the life of the contract. If prices rise during the period, the seller can capture upside price gains.

Contracted Production. Many variations of this type of contractural arrangement exist. Historically, production contracts have been used for specialty crops, poultry and livestock. Purchasers have been willing to offer such contracts to fulfill the need for highly specific agricultural products. Recently, contracted production has been offered on an increasingly broader range of crops and livestock. Contract production reduces flexibility and the opportunity to capture upside price potential. But, it assures a relatively reliable cash flow.

Marketing Cooperatives. Forming and participating in marketing cooperatives provides members the opportunity to benefit from volume sales or purchases. Benefits may be in the form of enhanced prices received or reduced costs. There has been an increased interest in marketing cooperatives for crops and livestock.



Direct Sales. For some producers, selling directly to final consumers is a way to enhance profitability and reduce risk. Smaller farms near population centers may especially benefit from direct sales. Examples include the sale of fruit and vegetables through roadside stands and 'you pick' operations. Also, some producers can increase profits and reduce risk with specialty livestock products, like '"all-natural" beef, which reach a specialized market niche.

Some Questions for Your Risk Management Check-Up

* Which marketing tools are most familiar to me?
* How can I learn the basics of unfamiliar marketing tools?
* Does the use of a particular marketing tool preclude the use of others? If it does, have I weighed all the alternatives?
* Is the use of a particular marketing tool likely to enhance income, reduce risk, or both?
* Can my marketing plan be executed without undue influence from income tax and cash-flow demands?

UNDERSTANDING FINANCIAL RISK

Financial risk has tree basis components" (1) the cost and availability of debt capital, (2) the ability to meet cash-flow needs in a timely manner, and (3) the ability to maintain and grow equity. Cash flows are especially important because of the variety of ongoing farm obligations, such as cash input costs, cash lease payments, tax payments, debt repayment and family living expenses.

Your objective should be to manage this risk through sound planing and financial control. To do that, you should continually monitor your ability to bear financial risk.

Farm Records and Financial Analysis

A set of well-maintained financial records is an absolute necessity to maintaining financial control of a farm or ranch. The flow of information is critical in evaluating past performance and in planning for future accomplishments. Financial risk management is not achieved directly by maintaining comprehensive records. However, records do provide much of the information needed to understand critical financial risks.

Essential financial statements include the balance sheet and statements of owner's equity, income statement, and projected and actual cash flows. These records provide a history of your business and the data you need to calculate financial performance measures. Even small farms need a basis level of record keeping.

As the size and complexity of an operation grows, so does the need for financial records. Ratios such as debt-to-asset, debt-to-equity, and turnover are important in monitoring overall financial performance. Other measures can be used to monitor the financial status of the business and provide guidelines for future decisions. These examine liquidity, solvency, profitability, financial efficiency, and repayment capacity of the business.

Interest Rate Risk

Investment decisions are based on assumptions about future borrowing costs or the opportunity cost of invested funds. Borrowed capital can be a reasonable expense, especially if you are prudent in the financial leverage of your business. After all, few operations are in a position to use only equity capital for new investments. Borrowing is a vital part of most farming businesses.

Interest rate risk is mostly out of your control. However, you can sometimes influence your interest rate by lowering your debt-to-asset ratio and through the use of crop insurance coupled with a sound marketing plan. These actions by you reduce a lender's risk exposure.

Some Questions for your Risk Management Check-Up

* What is the most effective way to monitor general financial conditions and expected changes in interest rates?
* What are alternative sources of financing and their terms and conditions?
* What can I do to reduce a lender's risk exposure and thereby ensure that I pay the lowest possible interest rate?
* Do I completely understand the terms and conditions of my borrowing arrangements, including the calculation of interest?

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