– Matthew Diersen, Risk & Business Management Specialist, Ness School of Management & Economics, South Dakota State University
Recently the Risk Management Agency (RMA) announced changes to Livestock Gross Margin (LGM) insurance. The premium subsidy now ranges from 18 percent to 50 percent depending on the deductible level. In addition, the premium payment date was moved from the time of purchase until the end of the coverage period. LGM covers the finishing margin for cattle. The margin mirrors a “cattle crush”, where one sells live cattle and buys corn and feeder cattle. As a product, LGM-Cattle is available in states throughout the central U.S., but it has not been widely used. After some initial interest in 2006, the only year with noticeable volume was 2017, with 13,012 head insured across 19 policies with premiums paid. In 2020 (the fiscal year that just ended on June 30) there were only 633 head covered in the U.S. by producers in Iowa, Nebraska and Wisconsin. The premium changes may make the product more attractive.
The expected and actual margins are reasonable indicators of what happens to feeding margins through time for unhedged or cash-only feedlots. The LGM margin is a little unrealistic, as it assumes a 750-pound yearling is fed 50 bushels of corn (as part of a ration) to an out-weight of 1250 pounds. Consider the LGM margin for yearlings that are six months from marketing as fed cattle. There is a formula that takes futures prices of either the contracts for those months or their surrounding months. In June, that expected margin was $148.40 per head for cattle to finish in December. That margin would have to cover other feed costs, yardage expenses and any profit. The five-year average expected margin is about $155 per head. The expected margin can get quite low, reaching $85.55 in April 2020 at the height of COVID-19 concerns. The actual margin is much more variable, averaging $160 over the same time span and ranging from $529.03 in April of 2017 to -$218.60 in April of 2020. It is difficult to overstate the risk involved feeding cattle.
LGM coverage essentially bundles put option coverage on live cattle with call option coverage on feeder cattle and corn. You are buying a weighted basket of three options. In June the coverage would have cost $71.41 per head for the $0 deductible. The cost of separately buying the equivalent at-the-money options would have totaled $101.75 per head. This ignores the time value that would likely remain in the call options and any underlying correlation among the options, which overstates the cost of using options outright. If a feedlot has all three risks (live cattle, feeder cattle and corn), then using LGM may be worth considering. However, the cost of LGM coverage is tied to volatility in the underlying contracts. The coverage premium (after the subsidy) in April 2020 was $103.02 per head (with the expected margin of $85.55). This may have been rational if one expected the actual margin would fall substantially. The cost spike was driven by live and feeder cattle volatility in 2020. Looking back, there was a cost spike in late 2008 driven by corn price volatility. While the subsidy on LGM is helpful, it does not make using LGM an automatic choice.