– Matthew Diersen, Risk & Business Management Specialist, Ness School of Management, South Dakota State University
July 1 marked the beginning of a new commodity year for Livestock Risk Protection (LRP), a price insurance product that functions similar to buying put options. As such, LRP is designed for the seller of cattle facing downside price risk. An LRP policy has endorsements for fed cattle and feeder cattle, the latter with adjustment factors (built in basis levels) for certain weights and classes. Two major changes were implemented for LRP, the premium subsidy was again increased and the premium payment date was moved from the time of purchase until the end of the coverage.
The LRP subsidy was substantially increased a year ago, with limited impacts in terms of volume of cattle covered. For Fed Cattle, there was an increase in the number of head covered in the 2020 commodity year to 8,098 head across 62 paid policies. However, that low aggregate volume implies that the premium has not been a driving factor in the use of LRP by feedlots. For Feeder Cattle, there was a decrease in the number of head covered from the prior year, down to 79,846 head across 393 paid policies. Sales volume continues to be steady for feeder cattle, especially from South Dakota down to Texas. The higher volatility in 2020 has resulted in sharply higher premium levels, so the subsidy is more relevant at this time.
A common question is how costs compare if considering buying LRP versus buying a put option. Before the subsidy changes, costs were often similar when comparing the alternatives on a per-cwt level. Consider a cost comparison from July 2, 2020 under the current subsidy structure. LRP on feeder cattle for the standard weight class had premium quotes for an October 29, 2020 end date. The highest coverage level available was $136 per cwt at a full premium cost of $6.82 per cwt. The subsidy (25% for this coverage level) would reduce the cost to $5.12 per cwt. A $136 strike price October put option on the same date settled at a premium of $6.00 per cwt. The premium would not include any commission costs, which could add $0.15 per cwt. As a settlement price, it does not reflect the bid-ask spread or how much may have to be included to get an order to fill. Note that the fixed size of option contracts may give LRP an additional cost advantage as it is purchased on a per-head level. The take-home message is that the subsidy would give a solid cost advantage to LRP.
Changing the time the LRP premium is payable, is more subtle, but still relevant. When buying options, having to pay the premium can use a substantial amount of financial capital. Lenders are often willing to lend the necessary capital, but then interest will add to the expense. In some cases, borrowing may use valuable credit reserves. Interest rates are generally low at this time, so explicit interest expense or the opportunity cost of capital are likely low at this time. Regardless, the change would again give a cost advantage to LRP compared to buying put options.
For more insights, see https://extension.sdstate.edu/livestock-risk-protection-cattle