The Future Role of Risk Management in Agriculture

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I had the opportunity last spring to speak with the Montana Agricultural Bankers Association in Bozeman.  I was positioned to speak with some new and growing areas of agriculture in Montana that included a cricket farmer and my favorite distillery in Bozeman.  I took the opportunity to discuss another evolving area in agriculture, albeit much less exciting than my fellow speakers, by talking about the long view of risk management and how I thought the direction of risk management would likely take over the next 10-20 years.  While my thoughts are summarized below, the full presentation is also linked here.

1. The relationship between agricultural lending and risk management will continue to be intertwined.
The expansion to crop insurance participation that has largely taken place over the last 15 years has allowed banks to lend more freely to agricultural producers.  This is because crop insurance works to stabilize the downside of revenue and provides payment assurances to lenders.  This finding was reported in Bekkerman, Belasco, and Watson (2015) and more directly in Ifft, Kuethe, and Morehart (2015), where we found that crop insurance participation largely encouraged higher debt accumulation by farms.  More recently, a national survey I participated in found that the largest determinant of corp insurance participation was the frequency with which a farmer uses an operating loan.  These results paint a very inter-related picture between lending and risk management that is likely to continue for years to come.

2. Better methods and access to weather/production data should allow for reduction of basis risk in index insurance products.
While farm groups and farmers/ranchers heavily favor individual insurance products over area-based insurance products, this may change in the future.  Methods are being developed in the U.S. and Europe to allow for better weather insurance products that reduce basis risk.  Basis risk is the risk that arises when payments are not tied directly to an individual.  For example, a weather metric may indicate weather that is normal, though a yield loss is experienced.  While weather-based livestock insurance and disaster aid products have been developed, those related to crops are limited but are being improved by accounting for weather, soil, etc.  Weather-based products are somewhat attractive because they can reduce the administrative cost of insurance delivery.  While individual insurance effectively eliminates most basis risk, it also comes with a high administrative cost.  From 2007-2016, payments to insurance companies have amounted to an average of $2.8B per year, which is 27% of average payments to farmers (in terms of subsidies and net indemnities).  With better methods to rate area crop insurance products that minimize basis risk, the next logical step to lower the price of insurance will be to deliver these benefits directly to the producer.

3.  Continued development of new exotic insurance and marketing products
The Harvest Price Option began as a wrapper product on top of revenue insurance products.  It is a ‘wrapper’ product in the sense that it provides an additional layer of insurance that works along with existing insurance products.  A more recent addition to the crop insurance suite of products includes Margin Protection for corn, rice, soybeans, and wheat, which provides insurance against shrinking margins between revenue and costs and can be used with YP or RP policies.  These products can be included as the suite of RMA-sponsored products or offered as a private product.  To price these products, financial engineering is utilized to establish the expected payouts using Monte Carlo simulation or other more direct finance pricing methods.  These are methods taught in MSU’s new Financial Engineering program.  These products are not just limited to insurance products, but have been recently introduced as upside pricing products where producers can both lock in a price floor and simultaneously leave the option open to capture upside price movements.  These products were discussed in more detail in a previous post.  The continued tailoring and expansion of new marketing and insurance products will be an exciting avenue to watch over the next 10-20 years.

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Eric Belasco

Eric Belasco is an Associate Professor in the Department of Agricultural Economics and Economics at Montana State University. He received both his M.S. and Ph.D. in Economics from North Carolina State University in 2005 and 2007, respectively. He conducts research in the areas of agricultural marketing, risk management, farm policy, and financial engineering. Examples of this research include evaluations into grid pricing risk, the use of forward contracts in mitigating profit risk, modeling revenue risk in cattle production, and characterizing the link between weather and production indicators.

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