How Do Farmers Manage Risk When it Comes in So Many Forms

CropInsuranceTODAYHow Do Farmers Manage RiskWhen It Comes in So Many Forms?By Dave Ray, North Bridge CommunicationsIt’s often said that farming is a risky business, and farmers would likelyargue that this is a gross understatement. While the risks caused by MotherNature make the most news, there are many other risks involved that farmersmust prepare to manage.In 2011, farmers saw a string of major natural disasters, including earlyfreezes, record floods, droughts, wildfires and hurricanes. Then, 2012 dealtfarmers the worst drought in decades, with a majority of the continental U.S.experiencing some level of drought during most of the growing season. Andthe drought continues in 2013, with more than 60 percent of the continentalUnited States remaining in some degree of drought.The economic nature of farming, which consists of many people producingone common product with limited buyers, is itself susceptible torisk, since individual producers have very little, if any, influence over theprices they receive for their final products or what they pay for their productioninputs. When you add this inability to influence a price to thevolatility of the world market—where the price of a commodity changes bythe minute—it’s easy to understand why farmers are always thinking of waysto manage their risk.There are also the financial constraints of farming, which is very capitalintensive. These constraints are so great that it’s becoming increasingly difficultfor younger farmers to enter the business without an endowment ofworking capital from a financial backer, usually a bank.Thankfully, there are a number of tools available, and widely used, tomanage the economic, structural and environmental risks of farmingand ranching. While crop insurance is the most ubiquitous risk managementtool used by farmers—86 percent of total planted acres in 2012CROPINSURANCE TODAY ® 27

were insured—there are other tools that manyfarmers use as well. This article will provide abroad overview of these tools, examiningwhere they are useful, the risks they can andcannot mitigate, and will assess their limits andoverall value to farmers.Agricultural Practices1. Crop Rotation. Crop rotation is the practiceof growing different types of crops on the samefield in different years or growing seasons. Oneof the most common crop rotations in the U.S. isinterchanging corn with soybeans.Advantages: Crop rotation confers variousbenefits to the soil, as well as replenishing nitrogen,mitigating the buildup of pathogens and improvingsoil structure.Disadvantages: Crop rotation does not fullymitigate weather-related risks.Crop and locationdiversification canhedge against localizedweather-related crop losses.Growing multiple cropsmay help reduce incomevariability by providingdifferent sources of revenue.2. Crop Diversification. Crop diversification is astrategy whereby farmers diversify geographically,or by crops, or both.Advantages: Crop and location diversificationcan hedge against localized weather-relatedcrop losses. Growing multiple crops may help reduceincome variability by providing differentsources of revenue.Disadvantages: Farming on several tracts ofland that are diverse geographically and growingmultiple crops can be very capital intensive andreduce economies of scale, thereby raising productioncosts.3. Seed Varieties. Hybrid seed varieties havebeen developed that produce plants that are tolerantto different kinds of stresses.Advantages: The use of hybrids can mitigatecertain weather risks, like drought, repel pests orproduce plants that have tolerance to pesticides28 MAY2013and the presence of salt or other compounds inthe soil.Disadvantages: Hybrids tend to be more expensivethan regular varieties, and if unnecessary,their use is not cost effective.4. Irrigation. Irrigation is the practice ofbringing water to plants using various methods,including flooding the fields, overhead,pivot-irrigation and drip irrigation.Advantages: Irrigation can be used to increaseyields.Disadvantages: Irrigation is not alwaysenough to combat a severe drought, and can bevery costly due to the cost of pumping and distributingwater. Irrigation does little to addressother weather anomalies, like hurricanes or hailstorms. It can also make a crop more expensiveto produce.5. No-Till Planting. No-till planting is a wayof planting crops without breaking the soilthrough tillage. This practice increases theamount of organic matter and water maintainedin the soil while decreasing overall erosion.Advantages: No-till planting helps the soilretain its moisture content and structure, thusimproving the productivity of the soil. It also reducescosts and allows a farmer to farm moreacres than under conventional tillage. Precisionagriculture often makes no till even moreefficient.Disadvantages: No-till planting can offersome benefit in drought, but does little to addressother weather or market-related risks.When a farmer uses no-till, there will be an increaseddependence on herbicides. Additionally,organic matter is not fully incorporated backinto the soil.6. Timing of Planting and Harvesting. Farmersmust hit the window for the best time to plant tomaximize the potential of their crop. The same istrue for the harvest. For example, harvestingduring a dry spell reduces the costs of drying thegrain before storage.Advantages: Precision timing can optimizeyield, reduce the cost of production and harvestand maximize a farmer’s bottom line. Correcttiming can help a farmer beat the market andlead to price premiums for early harvest.Disadvantages: This tool is subject to thewhims of Mother Nature and offers very limitedif any leverage against volatile price swings.7. Pest management. Farmers and ranchers canuse various herbicides to reduce competitionfrom weeds and use insecticides and fungicidesto combat unwanted insects and disease in farmingoperations. They may also employ scoutingto detect pests to best time their applications.Advantages: Insecticides, fungicides and herbicidescan greatly control pests and enhanceproductivity.Disadvantages: Pesticides can be “very expensive”and may need to be repeated manytimes during a given growing season or timeperiod.8. Use of advisors. Agriculture extension agentsor professional crop advisors are present in moststates to advise farmers and ranchers on a widevariety of topics, such as marketing, nutrient useor pest management. Usually, this advice is “free”or requires a “small” charge.Advantages: Advisors offer on-site, practical,professional advice to farmers on issues rangingfrom financing and planning to production andmarketing.Disadvantages: Private sector, certified cropadvisors are paid consultants and thus affect afarmer or rancher’s bottom line.Marketing Instruments9. Product differentiation. Product differentiationis the process whereby farmers or ranchersmanipulate the quality, characteristics or inputsinvolved in the production of their product inhopes of attaining a premium from the consumer.Examples of this in ranching would be“humane raised” or “free range.” Examples infarming would be “organic”, “certified natural” oruse of specific varieties that improve processingperformance (high oil, high fermentablestarch, etc.).Advantages: Product differentiation helps insulatea product from some market fluctuationsand helps build a clientele for a specific productor producer.Disadvantages: This tool does not addresslosses caused by weather, rising inputs costs orlong-term market prices.10. On-Farm Storage. For storable crops, farmerscan invest in on-farm facilities to store theirproduction allowing sales to be prolonged untilprices improve.Advantages: On-farm storage offers farmerssome buffer from severe price fluctuations.

Disadvantages: On-farm storage is capitalintensive and does little to mitigate against riskfrom natural disasters before the crop isharvested.Financial Instruments11. Crop insurance. Crop insurance is a privateinsurance policy, purchased by a farmer or arancher—partially underwritten by the federalgovernment—that insures crops or livestockagainst price volatility and/or weather losses.Advantages: Crop insurance is available for128 different crops and can be modified to addresseach farmer’s specific risks, specific cropsgrown, and overall tolerance to risk. Crop insurancepolicies can protect farmers from both marketswings and natural disasters.Disadvantages: Crop insurance can becostly to farmers and farmers must suffer a verifiableloss and meet a deductible to collect anindemnity.12. Marketing Contracts. Marketing contractsinclude the various types of contracts betweenproducers of commodities and buyers that lockin prices in advance, including forward contracts.The product is owned and controlled by the producerduring the production process. Similarmarketing contracts may also be used by producersto acquire production inputs and reduceinput price risk.Advantages: A producer can use a contractto lock in a price (or a basis) in advance, protectingagainst large drops in market prices.Disadvantages: When a producer locks in aprice in advance, it helps hedge against loss butmay prevent gains should prices rise later. Additionally,if the crop is lost due to a natural disaster,the producer will have to fulfill the contract bypurchasing the crop from another farm —at thatday’s price—or by paying the contract cancellationpenalty in cash.13. Options and futures contracts. Both optionsand futures contracts are specific types of marketingcontracts—that protect against price riskonly—between the producer and a specific buyerat a price on a given date. The basic difference betweenthe two is that options give the holder ofthe contract the right to buy or sell the asset duringa given time period, while the holder of a futurescontract is obligated to take delivery ordeliver the asset by the end of a given time periodunder the terms of the contract.Advantages: These contracts remove some ofthe market risk by locking in a price.Disadvantages: These contracts do not protectagainst yield risk. As such, they can leave aproducer indebted to the contract holder if thecrop is lost. These contracts cover fixed quantitiesand involve costs, including fees and marginrequirements.14. Production contracts. A production contractis a legally binding agreement made betweentwo parties, generally a producer and acontractor, where the producer transfers ownershipor control of the product to the contractor.For example, the producer may agree to sellthe output prior to production or agree to producethe output that is owned by the contractorin exchange for a payment. The agreement isfor a fixed period of time—either one crop yearor several production cycles—and begins priorto production.Advantages: The contact holder has a guaranteedproduct at a guaranteed price.Disadvantages: The production contractguarantees the market for the farmer, but thisassured market may come with a lower priceand if the farmer fails to perform or suffers aloss and cannot fulfill the contract, the farmermay be forced to settle the contract insome way.CROPINSURANCE TODAY ® 29

Financial Strategies15. Share rent and variable cash leasingarrangements. Rather than own farmland, aproducer may rent farmland under variousrental arrangements. For example, land may berented just for cash or rented under a flexiblecasharrangement where the landlord may paysome expenses or bear some risk. Or farmlandmay be rented under a share rent arrangementwhere the landlord receives a share of productionas rent.Advantages: Renting allows a farmer toavoid land ownership costs and may facilitateadding or decreasing planted acres. Some cashrents provide some protection against loss orprice fluctuation. Farmers who share rent landshift some of the production and marketingrisk to the landlord.Disadvantages: While rental agreementscan provide some protection against a steeprental or leasing payment should the crop fail,the agreement is partial protection, does notcover any other input costs and may not permitthe producer to reap the full benefit of any priceincreases.16. Maintaining cash reserves and liquidity.Holding cash or near-cash allows farmers toweather adverse events. Essentially this tool isself-insurance.Advantages: Quick liquidity or ample cashreserves can shoulder losses, regardless of howthey are caused.Disadvantages: Many farmers lack large cashreserves or can easily liquidate capital.ConclusionMost farmers use many of the above strategiesto protect against the many risks they faceThe question for the farmeris one of profitability:How many risk mitigationstrategies can be employedwhile maintaining theprofitable margins neededto keep the farm running?during any typical year. The question for thefarmer is one of profitability: How many risk mitigationstrategies can be employed while maintainingthe profitable margins needed to keep thefarm running?Also, most of the strategies above only mitigatefairly specific threats, and not the wholegamut of risks faced by farmers. Crop insuranceis the only tool available that helps farmers mitigateboth natural disasters and market fluctuations,which is why it’s a complimentary riskmanagement tool to all of the above strategies.This year, nearly 282 million acres (over 86percent of total acres planted to crops) will beprotected by crop insurance, which, alongwith some of these other strategies listedabove, will help farmers and ranchers managetheir risks. That statement alone underscoresthe fact that crop insurance has become thepreferred risk management tool for America’sfarmers, and underpins the stability of the nation’sfood supply.This piece greatly benefitted from comments byKeith Collins, Ph.D., Mechel Paggi, Ph.D., Joe Outlaw,Ph.D., Art Barnaby, Ph.D., and Gary DonaldSchnitke, Ph.D.