As a risk management tool, Dairy Revenue Protection (Dairy-RP) provides protection against a decline in revenue (yield and/or price). With premiums subsidized by the USDA’s Risk Management Agency (RMA), dairy producers can protect quarterly milk revenue for up to five quarters into the future.
Since its inception in October 2018, the popularity of Dairy-RP has grown and is now used to protect revenue on over 25% of U.S. milk production. Below are five “best practices” I’ve found to help you get the most out of your DRP coverage.
1. Do not cover all of your production at once
A common misconception for many producers just getting started using Dairy Revenue Protection (Dairy-RP) is that when booking the insurance, you must cover your farm’s entire milk production for the quarterly coverage period. You can (and should) establish coverage in whatever size increments you are comfortable.
Since Dairy-RP coverage can be established up to five quarters into the future, there are significant advantages to locking in small amounts over time. By doing this, you are not only allowing the markets to provide you with more information to make informed decisions, but as markets jump around you are able to establish coverage at various trigger prices, which greatly increases the probability you will receive an indemnity.
One of the main elements used in calculating Dairy-RP premiums is “time value” – another advantage to layering in coverage over time is that you can potentially save money on premiums by holding back a certain amount of your production to lock in later, when premiums tend to be cheaper.
2. Always book the higher coverage levels
No, this is not some sales tool we insurance agents use to get more premiums from clients – there is real science behind this. Since Dairy-RP is a market-based insurance program, you should be looking for the highest expected value. For every dollar paid in premium, you should try to maximize the potential return of that dollar. The 80% and 85% coverage levels certainly would have paid out in few historical scenarios, but indemnities are very infrequent and significantly less than if the 95% coverage level had been selected.
When you consider the volatility of commodity markets (especially dairy in recent years), the frequency and magnitude of the indemnity that would be triggered at the 95% level far exceeds the additional premium paid to establish that coverage. As mentioned above, you do not have to cover all your production at once. You can always cover less milk at a higher coverage level, therefore maximizing the expected value of that coverage.
If you look through the RMA Summary of Business data, you can see the majority of Dairy-RP that has been booked by producers has been at the 95% coverage level. This is great to see, but did you notice how I did not say to exclusively use the 95% coverage level? There are certain scenarios when utilizing the 90% coverage level also makes sense to achieve your financial goals.
3. Be proactive
Another interesting insight from the RMA’s Summary of Business data is the mad rush that insurance agents experienced in March 2020. When the COVID-19 pandemic effectively shut down the food service industry, sending commodity markets into a free fall, many producers scrambled and bought “panic coverage” with lower trigger prices and higher premiums compared to what was available for 2020 coverage in 2019. It is human nature to discount the probability of rare events until we are faced with a direct experience.
Unfortunately, now there are many producers who purchased this panic coverage who have a sour taste in their mouth about Dairy-RP. The severity of major market events such as COVID-19 are not predictable. If someone claims to have accurately predicted the impact the pandemic would have had on the dairy markets and the government’s subsequent response, I have some oceanfront property in Arizona I would love to sell them. Being proactive is arguably the most important thing on this list of best practices. There is a massive advantage to having coverage in place well before a major market event. It is best to buy fire insurance before a wildfire.
4. Stay consistent with getting coverage
Do you have a home alarm system? When you first bought that alarm system and set it up, you probably felt more secure. A year later, when no one has broken into your house but the bill for the monitoring service keeps showing up, you probably began to debate whether it is worth it to continue paying for that service. Now imagine you got rid of your alarm system to save some money, and your house was broken into while you were out of town.
All your family’s valuable possessions are gone forever. The small fee the alarm company charges seems like nothing compared to what it was actually protecting. The investment for an alarm system versus the value it brings when someone breaks into your house is asymmetrical.
This principle is also true for Dairy-RP. The premiums paid (especially after the subsidy is applied) is significantly less than the security it provides. Staying consistent can be difficult when a few quarters pass by and you have not received an indemnity but, as I mentioned before, the severity of market events are often not predictable. Trying to time your coverage so that you only book when something major is going to happen is a fool’s errand.
5. Work with an agent who understands dairy
One of the things I tell all producers is: Crop and livestock insurance is a commodity. The price you pay is the same regardless of who your agent is. The only difference an agent can provide is service and market expertise. There are a ton of crop insurance agents out there with all the minimum credentials required to provide you with Dairy-RP coverage, but there are very few who understand milk pricing and the dynamics of the Chicago Mercantile Exchange (CME) futures markets. Since Dairy-RP is a market-based insurance program, it makes sense to work with an agent who is an expert in those markets.
Futures and options trading involves substantial risk and is not suitable for all investors. All material distributed by HighGround Trading LLC shall be construed as a solicitation for entering into a derivatives transaction. While every effort is made to ensure the accuracy of the data within this report, HighGround Dairy makes no guarantees as to the accuracy of the information contained herein.
