We're often asked, "are these investments risky?" Of course, every investment has some level of risk, but agriculture can be one of the safest asset classes if the risks are managed properly. Investors should understand how risks are reduced in any particular asset and agriculture is no different.
The federal crop insurance program in the United States is the principal instrument of American agricultural policy and insured over 366 million acres in 2015. In the U.S., crop revenue insurance is designed, rated, and underwritten by the USDA Risk Management Agency. The two most popular farm-level insurance policies are Revenue Protection (RP) and Revenue Protection - Harvest Price Exclusion (RP-HPE). In 2015, roughly 70% of the total $102 billion liability in the US crop insurance program was tied to a revenue insurance policy. [Agricultural Resource Management Survey (ARMS) Data]
Crop insurance is contracted by farmers to protect themselves against yield losses due to natural hazards such as drought, hail, fire, crop damage caused by wild fauna, flood and excessive rainfall and other adversities impeding crop emergence or limiting crop growth. The insured is the main focus of the crop insurance program, and has entered into a contract to insure a crop in a county where the product is available. An indemnity will be paid to the insured when the requirements of the policy have been met and his guaranteed production or revenue in some cases is not met due to an insurable cause. Providing the ag producer with tools to manage their risks is the primary goal of the Federal Crop Insurance Act (FCIC). Premium rates and insurance terms and conditions are established by FCIC, however, the policies are delivered by the private firms who share in the risk exposure of the policies they sell. Companies and agencies compete by way of their crop knowledge, customer service, and related insurance products.
Crop revenue is determined by prices on the Chicago Mercantile Exchange and farm-level yields. The benefit of using a futures market to determine payouts is that no single actor can influence market prices. Crop revenue insurance indemnifies the deficit in the farmer’s gross revenue which results from either low yield or low price or a combination of the two. The USDA revenue protection plan uses the change in commodity futures prices from a time period before planting to approximately the harvest month for the price risk component. If the indemnities are triggered by low prices then the crop insurance company has to compensate all of its policyholders holding the revenue insurance at the same time.
Without a doubt, specialty and/or organic crops are the fastest expansion in crop insurance protection. Specialty crop insurance coverage has more than doubled in recent years to 8 million acres and 16 billion dollars of liability coverage. At the same time sixty crops are now eligible for organic coverage.
Tom Zacharias, president, National Crop Insurance Services, in response to a recent Bloomberg News series on crop insurance, said “Over the last decade, elected officials, financial institutions, farm leaders and farmers have reached a general consensus that crop insurance is the best risk management tool available."
While it comes in several, complicated forms, hedging is simply a strategy that allows farmers to reduce potential risk of price fluctuations that could occur between the time the crop is planted and the time it is harvested and ready for sell on the market. Price risk for agricultural commodities can occur for a number of reasons, including drought, near-record production, increased demand or decreased international production. The same futures markets mentioned above help a grower "hedge" against volatile commodity prices, and is one of the more well known versions of hedging in the agriculture sector.
The commodity futures markets provide a means to transfer risk between persons holding the physical commodity (hedgers) and other hedgers or persons speculating in the market. Before committing to a certain crop, or allocating an amount of farmland to that crop, farmers can lock in prices with futures contracts to sell their crop at a predetermined price, ensuring they can cover production costs and make some level of profit. Futures exchanges exist and are successful based on the principle that hedgers may forego some profit potential in exchange for less risk and that speculators will have access to increased profit potential from assuming this risk.
Futures require some sophistication on the part of the farmer. Fortunately, services are emerging that use artificial intelligence to help growers make hedging decisions and selecting crop insurance into a more automated process, taking out the guess work.
The best way to mitigate the uncertainties faced by production agriculture is to ensure that the operation is being run by an experienced, professional farmer who makes decisions based on profitability. Variables such as weather, water, and disease that most growing operations face can be mitigated by someone who knows what he or she is doing. Before investing in any type of production agriculture, be confident that the grower will manage risk effectively to maximize your returns.