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LRP Considerations

By Matthew Diersen

In early 2021 the Risk Management Agency implemented a subtle change to Livestock Risk Protection (LRP) insurance. LRP covers the price risk or the risk of cattle prices moving lower while owned by those raising cattle. The policy was changed to allow those with coverage to collect indemnity payments if they dispose of (think sell) insured cattle within the last 60 days of coverage. Without such a clause people without cattle would have an incentive to purchase the subsidized coverage. Prior to the change, the limit was the last 30 days of coverage. Cattle could be (and still can be) owned past the end of coverage and remain insured.

Does this change matter? In short, yes, as it makes an LRP policy more flexible and therefore more attractive for cattle producers. LRP is sold with fixed end dates from 13 to 52 weeks out in 4-week intervals; basically, these are monthly end dates. Producers generally want insurance coverage to span the timeframe they own the cattle. Once any such cattle are sold there would be no more price risk so producers would not want to pay for a longer coverage period than needed. LRP cannot be exercised nor offset prior to the end date, but coverage can be transferred to another party such as the buyer of the cattle. In contrast, with futures and options any hedge position can be lifted or offset when the cattle are sold.

Consider a feedlot in early June expecting a pen of cattle to finish in mid-October. The feedlot buys LRP at a high coverage level with an end date in late October. Assume the cattle gain well and finish early in mid-September. If prices remain steady or increase the cattle can be sold and the LRP premium paid. However, if prices fall the feedlot would be expecting an indemnity payment. Under the prior policy, selling the cattle earlier than 30 days before the end date either meant foregoing any indemnity (because the coverage stopped) or transferring the coverage to the buyer. Regardless, the premium still needed to be paid.

Under the current policy, the window is now 60 days before the end date. Using recent market conditions (futures prices and implied volatility), the difference in time value between 60 and 30 days from expiration is about $1.00 per cwt for an at-the-money live cattle put option (or 100% coverage LRP on fed cattle). That value could have been foregone in the past if not captured when transferring the coverage. In other words, being able to keep LRP coverage for the wider window is worth $1.00 per cwt (for the fraction of the time that cattle are sold early). If the likely end value is much higher than the original expected end value, then the remaining value of the LRP coverage is very small regardless of the window. If the likely end value is much lower, then the situation is more interesting. The expected indemnity is analogous to the intrinsic value of a put option, and it would serve as a lower bound if considering transferring the coverage. With the wider 60-day window, there is less of an incentive to transfer the coverage to capture its value, which can be quite large. Regardless, the premium still needs to be paid.

Source : osu.edu

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