Testimony of

David A. Bossman

President

American Feed Industry Association

Arlington, Virginia

before the

Senate Committee on Agriculture, Nutrition & Forestry

on

Nature of Agricultural Production and Financial Risk:

The Role of Insurance and Futures Markets in Helping Farmers

Manage Risk

March 10, 1999

INTRODUCTION

Chairman Lugar, members of the Committee, my name is David Bossman. I am president of the American Feed Industry Association (AFIA) of Arlington, Virginia.

I want to thank you for the invitation to AFIA to participate in this important examination of the federal crop insurance program, and how related insurance products for livestock producers can help farmers and ranchers manage the risks inherent in livestock and crop production. Formal testimony has been submitted for the record of this proceeding.

AFIA is the national trade association representing nearly 75% of the commercial livestock, poultry and pet food sold annually in the U.S. AFIA's members include feed and pet food companies, equipment manufacturers, animal health companies, large livestock and poultry producers, as well as firms providing goods and services to the feed industry. Our members represent nearly 5,000 facilities in all 50 states, and AFIA enjoys the added support of more than 40 state, regional and international associations.

In addition to being AFIA's chief executive, I am president of the American Feed Industry Insurance Co. (AFIIC), a risk retention group headquartered in Des Moines, Iowa. American Agri-Business Insurance Co., an AFIIC subsidiary, will write multi-peril crop insurance this year.

Because AFIA's priority is keeping as many livestock producers - and feed buyers - on the land as possible, I want to lay out for the Committee a new - and we think, creative -- approach to livestock production risk management.

AFIA proposes Congress authorize the U.S. Department of Agriculture to partner with private industry to create a new livestock income risk management tool - Livestock Revenue Protection (LRP).

AFIA's proposed LRP program centers on a unique insurance product designed to allow farmers and ranchers relatively simple, understandable, self-directed protection from downside market moves, while leaving upside price potential unimpeded.

You only need to review the disaster in the hog industry over the last 12 months to understand why such an important contemporary risk management tool is needed.

Over the last 30 days, American Agri-Business Insurance conducted farmer/rancher focus group sessions across the country -- in Missouri, Indiana, Minnesota, and last week, Nebraska. Consistently, the producer message is the same: Yes, we want an affordable, producer-directed price risk management tool that doesn't influence the markets, and yes, we're familiar and comfortable with a simple insurance policy format.

That's LRP in a nutshell - simple, producer-directed, and with a government partnership, affordable to any livestock farmer or rancher.

SUMMARY

Livestock producers experience great risk of livestock price declines because existing risk management tools offered by futures and futures options markets are not widely used. USDA-backed crop insurance traditionally focuses on catastrophic risks, such as drought and hail, and not on the price risks which typically confront livestock producers. Basically, there has been a market failure to provide user-friendly risk management tools for livestock producers.

AFIA proposes Congress authorize USDA to partner with private industry to create and issue livestock revenue protection insurance policies. Futures options and futures contracts offered as risk management tools for livestock producers would secure these policies. The acceptability of these insurance policies to livestock producers would depend on obtaining reinsurance, administrative cost support and premium support from USDA's Federal Crop Insurance Corporation (FCIC) in a manner similar to support now provided by FCIC for insurers of grains and other crops.

Existing Tools Not Used

The main risk management tools currently available to livestock producers are futures and futures options contracts traded at the Chicago Mercantile Exchange (hog and cattle prices) and the Chicago Board of Trade (corn and soybean meal prices).

These tools are not widely used for several reasons. First, hedging with futures and options requires training, experience, and some expertise. In general, producers want focus on production first, marketing second, and believe they haven't sufficient time to become proficient with these contracts. Second, this lack of familiarity with the markets breeds a distrust of the markets and the commercial and institutional players who participate in them. Third, livestock production margins are often not large enough to cover the premium costs of hedging with options. Futures are an even riskier management tool than options, and require a greater level of oversight and expertise. In the final analysis, producers stay away from futures markets.

Underdeveloped Markets

The insurance and financial industries have not developed price guarantee contracts for two reasons. First, livestock prices, unlike crop prices, are a systemic risk. Price rises or declines in livestock markets affect all local markets in the same way. In the case of price drops, all policies based on livestock prices would be called upon to indemnify at the same time. Therefore, the potential losses and the reserve requirements to private insurers would be extraordinary. This translates into a policy cost much greater than most producers can afford or are willing to pay.

Since the potential policy providers are not willing to offer risk instruments at prices acceptable to producers, the market is incomplete. Without viable market solutions to this problem, a market failure exists, and a strong case for government involvement is made.

Government-Assisted Solutions

Government involvement in the market is the most efficient means of overcoming market failure. In the case of crop insurance, the government's role is to pay down a portion of the premium cost, as well as administrative costs.

Government support of a livestock risk management program could take several forms. There could be a partnership based on exchange-traded tool premiums (e.g., cattle price contracts). Government support could be based on the current volatility of prices, a percent of premiums, or set up as a constant amount (e.g., at catastrophic levels). Second, the government could defray program administration costs. The level of administration reimbursements would likely be nominal unless there were significant additional involvement with a producer's operation -- either advising on policies or evaluating losses. Third, the government could provide reinsurance to primary companies. This last method directly addresses the issues of capacity and reserve requirements.

NATURE OF THE LIVESTOCK REVENUE INSURANCE POLICY

Protecting a Price

Whether it is called income protection or price protection is irrelevant. For the livestock producer, price ultimately equals income.

What any livestock production risk management tool - private or government -- must recognize is that in today's market, cattle/hog price risk is not just local risk, but systemic risk.

Unlike crop production, where crop losses are generally regional and price fluctuations relatively less volatile, if hog prices drop in Logansport, Indiana, they fall just as far in Decatur, Georgia and Lexington, Kentucky, and Omaha, Nebraska. If a market across the Pacific disappears, every U.S. hog or cattle producer feels the financial pain.

At the same time, livestock and poultry producers don't enjoy the luxury of "holding" production pending price increases. A producer can't "warehouse" or "inventory" cattle, pigs or poultry once they've reached market weight --- he takes the price he can get.

These are some of the reasons why insurance and financial industries up to now have not developed price guarantee contracts. Recognizing the systemic risk in the market, all policies based upon livestock prices would be called to pay all owners at the same time, creating astronomical reserve requirements to satisfy the incredible loss potential. This translates to premium prices higher than the average producer can afford or is willing to pay.

At the same time, livestock producers do not routinely use futures or futures options tools to manage risk. Producers generally reject hedging, options, etc. as too risky, too arcane, too complex and way too time-consuming. Compounding this is a basic distrust of the institutional players in those markets.

All of the above add up to livestock markets without user-friendly risk management options. To AFIA, this equals "market failure, and argues strongly for a government partnership to increase - and simplify - farmer/rancher risk management options.

In its simplest form LRP lets a farmer/rancher buy an insurance policy to protect against market price declines, while not interfering with price increases. Scenarios covering hogs, cow/calf and cattle finishing operations are included in with this testimony.

LRP policies would allow the livestock producer to protect the price he or she eventually receives for the insured livestock against market decline. The producer could insure for the period of ownership, e.g., 120-150 days for cattle on feed, beginning when the producer first takes possession of the animals, and at a price up to the futures price for that class of livestock on the day the insurance was bound. The policies for feeder cattle and for hogs would likely be of greater duration, perhaps up to 360 days, keyed to the expected period of the producer's ownership.

The producer would provide proof of ownership in order to purchase a livestock revenue policy. The payout under the policy would be based on the average price of that class of livestock during the last five days of the last month of the policy term, as reported by USDA/Agricultural Marketing Service's Market News. Thus the producer would have to own livestock to initiate a policy, but could sell those livestock at any time, and the payout under the policy would be independent of the price at which the insured livestock were actually sold.

Backing Policies with Futures Instruments

LRP policies would be backed by reinsurance supported by futures options and futures contracts in the underlying commodity (hogs/cattle). As noted, producers do not broadly use these risk management tools. However, by securing insurance policies with futures options and futures, it will be possible to bring user-friendly risk management tools to the producer.

Unfortunately, futures and futures options contracts on cattle and hogs are presently only offered on alternate, not consecutive months.1 In order to provide coverage for livestock coming to market in non-futures contract months, either the insurer or reinsurer will have to bear the risk of fluctuations in these non-contract months. That risk can be partially secured by futures and options from the immediately preceding and succeeding months. However, those instruments will only approximate the cash price for the intervening month. Therefore, non-contract month risks may need to be covered in part by more traditional reinsurance.

Not Traditional Crop Insurance

LRP polices differ from traditional crop insurance policies in several important ways. First, they cover a price risk and not a catastrophic risk. Traditional crop catastrophe risks of drought, flood and crop failure are not large risks for livestock producers. Animal mortality coverage is already available from the commercial market. Second, livestock revenue policies can and should be backed by futures exchange instruments. Futures exchanges already provide tools for management of price fluctuation risks. Insurance markets provide tools for managing catastrophic risks. Livestock revenue insurance will use the products available in each of these markets to secure adequate reinsurance.

MARKETING

Livestock revenue policies will be marketed electronically. Because premiums will be revised at least daily, and perhaps on a continuous, real-time basis, livestock revenue policies will be available on the Internet.

Both USDA's Risk Management Agency (RMA) and state insurance departments require a licensed agent be involved in placing each policy. This licensed agent could be either an insurance agent or a futures broker since the policies will have elements understood by either of these professionals. Each agent will need to verify that the livestock producer/policyholder does own the insured livestock. The Internet information regarding policy terms and premiums will be readily available to each agent. That information can also be directly available to livestock producers.

Commission levels differ considerably for insurance agents and futures brokers. Crop insurance agents receive a commission on the order of 17.5% of premium, while selling fees for futures options are normally a fixed rate negotiated between the broker and the customer, which can range from $20-100 per contract. For LRP policies, it appears that for many placements, brokerage fees would likely be much lower.

REINSURANCE

Traditional reinsurance is a pooling of the liability or property risks of several insurers. The larger and more diversified the pool of risk, the less likely the reinsurer will experience extraordinary losses. Because livestock price risks are systemic, i.e. all policies pay at the same time, they are not suitable for pooling used in traditional reinsurance.

Futures and futures options markets provide risk management tools for systemic price risks. However futures contracts and futures options are contracts not accepted by state insurance commissioners as admitted assets for a state-licensed insurer or reinsurer. In order to use futures and futures options, which are the best available risk management tools to back LRP policies, reinsurance will have to be obtained either offshore or from FCIC.

It is important to recognize that even with the use of futures instruments as security for reinsurance, there will be elements of risk which are not completely offset by these instruments. These risks include non-contract month exposures and thin markets.

The risk of thin markets exists because the current volume of trading in livestock futures options and futures can not support extensive issuance of livestock revenue insurance policies. In theory, the volume of futures option and futures trading would increase to offset purchases of these instruments for reinsurance purposes. But even with a large increase in trading, there will still be some contracts for some months where there will be few transactions. The reinsurer will bear the risk of covering the difference between these imperfect thin market conditions and the actual markets when policies mature and must be paid.

ADMINISTRATION

Private industry's development responsibilities will include designing an online program to purchase futures options and futures contracts so as to secure reinsurance for insured risks as fully as possible. The online management system being developed will need to include an Internet component to communicate policy terms and premium quotes to agents and producers, and to record and bind new policies. The program being developed will also provide for marketing of livestock revenue policies by insurance agents, futures brokers, and employees of feed dealers, banks, and agricultural suppliers who are properly licensed.

ROLE OF GOVERNMENT

The participation of USDA's RMA and the FCIC is critical to the success of livestock revenue insurance. FCIC is the preferred reinsurer for this program because of its extensive experience with agricultural risks and because its reinsurance is recognized and accepted by every state insurance department.

A key element of making livestock revenue insurance user-friendly for producers is user-friendly pricing. In its pilot dairy options program, FCIC currently pays 80% of the program expense. In traditional crop insurance, the federal government buys down the premium costs, and also shares expenses for marketing and administration. In order to introduce livestock revenue insurance at premium levels that will attract substantial numbers of producers, it will be desirable and likely necessary to have FCIC support at comparable levels.

LEGISLATIVE AND REGULATORY REQUIREMENTS

Legislation is needed to remove existing language in the Federal Crop Insurance Act which bars the issuance of livestock insurance. There may also need to be an authorization/appropriations package developed for LRP. This legislation is desirable, in part, to clarify the regulatory responsibilities of USDA and other federal agencies over livestock revenue protection policies. USDA's agencies, RMA and FCIC, would have primary regulatory jurisdiction over this program.

States presently require state-licensed insurance agents to sell federal crop insurance. For LRP, the sales agent would be either a state-licensed insurance agent or a futures broker in compliance with CFTC licensing requirements.

WHAT LRP IS NOT

Some contend LRP creates a new federal bureaucracy. We don't think so; USDA's RMA and FCIC have demonstrated they can handle another insurance product.

Some say LRP is merely ag trade options masquerading as insurance. We respectfully disagree.

If we all stipulate that an insurance policy is a contract where one party transfers a pre-existing risk of financial loss to another party in consideration of a premium. The insurer promises to pay the insured should a loss occur. The insurer then seeks to mitigate risk by reinsuring through pooling similar and dissimilar risks.

Reserving judgement on ATO's, AFIA would like to reiterate the unique insurance features of LRP:

* LRP will insure producers who are at risk of financial loss if prices go south between the time the animals are started and when they're sold;

* The amount of LRP coverage is limited by the number of animals owned and the time during which they're owned;

* LRP will be sold by state-licensed agents, it will be an insurance policy filed with and approved by USDA's FCIC (the federal agency providing reinsurance), which will also review and approve premium rates;

* The insurer manages the remaining risk after FCIC reinsurance by pooling with other risks it writes, traditional reinsurance, and use of exchange-traded instruments, and

* There is no speculator activity allowed with LRP.

CONCLUSION

In 1998, Congress enacted a $6-billion agriculture disaster package; some members propose similar action again this year. AFIA contends LRP can be an important risk control tool to hopefully mitigate the need for such emergency actions in the future.

Consider: If LRP had been available to hog producers during 1998, the producer policy payout would have totaled more than $1.3 billion, based on participation by 50% of the eligible hog farmers in the U.S. The cost to the U.S. Treasury would have been about $100 million, assuming a 30% premium cost-share by USDA.

AFIA was and is a strong supporter of 1995's Freedom to Farm. We believe with the addition of LRP to USDA's array of risk management programs, the current farm income safety net can be made much stronger.

It's time for a simple, producer and Treasury-friendly, market neutral insurance policy as the livestock producer's risk management tool of choice.

Thank you, Mr. Chairman. AFIA would be happy to answer any questions you or other members of the Committee may have, and looks forward to working with you on this important issue.

Livestock Revenue Protection (LRP)

Hog Operation

During March, 10 sows are bred. The expected pig crop is 100 head, with a target weight of 250 lb. The current local market price for live hogs is $38 per hundredweight (cwt). However, the hogs are going to market in 240 days (November).

Having heard of Livestock Revenue Protection (LRP) as a risk management tool, the producer is considering using the revenue protection product to guard against a drop in prices over the next eight months. She takes the following steps:

Step 1: First, she contacts a licensed LRP representative (such as an insurance agent, feed dealer or banker).

Step 2: The LRP representative provides a forecast price for November of $42 cwt. Also provided is a list of deductibles, from $0 to $10. The more risk the producer is willing to assume, the higher the deductible.

(The forecast price refers to the price that will be reported by USDA's Agricultural Marketing Service (AMS) for central Iowa. The policy pays on the average trade over five reported days.)

The producer wants to coverage for price drops below $40 cwt, a $2 deductible. For this the representative quotes her a price of $3.50 cwt.

Step 3: The producer decides to take the LRP coverage. For $3.50 cwt, the producer knows she can cover her costs.

The premium paid is equal to 100 hogs x 2.5 cwt. x $3.50 per cwt = $875, where 100 hogs is the herd to be covered, 2.5 cwt equals the target weight (2.5 x 100 or 250) and $3.50 is the premium.

The policy start date is March 20, and the ending date is Nov. 20.

Step 4: The licensed LRP representative confirms the number of hogs owned and in possession of the producer, confirming the producer has a hog operation.

Step 5: In November, AMS reports the Iowa market prices. The five-day reported average of the Iowa trades from Nov. 16-20 was $30.

The producer is paid the difference between the covered price ($40) and the five-day average price ($30). The total paid is 100 hogs x 2.5 cwt (250) x $10 per cwt = $2,500.

Livestock Revenue Protection (LRP)

Cattle Finishing Operation

During November, 100 feeder cattle are purchased. The target weight for the fed cattle is 1,100 lb. The current local market price for fed cattle is $65 per hundredweight (cwt). The finished cattle are going to market in 120 days (March of the following year).

The feeder has heard of Livestock Revenue Protection as an alternative risk management tool. The producer is considering the revenue protection product to guard against a drop in prices over the next four months. He takes the following steps:

Step 1: He contacts a licensed LRP representative (such as an insurance agent, feed dealer or banker).

Step 2: The LRP representative provides a forecast price for March of $70 cwt. Also provided is a list of deductibles, from $0 to $10. The greater the amount of risk the producer is willing to assume, the higher the deductible.

(The forecast price refers to the price to be reported by USDA's Agricultural Marketing Service (AMS) for Texas and Oklahoma in March. The policy pays on the average trade over five reported days.)

The producer wants coverage for price drops below $68 cwt, a $2 deductible. For this the representative quotes a premium price of $1.50 cwt.

Step 3: The feeder decides to take the LRP coverage. For $1.50 cwt, the producer knows he can cover his costs.

The total premium paid is equal to 100 head x 11 cwt x $1.50 cwt = $1,650, where 100 head is the total herd to be covered, 11 cwt is the target weight (11 x 100 or 1,100), and $1.50 is premium per hundredweight.

The policy start date is Nov. 25, and the ending date is March 25.

Step 4: The licensed LRP representative confirms ownership and possession of the cattle, confirming the producer has a cattle finishing operation.

Step 5: In March, AMS reports the market prices for the days traded. The five-day reported average of the Texas and Oklahoma trades from March 21-25 was $60.

The producer is paid the difference between the covered price ($68) and the five-day average price ($60). Total paid is 100 head x 11 cwt (1,100) x $8 cwt = $8,800.

Livestock Revenue Protection (LRP)

Cow/Calf Operation

In March, 100 calves are born. The target weight per animal is 750 lb. The current local market price for feeder cattle is $70 per hundredweight (cwt). The cattle won't go to market for 240 days (November).

The rancher reviews his risk management options, looking to protect himself against a drop in price over the next eight months. He opts to pursue the Livestock Revenue Protection (LRP) program. He takes the following steps:

Step 1: The producer contacts a licensed LRP representative (such as an insurance agent, feed dealer or banker).

Step 2: The licensed LRP representative provides a forecast price for November of $78 cwt. Also provided to the rancher is a list of deductibles, from $0 to $10, based upon the amount of risk the rancher wishes to cover. i.e. the more risk the producer will assume, the higher the deductible.

(The forecast price refers to the price to be reported by USDA's Agricultural Marketing Service (AMS) for the Oklahoma City market in November. The LRP policy pays on the average trade over five reported days.)

The rancher decides to cover price drops below $75 cwt, a $3 deductible. For this amount of coverage, the representative quotes a premium price of $2.50 cwt.

Step 3: The rancher decides to buy the coverage as a risk management option. For $2.50 cwt, the producer knows he can cover his costs.

The premium paid is equal to 100 feeders x 7.5 cwt x $2.50 cwt = $1,875, where 100 is the number of cattle covered, 7.5 cwt is the target weight (7.5 x 100 or 750), and $2.50 is the policy premium per hundredweight.

The policy starts on March 15, and ends Nov. 15.

Step 4: The licensed agent confirms ownership and possession of the rancher's cattle. The LRP representative confirms the producer has a cow/calf cattle operation.

Step 5: In November, AMS reports the local market prices for the days traded. The five-day reported average of the Oklahoma City trades for Nov. 11-15 was $67.

The producer is paid the difference between the $75 covered price and the five-day average price of $67. The total paid is 100 feeders x 7.5 cwt x $8 per cwt = $6,000.

Peter W. Griffin, Ph.D.

1144 W. Montana

Chicago, IL 60614

(773) 404-1605

M E M O R A N D U M

To: David Bossman

From: Pete Griffin

Date: January 23th, 1999

Subject: Estimates of Market Size and Government Costs for LRP

I have completed the market and costs analysis for Livestock Revenue Protection (LRP) for hogs, feeder/stocker cattle, and fed cattle. The total market potential for LRP was estimated at 73.5 million head of livestock. This figure comprises of 45 million hogs, 15 million feeders and stockers, and 13.5 million fed cattle.

The potential premium for LRP protection was estimated at about $500 million. If the government bought down premiums at a rate of 30%, the government co-payment costs would be about $150 million. Another important form of government support would be administrative reimbursements. I estimate that this cost would be less than 10% of premiums, a maximum of $50 million.

There are transaction risks associated with the provision of LRP. These incidental risks could lead to overall gains or losses. While these risks could be priced directly into the LRP premium, a reinsurance agreement with the government would be an efficient way to manage these potential losses.

Background

The LRP protects producers against a drop in prices over an insured period, from 120 to 360 days. Coverage levels are based on expected prices, with the exact price coverage dependent on the deductible selected by the producer. Producers receive an LRP payment if prices drop below coverage levels at the end of the policy period.

LRP is meant to provide a risk management tool for producers in a form and cost manageable to producers. The cost of protection, however, is generally greater than producers' willingness to pay. It is for this reason that government support is sought.

Clearly the risk management tools available to producers are not being utilized. The main risk management tools outside of contract production are the futures and options contracts on the Chicago Mercantile Exchange. The volumes of these contracts are very low for the contracts 4-8 months out-the contracts that correspond with production time periods. This illustrates the need for LRP.

Market Analysis and Participation

The potential market for LRP is the amount of marketed livestock. Starting with the entire production for one year, I have made allowance for livestock retained for breeding as well as other uses. Since some amount of livestock is already under marketing contracts, I have estimated that the potential market for LRP is 50% of the marketed animals. I would not expected participation under any circumstances to be much above this level, given marketing contracts as well as producers' focus on production rather than risk management.

Hogs

There are two ways to calculate the expected market for hogs. The first and simplest is too estimate the total slaughter and hence marketed hogs. There were a total of 91 million hogs slaughtered in 1997. The second relies on estimates of pig crops and retention levels. We have had about a 100 million-head pig crop each year, with 10 percent retained for breeding. This leaves about 90 million head of hogs marketed each year.

I have assumed that participation rates would be at a maximum of 50% of the total marketed hogs. This leaves a potential market of about 45 million head of hogs.

Hog marketing can correspond with two different time periods, at initial breeding and at the start of the life cycle. Hogs take about 240 days from breeding to market. The live cycle of hogs is about 120 days. I have assumed that of the hog producers in LRP, 30% will protect against price declines over a 240-day (8-month) period. The remaining 70% will protect against declines over a 120-day (4-month) period.

Feeder and Stocker Cattle

The total calf-crop for a given year is about 40 million head. Given a 25% retention for milk and breeding uses, there would be an estimated 30 million head of feeder and stocker cattle marketed in one year. This amount is in line with slaughter estimates for fed cattle, about 36 million head. In as much as stocker and feeder cattle are replacements for fed cattle disappearance, these statistics confirm one another.

I have assumed that participation rates would be at a maximum of 50% of the total marketed stocker and feeder cattle. This leaves a potential market of about 15 million head of cattle. While there are several possible time periods for stocker and feeder cattle to be marketed, I have assumed that the most relevant is the 240-day (8-month) period.

Fed Cattle

There are an estimated 36 million head of cattle slaughtered in a year. About 25% of this number are for non-beef cows, leading total fed beef slaughter of about 27 million. The total slaughter of fed cattle serves as a reasonable estimate of the total fed cattle marketed in one year. I have assumed that participation rates would be at a maximum of 50% of the total marketed fed cattle-about 13.5 million head.

I have also assumed that the producers in LRP are equally split between two marketing periods, a 120 days (4 months) and 180 days (6 months).

LRP Premium and Government Costs

Based on the livestock market numbers explained above, I developed the Total Premium, Producer Premium and Government Co-Payment. The premium rate per hundredweight (cwt) was estimated for different time periods and deductible levels (from 0$ to $10). I price the policies using the Chicago Mercantile Exchange option prices as a benchmark.

The co-payment rate was set a 30% of the Total Premium. This was done with the following information in mind. Premiums per hundredweight are as much as $4 to $5 per cwt. for hogs at low deductible levels. Feeder and stocker cattle are about $3 per cwt. for level deductible levels. Fed cattle are about $2 per cwt. Our initial research has shown that producers are resistant to pay more than $1 per hundredweight-understandable given the expected profit margin.

Under the market size estimates and the estimated premiums, I have developed Total Premium and Government costs. The total LRP premium would be about $500 million. The government co-payment costs at a 30% buy-down rate would be approximately $150 million.

Government Support-Administrative Costs

There are other costs of providing LRP to producers. By supporting these costs, the government would be enabling the provision of LRP to producers at a reasonable cost.

There are several costs related to providing LRP to producers. The first is the cost of processing the policies, particularly the computer infrastructure. It is expected that this cost will be for the startup only. The second is the costs of ensuring that the producers have the animals in production. The third cost involves the transaction to cover the risks. Each policy would have a corresponding contract traded in the Chicago Mercantile Exchange market, and an associated commission cost.

It is estimated that the transaction costs related to LRP provision would not exceed 10% of the Total Premium. Using the costs estimated above, the maximum administrative costs would be $50 million.

Government Support-Reinsurance Costs

There are some transaction costs and pricing difficulties related to LRP that would naturally fall under a reinsurance agreement. These costs are difficult to quantify, especially since there may actually be positive balances resulting from them. By imbedding these potential risks in to a reinsurance agreement, then the gains may offset the losses. This would be an efficient manner to handle the incidental risks of LRP provision.

There are two main types of incidental costs. First, there would be a time lag between the producers' request for LRP and the actual transference of risk to the Chicago Mercantile Exchange. This may result in differences between the policy costs and the actual costs of coverage. Over a day or year's time, the total difference may be positive or negative. Nonetheless, this type of cost could be imbedded into a reinsurance agreement with the government.

Second, LRP would be offered for each month of the year. The Chicago Mercantile Exchange offers protection, in general, for every other month. Therefore, there would be the possibility of losses (or gains) due to the differences in policy ending periods and the risk transfer method. A reinsurance agreement covering these types of losses would be an efficient way to handle this risk.

.

1 There is one exception to this general rule. Hog futures are offered in the consecutive months of June, July and August.

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