May 25, 2023
DRP Insurance in Commodity Hedging
Recognizing the risks and volatility dairy producers face in milk production and pricing, the federal government launched the Dairy Revenue Protection (DRP) insurance product in 2018 as a Dairy Risk Management tool. The insurance program is administered by the U.S. Department of Agriculture’s Risk Management Agency (RMA). DRP is a voluntary risk management program designed to protect dairy producers against declines in quarterly milk revenue below a guaranteed coverage level on a producer-declared milk production quantity. Premiums are due at the end of the coverage period and are subsidized by the government. DRP has become an important component of the risk management solutions toolbox for dairy farmers. It can be used in conjunction with agricultural support programs such as the Dairy Margin Coverage (DMC) program and exchange-traded products such as futures and options.
Dairy Revenue Protection’s coverage levels, premiums, and indemnities are the same no matter who the producer purchases the endorsement from. Those interested in purchasing DRP must do so through an approved insurance agent on behalf of an approved insurance provider. The difference between the insurance companies boils down to expertise, insight, and tools offered to help make sound and efficient risk management decisions.
DRP coverage is available in all 50 states and protects against a decline in quarterly revenue from milk sales. The crop year for DRP insurance begins July 1 and runs through June 30. Producers may purchase quarterly coverage endorsements during the daily sales window for up to five quarterly insurance periods. Prices and rates are generally published on a daily basis, except on exchange holidays and days when USDA’s Milk Production, Dairy Products, and Cold Storage reports are released. Milk or dairy prices that experience a limit up or down move in the futures markets will not be available for determining quarterly expected revenue, either. An indemnity is paid to the producer if the actual milk revenue for a quarter falls below the final revenue guarantee. The final revenue guarantee is the product of five decisions elected by the producer, summarized in the section below. DRP is not designed to protect against revenue losses caused by death of dairy cattle, disease, or mandatory deductions at the plant for balancing costs.
It is important to recognize DRP insurance does not protect against milk production or component test declines on the farm. Rather, DRP uses USDA quarterly milk production data to calculate an expected yield and a yield adjustment factor. This yield adjustment factor is determined for producers based on actual versus expected production yields in their state or pooled production region.
For example, if expected milk production per cow for a given quarter and state is 7,500 pounds and the USDA publishes actual milk production per cow of 7,800 pounds for that quarter and state, the yield adjustment factor would be equal to 1.04, as 1.04 = (7,800 ÷ 7,500). Similarly, if actual quarterly milk production per cow was 7,200 pounds, the yield adjustment factor would be 0.96, as 0.96 = (7,200 ÷ 7,500).
A yield adjustment factor greater than 1.0 will increase the actual milk revenue and reduce any indemnity due to the dairy farmer. This holds true regardless of actual farm level production. The individual producer’s production may not have moved in the same direction or magnitude as the state or region’s average. Yield adjustment factors are calculated for the major 24 dairy states (see below) while farmers in states outside the major 24 are grouped into pooled production regions.
Five Producer Decisions
The following elections must be made by a producer at the time of DRP endorsement purchases. These decisions allow the farmer to customize the endorsement to most accurately align with their production practices, risk management goals, and risk tolerances.
1. Method to value milk
The purpose of DRP insurance is to protect against a decline in a producer’s quarterly milk revenue. As such, it is important for the policy to accurately reflect the manner in which the producer is paid for their milk. DRP allows dairy farmers to select a class- or component-based milk pricing option.
The class-pricing options uses a three-month average of the Chicago Mercantile Exchange’s Class III and Class IV milk futures prices for the insured quarter. The weighting of each class price in the calculation is determined upfront by the producer and used to determine coverage and indemnities. The component-pricing option uses the component prices of butterfat, protein, nonfat solids and other solids as a basis for determining coverage and indemnities. The butterfat and protein test percentages are declared by the producer to establish their insured milk price. This option uses three-month averages of the Chicago Mercantile Exchange’s butter, cheese, dry whey and nonfat dry milk futures to derive implied component values.
2. Amount of milk coverage
Each producer declares an amount of quarterly milk production to insure under the DRP insurance program. There are no minimum or maximum volume requirements or limitations. Multiple quarterly coverage endorsement for the same quarterly insurance period are allowed, although they cannot cover the same pounds of milk production. RMA requires producers to prove milk production within 85 percent of the declared pounds protected on the class-pricing option and components need to be within 90 percent of declared butterfat/protein levels.
3. Optional protection factor
Farm-level milk production is more variable than state-averaged values. Under DRP, a producer must elect a protection factor between 1.0 and 1.5 in 5 percent increments. The purpose of the protection factor is to provide greater flexibility in matching farm-level production risk. Quarterly indemnities increase proportionally with the protection factor, as do premiums. The ability to use a higher protection factor when executing DRP insurance allows for producers to scale into higher levels of coverage should the market move in their favor. Protection factors also allow for greater flexibility with respect to higher component milk. It also allows producers with higher component milk to protect the equivalent value of their milk (energy corrected) when component-pricing DRP is not offered. Oftentimes component-pricing is not listed, especially for Class IV components.
4. Coverage level
Quarterly insurance coverage levels are available from 80 to 95 percent in 5 percent increments. This coverage level determines the final revenue guarantee a producer will receive on their covered milk production. Like other crop insurance products offered by the federal government, there is a premium discount provided to purchase DRP insurance and it varies by the elected deductible. The producer’s elected coverage level also determines the magnitude of the government subsidy paid toward the premium. The subsidy is dependent upon a producer’s declared coverage level, as illustrated below.
|Coverage Level||Premium Subsidy|
For example, if the DRP insurance policy premium for 95 percent coverage was 19 cent per hundredweight, the farmer would receive a discount of 8 cents ($0.19×44%) and pay 11 cents per hundredweight for the policy. Unlike exchange-traded options, premiums are due at the end of the quarter being insured rather than paid as an upfront cost when the coverage begins. Many producers view this cash flow-friendly aspect of the program as a significant advantage.
5. Insurance period
Each crop year has 8 quarterly insurance periods available but only up to 5 quarters are available at each daily sales period. Coverage is established by adding quarterly coverage endorsements to a policy. The daily sales period for Monday through Thursday begins when prices and rates are published on the RMA website and runs through 9:00 AM Central the following business day. When prices and rates are published on Fridays, the daily sales period ends Sunday morning at 9:00 AM Central. Keep in mind, as outlined above, there may be times when RMA does not publish prices and rates.
A producer is due an indemnity if the Final Revenue Guarantee is greater than the Actual Milk Revenue.
The Final Revenue Guarantee is equal to the coverage level (elected by the producer) multiplied by value of milk (determined by producer’s pricing election) multiplied by covered milk production (elected by the producer).
The Actual Milk Revenue under DRP is the product of the actual value of milk (based upon pricing selected by producer), the covered milk production (elected by producer), and the yield adjustment factor (determined by state or region milk production per cow).
Finally, if an indemnity is due, the payment is multiplied by the producer-elected protection factor.
Dairy Revenue Protection plays a critical role in safeguarding the financial stability of dairy farmers. It is an excellent tool for a producer looking to establish cash flow-friendly, cost-effective coverage. Much like exchange-traded put options, endorsements establish some level of protection while maintaining opportunity to the upside should the market move higher. The sign-up process is simple and program costs are uniform across all agencies. The value the agent brings is their expertise, tools, and analysis. CIH has built a suite of tools to allow producers to efficiently analyze how prices and premiums offered by the program fit into their operation, risk tolerances, and help manage margins forward out in time. It is critical to assess how farm-level factors and features under DRP relate to your specific operation. Contact Dairy Team with any questions about how DRP may fit into your risk management approach, or learn more about DRP Insurance here.