Understanding Your Price Risk Is Crucial in Today's Crop Insurance Market

October 17, 2016

In 2016, 76% of total premium was written in Revenue Protection alone. Revenue Protection insures producers against both yield and price risk, paying out on the higher of two prices:  the price established at planting and the price established at harvest. In the U.S. Multi-Peril Crop Insurance (MPCI) Program, prices are generally established using the commodities futures market, with two discovery periods to establish a planting price at the start of the season and a harvest price at the end of the season.

Beyond the establishment of the planting and harvest prices, there is an important secondary factor influencing the industry from the price side—the implied price volatility. Price volatility represents the standard deviation of the true price distribution. High implied volatilities indicate the potential for large price swings, while lower implied volatilities indicate smaller swings. Premium rates, set by the Risk Management Agency, are influenced significantly by price volatility. If implied price volatility measures are high at planting, premium rates will be higher than if low implied price volatility is established for the crop year.

Chart: premium rates and implied volatility
Figure 1. How premium rates and implied volatility move together. (Source: AIR)

Implied Price Volatility in the Past

It is important to stress that implied price volatility is a market expectation over price swings and, given that it is set at planting, may incorrectly signal small movements in a season during which large price swings occur. This is precisely what  happened in 2014, when corn and soybean volatilities were 0.19 and 0.13. These volatilities were far below the 10-year averages of 0.26 for corn and 0.22 for soybeans. Price outcomes for the 2014 crop year were a decline from $4.62 to $3.49 for corn, and from $11.36 to $9.65 for soybeans. A similar price drop occurred in 2008; however, the implied price volatility was much higher indicating the likelihood of such an event occurring would be much higher (see Figure 2).

AIR staffer volunteer
Figure 2: Illustration of price volatility and likelihood over different ratios of harvest to planting price. Representative log normal price distributions at 2008 and 2014 implied price volatilities and the respective price ratios are shown. (Source: AIR)

Recent Low Implied Price Volatility Regimes and the U.S. MPCI Model Update

The AIR U.S. MPCI model incorporates prices and price volatilities such that users of the model can easily understand how price volatility affects losses. In the current version of the model, there are three catalogs, representing high, medium, and low scenarios for price outcomes (respectively known as the High, Medium, and Low catalogs). The Low catalog is most aligned with historical average implied price volatilities.

In 2016, the industry saw record low implied price volatilities established for corn and soybeans at 0.17 and 0.12, respectively. These low volatilities have motivated AIR to generate a new set of four catalogs in the AIR U.S. MPCI model update, scheduled for release later this year. These catalogs are known as the Historical Price Volatility catalog, the Low Price Volatility catalog, the Medium Price Volatility catalog, and the High Price Volatility catalog. The major change is that we have created a new version of the Low catalog to represent a very tight market view on price outcomes. To capture a view of historical implied price volatility levels, there is now the Historical Price Volatility catalog. The Medium and High catalogs continue to represent views on larger price swing outcomes, as in the previous model version.

A key advantage in using the updated AIR U.S. MPCI model is the ability to model price risks accurately. Moving from a three to four catalog system allows even greater flexibility in creating more representative loss estimates under a variety of implied price volatility scenarios. If current, low price volatility regimes prevail, the updated Low catalog can best represent this market view. However, if the user would like other views of their price risk, there are now three other catalogs to compare to, including the historical average price volatility. These many views of the price risk allow companies to best prepare for the upcoming crop season.

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