White Paper on Subsidy Harvesting

Livestock Risk Protection (LRP) has become an integral part of many livestock producers’ risk
management toolbox in recent years. The program is intended to protect farmers from
unexpected price declines with customizable end dates, coverage levels, and number of
animals per endorsement. The reasons behind the dramatic uptick in usage are straightforward.
Modifications over the past several years to increase head limits, increase subsidy levels, and
change the premium due date to help with cash flow needs have all been made with the
producers’ best interests in mind.

Figure 1. Swine Participation by Insurance Program, Crop Year

Figure 2. Cattle LRP Participation by Crop Year

LRP and its relatively affordable price protection coverage has been a game changer for many
producers across the country at a time when profit margins have been severely depressed.
Similarly, Dairy Revenue Protection (DRP) has seen similar success by offering subsidized
protection for dairy producers. Oftentimes, LRP is thought of as similar to an exchange-traded
put option. While they both provide a form of price protection, they are fundamentally different
products with different mechanics. At times, LRP premiums may be less expensive than put
options at similar coverage levels and coverage lengths. Rumors exist of a handful of producers
and their insurance agents and/or commodity brokers engaging in a tactic to attempt to capture
this difference in premium. This tactic is often referred to as subsidy harvesting. CIH and its
affiliates have internal policies in place to entirely prevent this practice. Subsidy harvesting is not
only an ill-advised strategy that threatens the financial viability of the producer, it is an afront to
the integrity of the program and should be avoided at all costs.

Subsidy Harvesting Overview

The process of subsidy harvesting is straightforward—it is a tactic involving the purchase of
LRP and the simultaneous sale of the closest strike price exchange-traded put. The idea (albeit
flawed for the reasons outlined below) is that by purchasing a subsidized LRP and selling a put,
the producer captures the difference in premiums as a credit. There is also the belief the two
cancel each other out without any associated risks. While this appears to be true at first glance,
there are many hidden risks and consequences which may be deliberately not well-explained or
factored in for those who choose to participate in this practice.

• The process of subsidy harvesting contains significant risk with limited upside. The
  maximum that can be gained by such a strategy is the difference in premium between
  LRP and the put. It is important to note, however, that this is before consideration of
  financing costs and capital requirements, which would erode any expected return.
• From a cash flow perspective, there is serious risk to the operation in a down market. In
  reality, this is when the producer needs protection the most. Margin requirements would
  need to be maintained on the short put at all times. The cost of meeting these margin
  requirements becomes even higher in high interest rate environments, decreasing the
  supposed benefit of this strategy. Cash flows are generally strained when markets are
  falling and a producer could realize a substantial loss if their position had to be liquidated
  before the end date.
• Engaging in this practice carries no risk management application and is purely a
  speculative trade. As such, lender-secured hedge accounts would not allow such actions
  to be taken with those funds. Using a non-secured speculative account for the short put
  further drives up the cost of capital and makes the expected return even more negative.
• Federal crop insurance programs are designed to equip producers with the ability to
  weather market downturns. Because subsidy harvesting carries no risk management
  application, it is wasteful and an abuse of taxpayer dollars. It does not make sense from
  a risk/reward standpoint, nor does it align with the stated purpose of government-subsidized insurance products, which is to create a sound system of crop insurance andto prevent fraud, waste, or abuse of its programs.

Historical Example

In the example below (for illustrative purposes only), in mid-November a producer could have
purchased a 26-week, $96 LRP policy with an end date on April 13, 2023 for a premium of
$4.08 per hundredweight. This premium is after the 35 percent subsidy, which amounts to a
$2.20 per hundredweight discount. On the same day, a producer engaging in subsidy harvesting
could have sold a $96 put and brought in $5.40 per hundredweight. This tactic would have
created a credit of $1.32 per hundredweight (note the practice does not capture the full amount
of the subsidy).

Table 1. Subsidy Harvesting Example*

*For illustrative purposes only. Not an advisable strategy.

As we moved forward from November into April, the lean hog market fell substantially. On April
13, 2023, lean hog futures settled at $71.60 per hundredweight. Whereas the $96 LRP would
have established a price floor at $91.92 per hundredweight, selling the $96 put would have
negated this protection. The net price (ignoring basis) from the subsidy harvesting strategy
would have been $72.92 per hundredweight, as displayed in green below. The producer
appears to have been $1.32 per hundredweight ahead of the open market.

Figure 3. April 2023 Subsidy Harvesting Example*

*For illustrative purposes only. Not an advisable strategy.

Keep in mind, though, the supposed gain is before accounting for financing costs for the margin
requirements incurred while the market was falling from mid-December through mid-April. In this
example, the producer would have needed a minimum of $10,700 in performance bonds to hold
this short position ($1,700 for initial margin plus an additional $9,760 in variable margin).
Producers tend to have additional capital available to be comfortable, perhaps to the tune of $30
per hundredweight. In this case, the producer would have needed access to about $13,700
($1,700 for initial margin plus $30 per hundredweight times 40,000 carcass pounds). For a
duration of 6 months with a cost of capital of 8 percent, this comes out to $548, or $1.37 per
hundredweight.

There are, of course, many assumptions to the calculation above and it will differ from one
producer to the next, but it is clear subsidy harvesting is not a zero-cost endeavor. The prospect
of attempting to capture $1.32 per hundredweight ultimately would have cost this producer
significantly and kept him or her open on the more than $25 per hundredweight drop the market
experienced.

CIH Position

CIH has been very clear on its stance against subsidy harvesting for years. Part of this has
included industry education through speaking engagements on best practices around LRP,
articles in industry publications on the merits of modifications to the program, white papers on
the dangers of subsidy harvesting, as well as an educational seminar for lenders highlighting the
risks of such actions to all parties involved. Internal CIH policy prevents producers from
engaging in any attempt to capture the differential in value between LRP and similar exchange
equivalents. While the company and its affiliated brokerage entity have not seen its insured
attempt this due to significant internal educational efforts, compliance staff reviews of
endorsements and corresponding brokerage accounts are conducted on a routine basis to
ensure the practice is not taking place.

It is our belief that a similar approach can and should be taken by all LRP stakeholders. CIH is
supportive of any attempt to prevent subsidy harvesting from taking place, whether that be
through additional educational efforts or explicit policy language to prevent insureds, agents,
and advisors from pursuing or recommending such strategies.

Read More on Livestock Insurance:

Livestock Price Insurance – the Do’s and the Don’ts

USDA Livestock Insurance: A Game Changer in Risk Management

Mandatory Price Reporting: Make it Essential

Questions?

Reach out to our Cattle Team or Hog Team, and check out our upcoming educational seminars.