Strategies for Risk Management

Agriculture is constantly changing. Change creates unexplored frontiers of knowledge. The lack of certainty about occurrence of future events creates risk. Risk by definition is the "exposure to the chance of injury or loss." Profit can be viewed as a return for managing uncertain events that create exposure to losses. Many would contend that without uncertainty and risk, there is no opportunity for profit. Farmers of today and tomorrow need to manage this risk.

Sources of Risk

The first step in developing a risk management plan is to identify the sources of risk that may affect your farm business. Farm managers face a multitude of events that create risks, many resulting from change of one sort or another. During the 1980's, many farmers have learned firsthand about the problems of risk. Adverse weather, ranging from drought to floods, caused yield reduction in several of the Nation's major agricultural regions. These events, combined with fluctuating export demand, resulted in wide swing in commodity prices. Declining land values, along with high interest rates, put many farmers out of business and threatened the survival of many others--especially those with highly leveraged farms.

There are many ways to categorize the sources of risk that farm business face. (See Part II, Chapter 4 for an analysis of risk categories.)

Determine Risk-Bearing Capacity

Once a farm manager has identified the sources of risk, the next step in developing a risk-management plan is to evaluate the capacity and willingness to bear risk.

The primary financial document relating to risk-management capacity is the net worth statement (also known as a balance sheet). The statement lists the farm's assets and liabilities as of a specific date. The difference between the value of assets and debts (or liabilities) is called net worth or equity. This amount shows the degree to which the farm debts could be covered if the farm were liquidated through the sale of its assets.

Consider this example. If a farmer had total assets with a market value of $350,000 and total liabilities of $178,000, the equity would be $172,000. With that level of equity, there would be no immediate danger of foreclosure. However, dividing total liabilities ($178,000) by total assets ($350,000) yields the farmer's debt-to-asset percentage, which is just over 50 percent. Looking at the situation this way, it becomes clear that the farmer is highly leveraged, and a caution light should go on. By dividing the farmer's total liabilities by the farm's net worth, the result is the debt-to-equity ratio (also known as financial leverage). This example farm has debt-to-equity ratio just over 1 to 1. This leverage ratio indicates that the lender has just as much at risk as does the farmer.

Since the balance sheet measures how liquid a farmer's business is, it can be a useful tool in determining the ability of the farm business to meet financial obligations in a timely manner should an adverse event arise.

Assessing Risk

The third step in developing a risk-management plan is to determine potential loss exposure for each source of risk that can be managed. For each risky or uncertain event, the farmer must estimate the size or magnitude of the potential dollar loss, as well as the probability or chance of this occurrence. Estimates of the magnitude and probability of a potential loss enables the decisionmaker to evaluate the tradeoffs among risk-management strategies.

Alternative Risk. Management Strategies

For each source of risk that is identified, a risk-management strategy should be employed.

Development and evaluation of risk-management strategies under the chances of alternative net returns should be conducted within a risk/return framework. For example, the use of self-insurance can be compared with the use of risk-transfer mechanisms, which would reduce the level of net returns in good years but provide protection in catastrophic years. An alternative risk-management strategy is to avoid a risky situation. This approach eliminates the opportunity for profit but also the risk of loss.

The following discussion separates production strategies from marketing, but it is important to recognize that these areas are interrelated and that both have financial implications. A wise marketing strategy often starts with an assessment of market demand, as reflected in current and predicted prices.

Production and Financial Strategies

Risk management strategies for production and financial risk include diversification, spatial dispersion, enterprise selection, production management schemes, insurance, resource reserves, control of resource services, flexibility, crop insurance, and consideration of Government programs. It is crucial to base these strategies on adequate knowledge, including farm record data, the farmer's managerial expertise, and outside information sources when necessary.

Diversification. Diversification works only if the profits from two or more enterprises do not have a high positive correlation. Corn and soybeans are often influenced in the same way by growing conditions. For example, drought will probably reduce yields of both, although the timing of the rainfall or lack thereof can influence them a bit differently because of differences in the definiteness of their respective flowering periods. But by adding winter wheat to a row-crop, corn-soybean farm, the farm becomes more diversified. Such a change may reduce risk because winter wheat yields on midwestern farms are not highly correlated with corn and soybeans yields.

However, diversification has risks, too. Diversifying into another crop or livestock enterprise may require new knowledge and skills and increased capital investment. Also, diversification into volatile enterprises, with wide ranges in earnings, would increase risk.

Control of Resource Services. Alternative methods for controlling resources can also be part of a risk-management plan. For example, farmers who rent land for cash retain all of the yield and price risk on their balance sheets. Share renting is an alternative that allows sharing of this risk with landlords. A written contract, regardless of the rental method, clarifies the responsibilities of both farmer and landlord.

Control of Machinery Services. This is another area that has important ramifications for production and financial risk management. Ownership is one method to obtain absolute control over what machinery services are offered and when. The risk-returns tradeoff of owning your own machinery may be that this approach costs much more than custom hire or contracting. Contracting for machinery services may allow farmers to reduce their machinery investment and strengthen their balance sheet by avoiding new machinery debtor reducing old debt. Machinery requirements (and the risk of yield loss) are also influenced by selection of the cultural practices, for example when farmers choose between conventional tillage and alternative tillage practices such as no-till or ridge-till.

Crop Insurance. Purchase of crop insurance is another risk-management strategy. Crop insurance provides a guaranteed yield per acre. If actual yields are less than the guarantee, crop insurance makes up the difference. The indemnity payment is based on the yield loss multiplied by a preselected commodity price. With the potential decline of federally financed disaster payments, crop insurance may become more important as a risk-management tool.

Flexibility. In evaluating risk-management strategies, the farm manager needs to ask how much of an adverse event such as low yields, low prices, lawsuits it would take to exhaust the equity of the business. Common mistakes in developing risk-management strategies are to underestimate the probability of occurrence or the magnitude of loss if the event occurs. The farm manager must consider the costs of doing business and family living expenses in evaluating the impact of adverse events on the farm's equity position.