The term “risk management” has become a catch phrase for a variety of ideas in farming. Some use the term to describe various insurance programs. Others insist that learning to use the futures and options markets is the secret to farming success. In reality, the concept of risk management is much broader than any single idea. What some suggest as risk management tools may increase the amount of risk exposure.

 Farming is a risky business. The easiest way to eliminate risk would be to sell the farm and invest the money in government bonds. Most farmers have learned to deal with production risks. Crop rotations, crop protection chemicals, seed selection and geographical diversity all offer ways to reduce risk.

 Financial risk is a different story. The tools are not so easily understood. The costs are not as evident. The pitfalls may be hidden. The traits that make a farmer a good producer may make the same individual poor at dealing with financial risk management.

 Crop insurance is a common risk management tool. Coverage is based on yield history. Premiums are based on risk. The recent proliferation of riders has increased the complexity of the crop insurance picture. Policies that cover price are available at a wide variety of coverage levels. Certain policies allow a discount for putting production units together. Besides the multi-peril policies, insurance can be purchased for specific risks such as hail.

 In some circumstances the cost of the protection in crop insurance may be very high in comparison to the coverage offered. In one instance, I looked at a policy that charged 50 cents in  additional premium for a dollar in additional coverage. A lot of farmers bought the policy thinking that a loss was almost a certainty. They did not calculate how much they were paying for extra coverage. It turned out to be a year of good production and they added a lot to their costs.

 Futures and options are promoted as risk management tools. They may be, if used properly. However, the risks and returns are not as obvious as for insurance. Futures involve the use of margin to ensure compliance. When the futures transaction is in a losing position, additional margin money is required. Paying a margin call is very emotional for most farmers.

 Options require the payment of premium rather than margin. The premium on an option is more expensive for the same coverage than the premium on insurance. The buyer of an option usually loses money. A farmer who is going to use options successfully must have a carefully designed plan. Even then, a lot of experience  is required to make the use of options anything more than an additional operating expense.

 A former commissioner for the Commodity Futures Trading Commission stated that a farmer who opens a commodity account may be exposing his or her business to risks that they do not understand and which they do not have the skills to manage. Success in  the futures and options market requires much more than an academic understanding of how to make transactions with a broker.

 Even the cash grain and livestock markets  are not risk free. A look at the hedge-to-arrive fiasco in 1995-1996 shows how treacherous  cash markets can be. Farmers were advised to enter into contracts with grain buyers to price corn several years ahead. They did not understand that they were agreeing to deliver a crop that would not be produced when the contract came due. The price of the corn went to historical highs. They were not informed that their contracts were losing money until more than a dollar per bushel was lost on several years’ production.

 A strategy as simple as storing grain until the next year has risks. The drop of $1.50 per bushel in the soybean price in the winter of 1998-99 illustrates how risky it is to store grain. Farmers saw a billion dollars of equity slip away as the value of inventory dropped through the winter.

 There is no easy solution to the risk management puzzle. Some farmers deal well with financial risk. Many do not. If there were a probability table for every risk, the solution would be simple. Unfortunately, that is not the way it works.