Is Dairy Insurance the beginning of another taxpayer bailout?

According to the Capital Press (the West’s Ag Website in case, like me, you did not already know), “Dairy producers might soon have another tool to protect against unexpected declines in milk prices or milk production.” Dairy Revenue Protection (Dairy-RP) will allow farmers to insure quarterly revenues.
Agricultural revenues are volatile. The unreliability of future prices in farm production is a problem all over the world. But is insurance the right solution?
First, press releases indicate that potential payments would be “based on futures prices”. From the available information, though, it sounds as if the futures price is only an informational input. The futures may not be used as a trading mechanism.
Another article mentions that “market-implied risk” is used as an input to the price. Does that mean the pricing for the insurance varies in response to customer demand? I don’t think so. Usually, insurance prices may not vary from one customer to the next. Perhaps, market-implied risk simply means the futures price is as an index on which the outcome of the insurance is based.
So where is the feedback in this new offering?
There could be market feedback if the insurers selling this guarantee were selling futures contracts as farmers bought the insurance. There are still problems with this approach. Selling insurance is like selling an option. The price might not move and you end up collecting the premium. Or, the price might collapse and you take the loss the insured would have suffered. This is, of course, why option sellers hedge themselves. But hedging an option sale with a short futures position does not remove all risk. And, the number of futures contracts that must be sold to keep the insurer safe varies with movements in the price of the underlying commodity. The insurer (or option seller) faces risk from price volatility. Instead of standing still or moving in a nice orderly trend in one direction, the price of the underlying product, milk, in this case, could be more volatile than expected If that happens, the insurer can easily lose more on their futures hedging than they have received in insurance premiums.
This is all academic, though. They probably aren’t hedging. And the government is subsidizing the whole thing. The government, according to our sources, will be paying something in the neighborhood of 19% of the premium.
So, what we have here is not a new marketplace for the transfer of risk, but a government subsidy to help out a group of producers.
How has that worked in the past? Did FDIC insurance stop banks from taking too much risk before 2008? Did the mortgage guarantees from FNMA and FHLMC keep the mortgage market from tumbling? Subsidies and government-backed insurance are not markets. They miss the critical feedback information revealed in the interactions of a real market. They often lead to over-production and glut. And they can lead to the socialization of the loss in the case of price drops which harm the insurers.
None of this is to suggest that dairy farmers don’t need protection from price risk. I’m sure they do.
Why don’t farmers just use the CME’s futures product? It must exist for the Dairy Revenue Protection to use its price data. The CME certainly isn’t a problem as a counterparty. What are the problems that preclude simply hedging on the CME?
First, contracts and margin requirements are not always of the appropriate size. Even with the reduced margin levels available to hedgers, a dairy farmer would have to put up capital. Moreover, that margin amount would need to be increased if the price of the milk futures rose. A bullish market for milk prices could be a costly affair for a hedger. Second, milk prices are highly local, so there is significant risk that the price the farmer gets for his milk will vary substantially from the CME milk price. Third, the farmer would have to manage his futures position continually, taking attention away from his real job. Not all small farmers have the time or the knowledge to run a hedging operation properly. Fourth, what if the farmer faces a production shortfall and the price goes up? That could get ugly. And, finally, there are all the other risks I don’t know about but that dairy farmers could probably list.
What about something completely different?
How about a customizable derivative — something that allows the insured to design the extent and “shape” of the coverage? (Or that an insurer can design, passing a better product along to the insured without taking undue risk.) What if the financial commitment of the farmer were limited in a way that they would not be limited with futures contracts? Perhaps, a new product without the possibility of margin calls. Such a customizable derivative would still be priced in a market and, as such, would carry none of the moral hazard or incentive for production gluts associated with government-backed guarantees. Finally, how about a standard contract unit small enough to be appropriate for any user regardless of scale?
Sounds OK to me. Maybe someone should work on that?

