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Livestock Gross Margin Insurance for Dairy: Designing Margin Insurance Contracts to Account for Tail Dependence Risk

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  • Bozic, Marin
  • Newton, John
  • Thraen, Cameron S.
  • Gould, Brian W.

Abstract

Livestock Gross Margin Insurance for Dairy Cattle (LGM-Dairy) is a recently introduced tool for protecting average income over feed cost margins in milk production. In this paper we examine the assumptions underpinning the rating method used to determine premiums charged for LGM-Dairy insurance contracts. The first test relates to the assumption of lognormality in terminal futures prices. Using high-frequency futures and options data for milk, corn and soybean meal we estimate implied densities with flexible higher moments. Simulations indicate there is no strong evidence that imposing lognormality introduces bias in LGM-Dairy premiums. The remainder of the paper is dedicated to examining dependency between milk and feed marginal distributions. The current LGM-Dairy rating method imposes the restriction of zero conditional correlation between milk and corn, as well as milk and soybean meal futures prices. Using futures data from 1998-2011 we find that allowing for non-zero milk-feed correlations considerably reduces LGM-Dairy premiums for insurance contracts with substantial declared feed amounts. Further examination of the nature of milk-feed dependencies reveals that Spearman’s correlation coefficient is mostly reflecting tail dependence. Using the empirical copula approach we find that non-parametric method of modeling milk-feed dependence decreases LGM-Dairy premiums more than a method that allows only for linear correlation. Unlike other situations in portfolio risk assessment where extremal dependence increases risk, in agricultural margins, tail dependence between feed and the Class III milk price may actually decrease insurance risk, and reduce actuarially fair premiums.

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Bibliographic Info

Paper provided by Agricultural and Applied Economics Association in its series 2012 Annual Meeting, August 12-14, 2012, Seattle, Washington with number 124718.

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Date of creation: 2012
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Handle: RePEc:ags:aaea12:124718

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Related research

Keywords: LGM-Dairy; margin insurance; generalized lambda distribution; tail dependence; empirical copula; Demand and Price Analysis; Livestock Production/Industries; Research and Development/Tech Change/Emerging Technologies; Risk and Uncertainty;

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  1. Babcock, Bruce A. & Hart, Chad E. & Hayes, Dermot J., 2004. "Actuarial Fairness of Crop Insurance Rates with Constant Rate Relativities," Staff General Research Papers 11283, Iowa State University, Department of Economics.
  2. Williams,Jeffrey C. & Wright,Brian D., 2005. "Storage and Commodity Markets," Cambridge Books, Cambridge University Press, number 9780521023399.
  3. Chad E. Hart & Bruce A. Babcock & Dermot J. Hayes, 2001. "Livestock Revenue Insurance," Center for Agricultural and Rural Development (CARD) Publications 99-wp224, Center for Agricultural and Rural Development (CARD) at Iowa State University.
  4. Kousky, Carolyn & Cooke, Roger M., 2009. "The Unholy Trinity: Fat Tails, Tail Dependence, and Micro-Correlations," Discussion Papers dp-09-36-rev.pdf, Resources For the Future.
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