Developing risk management strategies for your operation is an important thing to give a little thought to as you go about making decisions. There are four main strategies a producer can use to manage risk:
- avoid the risk
- transfer the risk
- control the risk
- accept the risk
Avoid the Risk
Avoiding risk is a case of simply not doing the thing that exposes you to the risk. For example, if you want to avoid the risk of retaining heifer calves and trying to get them bred, you can simply not retain them anymore and buy bred heifers that are guaranteed pregnant. Keep in mind, avoiding a risk can sometimes expose you to a greater risk. This certainly might be the case if you suddenly stopped raising your own replacement heifers and started buying them from someone you didn’t know.
Transfer the Risk Outside Your Business
Transferring risk outside your farm or ranch is usually done through insurance or marketing contracts. Insurance contracts provide protection from downside risk in exchange for a premium expense. By paying the premium, you essentially transfer some of the potentially bad outcomes to an insurance company that is better equipped to tolerate the risk. Insurance has the effect of truncating your distribution of possible outcomes on the downside in exchange for subtracting the insurance premium expense from every outcome. Marketing tools like a put option work exactly the same way.
On the other hand, a marketing contract that locks in your price on some or all of your production would have the effect of squeezing your distribution of outcomes into a tighter range of possibilities. You are transferring some of the risk associated with the full range of possibilities to the person you are contracting with in exchange for a risk premium that they collect from you up front by offering you a contract price that is slightly in their favor compared to what they expect the actual price to be at the end of the contract period. The more you lock in, the tighter the range becomes for the outcome. As you lock in more and more, you transfer more of the potential upside and more of the risk premium to the person you are contracting with in exchange for also transferring more of the downside risk to them.
Evaluating insurance and marketing contracts can be frustrating if you only do it after the fact. Once the outcome is determined, it is tempting to declare the decision good or bad based on whether the contract worked in your favor. That is a bad habit to get into. You should always make a sincere effort to evaluate the insurance or marketing decision at the time you make it in terms of what it costs you in premium compared to the benefit of transferring the risk to a party outside of your farm or ranch.
Control the Risk
Controlling risk is by far the most active form of managing risk. There are two primary ways to control risk. You can either control the probability of the outcomes occurring or control their impact if they do occur. Very seldom can you do both with one tool.
For example, you can influence the probability of your replacement heifers getting pregnant by maintaining proper nutrition and a number of other things. Is this a good strategy? Probably, but you need to compare the extra expense with the increased pregnancy rate of your heifers to determine the value of this strategy. If you wanted to control the impact of your heifers not getting pregnant, you need to move to a different strategy.
Controlling the impact of risk involves using strategic risk management tools like diversification, keeping extra reserves on hand, and maintaining flexibility to lessen the impact of a bad outcome or increase the impact of a good outcome. For example, exposing extra heifers to breeding will lessen the impact of a poor conception rate. Maintaining the flexibility to buy bred replacement heifers would also lessen the impact without the need to increase the number of heifers you retain. This can also be thought of as diversification in that you have more than one source from which to obtain bred replacement heifers.
Accept the Risk
Risk is usually associated with a potential reward. Sometimes there are no tools available to control or transfer risk or the tools are just too expensive to justify using them. In this case, accepting the risk might be the right strategy. Producers speculate on risk all the time. That’s where a lot of the profit in farming and ranching exists. However, it should be done with careful evaluation of the potential impacts and your willingness to accept the probability of their occurrence.
Risk management is an activity that can pay big dividends. Thoughtfully considering and evaluating various risk management strategies as a habit of doing business can lead to a stable and prosperous future for your operation.
Jay Parsons, Farm & Ranch Management Specialist
University of Nebraska-Lincoln
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