Introduction
Risky events, as defined by Robison and Barry, are "those uncertain events whose outcomes alter the decisionmaker 's well-being." Thus, for an event to be risky, more than one outcome must be possible (e.g., high vs. low output), and the possible outcomes must have significance to the decision maker (e.g., high vs. low profits). Furthermore, for the event to represent a risk management issue, the decision-maker must be capable of at least subjectively evaluating the probabilities and payoffs associated with each possible outcome, i.e., the decision-maker must be able to make informed decisions.

Production risk is perhaps the most widely recognized risk element in agriculture and certainly qualifies as both a risky event and a risk management issue. Crop yields and quality, and costs of production are inherently uncertain because of the vagaries introduced by weather, disease, pests, and other factors. Certain agronomic practices (e.g., irrigation) can affect the degree of production risk but, ultimately, the biological nature of agricultural production means there will always remain a large degree of uncertainty. A farm s profitability and overall financial health is, of course, highly dependent on its degree of exposure to production risk and the mechanisms in place for mitigating this risk exposure. This is particularly true as farms become larger and more mechanized and, thus, incur typically larger debt obligations. A farm must be able to generate sufficient cash flow to meet debt obligations, which begins with producing an adequate quantity of output to market.

Sources of Production Risk

Environmental Factors
Environmental factors are perhaps the most prominent source of production risk. Drought, disease, and insect pressure, for example, all have the potential to drastically reduce crop yield and quality. At the same time, efforts to control these environmental threats can result in significant increases in the cost of production. In cotton production, for example, producers can incur extremely high chemical costs to control insects in years of severe infestations, yet still suffer significant yield losses.

Access to Inputs and Resources
Another source of production risk is access to inputs and resources. As farms become larger and more mechanized, access to inputs and resources to efficiently conduct operations becomes an increasing concern. For example, having adequate labor and machinery available for timely planting, cultivation, and harvesting of crops is critical to producing a bountiful harvest. Conducting these operations even slightly outside of their optimal windows can have significant detrimental effects on yields and quality, with a severe negative impact on the farm enterprise s bottom line.

Input Costs
Modern agricultural production is heavily dependent on purchased inputs (e.g., fertilizer, seed, chemicals), introducing a third source of production risk. The cost of many of these inputs is determined largely outside of the agricultural arena. For example, the prices of synthetic fertilizers and chemicals are heavily influenced by the price of crude oil. A significant tightening of the world supply/demand situation for crude oil will invariably lead to much higher fertilizer and chemical prices and, thus, a considerable and unexpected increase in the cost of production for growers.

Technology
Technology is often proffered as a means of reducing production risk. While true in many cases, new technology can also serve as a source of increased production risk. This is particularly true if unfamiliar management and/or agronomic practices are required. The producer may then not have the knowledge and experience base to utilize the new technology effectively, resulting in increased production risk exposure. In addition, the costs and benefits of emerging technologies may not be well known, such that a producer could incur considerable expense in adopting the technology, but receive limited benefits at best.

The Process of Risk Management

Having identified some of the primary sources of production risk, the obvious question is: What can be done in response? The operative concept in dealing with risk is risk management. Note that risk management does not necessarily imply risk elimination. In many cases, risk cannot be eliminated or even reduced. However, risk can often be transferred to another party willing to bear the risk (e.g., crop insurance). The objective of risk management is to design a set of strategies which will achieve the desired performance standards of the farm operator. A successful risk management program does not simply happen; rather, a thoughtful process is needed to design such a program. Barry, Hopkins, and Baker identify a five-step process of risk management.

1. Identify managerial goals

While the identification of goals seems self-evident to the process of risk management, too often producers have only very vague and ill-defined ideas regarding the goals of their risk management plan. To make as much profit as possible is NOT a goal. It is simply a statement. A successful risk management plan requires specific goals, i.e., I want to guarantee a minimum 5% rate of return on my investment outlay. Managerial goals relate to issues such as profitability, farm size, and financial structure and must take into account the farmer s risk preferences. In most economic activities, there is a tradeoff between the level of risk and the potential returns, i.e., higher potential profit requires accepting a higher degree of risk. Thus, the farmer s preference in the risk-return tradeoff is an important criterion for identifying managerial goals and selecting risk management strategies.

2. Formulate alternative risk management strategies

Risk management strategies can be classified into three broad categories: production, marketing, and financial. Strategies can cross categories of risk, e.g., a production risk management strategy can have implications for financial risk. The appropriate mix of strategies is influenced by how effectively risk can be transferred, producer preferences regarding the risk-return tradeoff, and the producer s managerial goals.

3. Identify and collect relevant information

As stated above, the key to successful risk management is the ability to make informed decisions. Making informed decisions, of course, requires information about the consequences of alternative choices. Thus, once a producer has identified the set of feasible alternative strategies, all relevant information regarding the probabilities and payoffs associated with each outcome must be collected and organized into a form useful for analysis and decision making. Note that the data set will still necessarily be incomplete, otherwise there would be no risk management problem.

4. Select appropriate strategies and implement the plan

Preferably, risk-return data will be available to be used in making objective decisions regarding the appropriate risk management strategies. The risk-return data do not in themselves indicate which strategies are best. Rather, the risk-return data must be combined with the producer s managerial goals and a set of decision rules consistent with managerial goals. Computerized decision models offer a convenient and efficient means to combine the risk-return data, managerial goals, and decision rules to design a set of appropriate strategies. When risk-return data is not available, a producer must rely on subjective evaluations and decision criteria, i.e., the producer must make educated guesses. Even so, the producer should still bring as much information and sophistication for analyzing the problem and making choices as possible. Once, the strategic plan is developed, the plan must be implemented, which leads to the final step in the process of risk management.

5. Design an effective system to monitor the plan and respond to new conditions

This final step, also called the control phase, is perhaps the most critical yet the most often neglected phase. It assures that goals and performance standards are attained. Strategic risk management plans cannot be run as if on autopilot if they are to be successful, rather they take an active hand. The plan must be continually reexamined to insure that goals and performance standards are being satisfied and to determine if the set of strategies adopted in the plan is still appropriate in light of new developments. Recall that the strategic plan was developed initially with important information absent (if all relevant information were available initially, then there would have been no uncertainty and, thus, no risk). Over time, some of this absent information may be revealed, requiring modification of the strategic plan to achieve best performance. Also, unexpected events may occur after development and implementation of the strategic plan, again requiring reevaluation and modification of the plan to achieve maximum performance. Thus, the control phase of risk management is crucial to achieving managerial goals.

Responses to Production Risk
Producers have a number of means of managing production risk. A successful risk management strategy will likely include more than one of the methods discussed below. However, each grower s situation is different and requires a risk management plan tailored to his or her individual needs for most effective performance.

Commodity Selection

One production risk management strategy is to simply produce low risk commodities, that is, commodities with low output and quality variability. Such commodities typically require less management skill, and have lower input and capitalization levels. However, low risk commodities also typically generate low rates of return, even in good years. This is not surprising as profit can quite appropriately be viewed as the return to risk high risk means high profit potential, and vice versa.

Diversification
Diversification to include alternative commodities in the production portfolio is another risk management strategy often employed by producers. The idea behind diversification is that a farm with a mix of crops is less likely to suffer a production disaster than a farm with a single crop. In addition, diversification can eliminate bottlenecks in input use by spreading out the timing of operations and providing for more efficient use of equipment. Diversification can also break up the harmful disease and pest cycles often associated with monoculture. However, diversification into alternative commodities may require unfamiliar management and agronomic techniques, as well as additional equipment. Cotton, for example, is a very management intensive crop in comparison to corn and soybeans and, furthermore, requires a specialized harvesting unit (picker or stripper).

Geographical Distribution
Geographical dispersion is another means of responding to production risk. By spreading production over a wider geographic area, the risk that a localized event (e.g., hail) will impact the entire crop is minimized. However, spreading production over a wider area could also place a greater strain on resources and be detrimental to managerial oversight, both of which could actually increase production risk.

Management Practices
A very common production risk management strategy is the adoption of various agronomic and management practices.
Supplemental irrigation, for example, can help avoid a crop disaster in a drought year and also provide needed moisture at critical junctures during a crop s development in years of otherwise adequate rainfall. As another example, excess machinery capacity on a farm makes it more likely that critical operations can be performed during their optimal windows, maximizing yield potential. And, of course, application of pesticides to control weeds, insects, and diseases is a strategy used by almost all farmers.

Crop Insurance
The responses discussed above constitute informal insurance against production risk. In this section, a discussion of formal crop insurance options is provided. Crop insurance is typically purchased to cover yield and quality risks, though some of the newer crop insurance products also provide price and revenue coverage. The passage of the Crop Insurance Reform Act (Reform) of 1994 increased the importance of crop insurance as a means of transferring production risks to some other entity. Under Reform, the federal government no longer provides ad hoc disaster relief to farmers. Thus, a farmer cannot look forward to a public bailout if a crop is lost due to uncontrollable phenomena such as drought, hurricanes, etc. The intent of Crop Insurance Reform was to provide farmers with a greater incentive to purchase crop insurance and, thus, bear greater responsibility for their production risks. Furthermore, Reform required producers to purchase at least the catastrophic level of crop insurance in order to be eligible for USDA payments, or to provide a written waiver of liability.

Every producer has crop insurance, even a producer who has not purchased a crop insurance policy. Failure to purchase crop insurance is commonly referred to as self-insurance, i.e., the producer has voluntarily chosen to bear 100% of the risk of any crop loss. While self-insurance is an option, it is not a prudent risk management strategy for most producers. The essence of effective risk management is the transferal of risk to some outside party. The price charged by the outside party to bear this risk is known as the premium. On average, a producer purchasing a federal crop insurance policy pays approximately 60% of the total premium, with the Federal Government subsidizing the remaining 40%. However, a sliding scale is used such that as the amount of coverage purchased increases, the subsidy also increases.

Producers have a variety of crop insurance coverage options available to manage their production risks. The most common coverage is multiple peril crop insurance (MPCI), administered by the Risk Management Agency (RMA) of the USDA. Two yield guarantee plans are available under MPCI, the Actual Production History Plan (APH), and the Group Risk Plan (GRP). The discussion below will focus only on the APH Plan. The GRP is seldom used because the APH Plan is much more attractive for the vast majority of growers.

Actual Production History Plan
The APH Plan provides protection against yield and quality losses resulting from uncontrollable adverse growing conditions, including weather, pests, and disease. Losses are measured as the shortfall from the yield and quality guarantee provided by the coverage. Loss payments (indemnities) are based on the amount of the shortfall multiplied by the indemnity price chosen by the grower when the coverage was purchased.

A coverage level and indemnity price must be chosen by the producer for each crop/county combination. Coverage levels available are 50, 55, 60, 65, and 70 percent of the producer s actual production history. The actual production history is based on at least four years (and building up to ten years) of the producer s own yield data for a given crop/county combination. If the producer does not have at least four years of yield records, RMA will assign a transitional yield. RMA notes that coverage can be increased greatly if a producer has at least four years of historical yield data. The coverage level indicates the amount of APH that is insured. For example, a 50 percent coverage level means that only 50 percent of a producer s yield is insured, i.e., indemnity payments will not be made unless the producer has experienced a greater than 50 percent loss. At the 70 percent coverage level, payments are made if the loss exceeds 30 percent.

An indemnity price level must also be chosen by the producer when the crop insurance is purchased. This indemnity price level is between 60 and 100 percent of the price established by RMA. Note that the price established by RMA is not the guaranteed price; rather, it is the price used by RMA to determine premiums and indemnities. The maximum price is generally established by RMA 30 days prior to sales closing of the insurance purchase.

Catastrophic (CAT) coverage is the minimum coverage available under MPCI. CAT coverage is defined as a 50 percent coverage level and a 60 percent indemnity price level. This is the minimum insurance requirement necessary for USDA payments. RMA notes that CAT coverage provides substantially less protection than was previously available under government crop disaster assistance programs. As an added incentive to purchase higher levels of protection, the premium subsidy increases as the purchased level of protection increases.

Supplemental Crop Insurance Products
Many private insurers have developed policies to supplement coverage available under the APH Plan. Each supplemental coverage plan is unique since it is designed and provided by a private insurer. However, these supplemental plans fall into two broad categories: (1) yield coverage supplements; and (2) price enhancement supplements.

(1) Yield Coverage Supplements
Two general types of yield coverage supplementals are available. The first, referred to as a disappearing deductible, reduces the difference between a producer's yield guarantee and APH average yield (i.e., the APH deductible) in the event of severe losses. The second yield coverage supplemental, referred to as companion coverage, reduces the APH deductible in response to specific types of losses.

(2) Price Enhancement Supplements
As with yield coverage supplemental policies, there are two general types of price enhancement supplemental policies. The first type of price enhancement supplemental provides a fixed increase in coverage per unit (e.g., per bushel or pound) above the indemnity price level selected by the producer. Thus, this type of supplemental simply raises the maximum indemnity payment level. The second price enhancement supplemental, termed replacement cost coverage, protects producers against upward price movements when yields are below the APH guarantee. This type of supplemental coverage is particularly useful for producers engaged in forward contracting or hedging in the futures market. For example, a grower who has forward contracted or hedged cotton faces the possibility that actual production may fall short of contractual commitments. If this were to occur, the grower would face the prospect of purchasing the shortfall quantity on the open market to fulfill contractual terms. The grower could thus purchase MPCI to provide protection from the production shortfall while replacement cost coverage would protect the grower from adverse price movements.

Crop Revenue Insurance Plans
Crop revenue insurance plans are recent innovations in the crop insurance market and are only available on a trial basis in a limited number of states and for a limited number of crops. Crop revenue insurance provides growers protection against both yield and price losses and, thus, against a reduction in revenue. The Income Protection (IP) plan is a Federal Crop Insurance Corporation (FCIC) product and is currently available for cotton growers in selected counties in Alabama and Georgia. Crop Revenue Coverage (CRC) plans are similar in concept to the IP plan, but are private insurance company products. The FCIC Board of Directors has recently approved a pilot CRC cotton plan for 1997 for all of Georgia, Arizona, and Oklahoma, and four crop reporting districts in Texas.

(1) Income Protection
The IP plan was developed by the Risk Management Agency of USDA and was mandated by CIRA. The revenue guarantee of IP is based on the commodities expected harvest-time price and the individual farmer s expected yield. If the harvest-time price times the farmer's actual yield falls below this revenue guarantee, the farmer receives an indemnity equal to the difference.

(2) Crop Revenue Coverage
CRC plans are developed by private insurance companies, but premiums are subsidized by USDA as with other crop insurance products. CRC essentially combines the IP plan along with replacement coverage. Thus, CRC offers a producer a revenue guarantee based on price and yield expectations, similar to IP. Replacement coverage increases the revenue guarantee if prices should rise during the season. As a result, the price component of the CRC indemnity is based on the higher of the early season projection and the actual harvest-time price. CRC premiums are significantly higher than comparable IP premiums because of the replacement coverage component.

The above discussion of crop insurance was necessarily quite general. Interested persons should contact a local crop insurance agent for more information about the crop insurance products available in their area.

Connections to Other Risks
As mentioned previously, production risk management strategies can interact with other types of risks and risk management strategies. A farmer can, for example, become a more aggressive marketer when production risk is mitigated. As quantity and quality become more certain, a farmer can hedge a greater proportion of the expected crop in the futures or forward markets to protect against price declines, because the risk of a production shortfall has decreased. Production risk strategies also have important implications for financial risk. Having an adequate quantity of output to market is a first ingredient toward generating the necessary cash flow to service debt obligations, cover living expenses, maintain and replace machinery, etc. While brief, these two examples illustrate that risk management strategies should not be developed in isolation how a given strategy affects other parts of the farm operation must be considered.

References
Barry, P. J., J. A. Hopkins, and C. B. Baker. Financial Management in Agriculture. Danville, Illinois: The Interstate Printers and Publishers, Inc., 1988.

Robison, L. J. and P. J. Barry. The Competitive Firm s Response to Risk. New York: Macmillan Publishing Company, 1987.