Experiments in Ranching: Rain-Index Insurance and Investment in Production and Drought Risk Management

Abstract:

Rainfall is one of the biggest predictors of profit in the ranching industry. Yet, rainfall varies widely from year to year. A major drought can put ranchers out of business and even a minor drought can significantly reduce their profit. In response to this risk, the USDA Risk Management Agency has developed a new policy called the Pasture, Rangeland and Forage (PRF) Insurance. This insurance is unique in the United States because it pays off based on rainfall, not measured losses. Rain-index policies such as the PRF program can reduce problems of moral hazard because insured ranchers cannot affect their own payout once they have purchased the policy.

 

However, the rain-index insurance may still affect rancher behavior. First, with the current levels of subsidies, the rain-index policy has a positive expected value: on average, it pays out more in indemnities than ranchers pay in premiums. Increasing the profitability of the ranching industry is likely to increase the intensity of ranching, both by increasing the number of firms in the industry and by increasing the number of cattle in an optimally profitable herd for a given rancher. When cattle production is more profitable, then the marginal revenues of production inputs increase leading to higher levels of investment in those inputs. The main inputs to cattle ranching are land, rainfall, mother cows, and supplemental feed. Rainfall is outside of the rancher's control and, in this study, ranch size is fixed. Therefore, the rancher can only modify their investment in herd size and supplemental feed. Second, the rain-index policy transfers drought risk from the rancher to the insurance system. Transferring drought risk may lead ranchers to reduce investments in other types of drought risk management investments. For example, the rancher may be less likely to purchase supplemental feed in a low rainfall year if they know that they are likely to receive a check from the insurance company that will offset their revenue losses from having a lower weight herd. Conversely, they could be more likely to purchase supplemental feed in a low rainfall year if they were previously cash constrained and know that they will likely have an insurance payout that will offset their expenditures.

 

In this paper, I introduce the Drought Ranching Insurance Response R Model (DRIR-R) and use a ranching simulation driven by the model to test these questions experimentally. The DRIR-R simulation is tested with a non-ranching study population recruited from MTurk. This paper describes the first test of an experimental paradigm that will soon be used with ranchers whose behavior is expected to best reflect the actual practices of the industry. The simulation is built from the DRIR-R model which simulates a cow-calf ranching operation in periodic drought. Participants choose their investment in supplemental feed to offset low forage growth in drought years. They also choose the number of cows and calves they sell each year which affects their current revenues and future herd size. Among the study population of non-ranchers in the simulation, I find that the rain-index insurance does not affect average herd size but does affect extreme herd management behavior. I also find that the rain-index insurance increases the investment in supplemental feed, especially for those who are risk averse. These experimental findings are a first step in using the DRIR-R model simulation to help better understand the impact of the rain-index insurance on two important aspects of the cattle ranching industry: grazing intensity and drought adaptation.

Last updated on 03/14/2018