Risk management has again taken on greater importance because the farm economy and farmer profit are deteriorating.

What is the definition of risk? Generally, risk is defined as "the uncertainty about an outcome and the possibility of an undesirable outcome from an expected goal." By example, this year's low grain prices and unknown yields produce an uncertainty about an outcome, farm profit, and probably an undesirable outcome, negative or low profit.

There are five sources of risk. Production risk and marketing risk are the two risks that pose the biggest problems for farmers. However, financial risk, legal risk and human resources risk can impact the farm operation.

Production risk typically grabs headlines since weather and crop conditions dominate throughout the growing season. Once the crop is planted, there are few options available to minimize production risk. Typical options available are weed, insect and disease control.

Marketing risk gets daily attention through commodity prices. However, marketing risk includes the purchase of inputs such as fertilizer, seed, herbicides, labor, machinery and fuel.

Financial risk is not as apparent as production and marketing risks, but is just as important to survival. Interest rate increases affect farm operations, since interest expense decreases the profitability. All farming operations require capital. Farming capital can be from farmer equity, lender borrowing, capital leasing or land leasing. When profits decrease or become negative, the access to capital becomes harder to obtain and, if obtained, becomes more expensive through borrowing terms that increases financial risk.

Legal risk is often overlooked until it surfaces. Contracts are more evident now than in the past since farmers use various marketing strategies and production contracts as well as have become more involved in written leasing agreements. At some time, legal risk will surface when there is a dispute with someone over a contract. Additionally, there are currently many environmental liability issues and regulations and more probable issues and regulations coming in the areas of animal odor and nuisance conflicts.

Human resources risk is the least evident risk. Farming has evolved from mainly a family operation with possibly some part time help into large operations that require more hired labor and efficient management. Labor regulations and issues are now very important. Death, disability or divorce can destroy current and future plans. Lastly, the human resources risk of retirement must be considered.

Risk management is basically planning so that all of your decisions produce a positive impact on your profitability and long term growth. It is well understood that risk carries an element of reward. The goal of risk management is not to eliminate every risk since that would eliminate every opportunity for profit. Therefore, the goal is to manage the risk effectively so that the risk produces an acceptable reward.

For example, a farmer that is highly leveraged might be considering paying a very high cash rent to try to increase his farming operation. The risk could be that a bad crop the first year could further reduce his net worth and prevent him from paying his agreed upon debt. Thus, he must consider whether the possible reward of a larger farming operation is worth that risk.There are defined steps in risk management that produce positive results.

• Identify goals and risk tolerances vs. sources of risk

• Analyze severity and frequency of sources of risk

• Develop a management strategy for sources of risk

• Implement a risk management strategy

• Monitor the risk management plan

The identification of goals provides a framework of objectives that the farmer wants to reach. Added to the goals is the farmer's tolerance for risk. Each operation is going to have different goals. For example, a young highly leveraged farmer's goal is to reduce debt and try to grow the operation while a multiple generation family farm operation's goal is to preserve the viability of the farm operation through generations. Likewise, each operation is going to have a different risk tolerance or stated another way, the ability to sleep at night with their decisions.

The analysis of the sources of risk evaluates the frequency and severity of the risk. One element is the frequency or number of occurrences that the risk happens. For example, the number of times that there is hail loss in a growing crop. The other element is the severity of the risk. For example, a severe localized drought that drastically reduces yield.

After the evaluation categorizes the sources of risk by frequency and severity, then methods for managing the sources of risk can be developed.

The first method for managing risk is to reduce the risk. A good example is to diversify crops by growing different crops such as corn, beans and wheat or by growing specialty crops.

The second method is to transfer the risk. The obvious example is to buy crop insurance that transfers the risk to the insurance company for the price of the insurance premium.

The third method is to avoid the risk altogether. By stopping machinery before you adjust it, you prevent any injury that could occur.

The fourth method is to retain the risk and attempt to manage the outcome. A good example is the retention of a well used tractor rather than replacing it because you think that you can substitute another tractor for it if the well used tractor breaks down during use.

The fifth method is to self-insure. Here the farmer knows that the risk will happen at some time, but prepares for the risk by saving or establishing reserves to cover the risk.

Next, the methods of managing the sources of risk must be implemented. Each source of risk is matched with a risk management method. Additionally, each risk management method is coordinated with all of the other methods of risk management so that an overall positive result, profitability, is reached. Often the implementation requires the use of professionals such as lenders, accountants, lawyers, commodity experts, vendors and extension educators.

Lastly, the risk management plan must be monitored. Monitoring should compare the performance of the risk management strategies to the goals and risk tolerances. Over time some will be very effective, others may be ineffective or too costly. Additionally, goals may change, thereby necessitating changing the risk management strategy.