Los Angeles’ devastating wildfires make clear a threat: Climate change is undermining the insurance systems that American homeowners rely on to protect themselves from disasters. As families and communities struggle to rebuild, the collapse begins to become painfully clear.

But another threat has yet to be recognized: The collapse could pose a threat to the stability of financial markets that extends far beyond the fires.

For more than a decade, it has been widely accepted that humans have three options when it comes to dealing with climate risks: adapt, mitigate, or endure. As an expert on economics and the environment, I know that some degree of suffering is inevitable—after all, humans have raised the average global temperature by 1.6 degrees Celsius, or 2.9 degrees Fahrenheit. That’s why having a functioning insurance market is so important.

Although insurance companies are often viewed as villains, when the system works well, they play an important role in improving social welfare. When insurance companies set premiums that accurately reflect and communicate risk—what economists call “actuarially fair insurance”—it can help people share risk efficiently, making everyone safer and society better.

But the scale and intensity of the Southern California fires — linked in part to climate change, including record global temperatures in 2023 and 2024 — have brought a big issue into focus: in a world affected by growing climate risks , the traditional insurance model no longer applies.

How climate change is disrupting insurance

Historically, the insurance system worked by relying on experts who studied records of past events to estimate the likelihood of a covered event occurring. They then use this information to determine how much to charge specific policyholders. This is called "risk pricing."

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When Americans try to borrow money to buy a home, they expect their mortgage lender to let them purchase and maintain a certain level of homeowners insurance, even if they choose to self-insure against additional losses that are unlikely to occur. But because of climate change, the risks are increasingly difficult to measure and the costs are increasingly catastrophic. It seems clear to me that a new paradigm is needed.

California pioneered this paradigm with its Fair Access to Insurance program, known as FAIR. When it was created in 1968, its authors expected it to provide coverage for the small number of homeowners who faced special risks due to exposure to unusual weather and local climate and were unable to obtain normal policies.

But the program's coverage limit is $500,000 per property, far less than what thousands of Los Angeles residents are currently experiencing. Total wildfire losses in the first week alone are estimated to exceed $250 billion.

How insurance is ruining the economy

Not only is this situation dangerous for homeowners and communities, it can also create widespread financial instability. And I'm not the only one making this point. Over the past few years, central bankers at home and abroad have raised similar concerns. So let’s talk about the risk of large-scale financial contagion.

Anyone who remembers the Great Recession of 2007-2009 knows that seemingly local problems can snowball into bigger problems.

In that event, the value of a portfolio of opaque real estate derivatives plummeted from artificial, unsustainable highs, leaving millions of mortgages across the United States “in trouble.” These properties are no longer worth more than the owners’ mortgage liabilities, so their best option is to forego their monthly payment obligations.

Lenders were forced to foreclose, often at huge losses, and the collapse of the U.S. housing market caused a global recession that affected financial stability around the world.

Alerted by this experience, the U.S. Federal Reserve wrote in 2020 that "characteristics of climate change can also increase the vulnerability of the financial system." The central bank noted that uncertainty and disagreement about climate risks could lead to sudden falls in asset values, Leaving individuals and businesses vulnerable.

At the time, the Fed had a specific climate-based example in mind, namely the global risk posed by a sudden and significant rise in global sea levels within about 20 years from a not-unbelievable infectious disease. The collapse of the West Antarctic Ice Sheet could cause such an event, and coastlines around the world would not have enough time to adapt.

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The Fed now needs to consider another scenario - one that is not hypothetical.

Most recently, it conducted “stress tests” of U.S. banks to measure their vulnerability to climate risks. In these exercises, the Fed asks member banks to respond to hypothetical but not implausible climate contagion scenarios that would threaten the stability of the entire system.

Now we'll see if the plans developed by these stress tests can hold up in the face of massive wildfires burning across an urban area that is also the financial, cultural and entertainment center of the world.