LA Fires, Climate Change And The Coming Collapse Of Insurance

Historically, the insurance system has worked by relying on experts who study records of past events to estimate how likely it is that a covered event might happen. They then use this information to determine how much to charge a given policyholder. This is called“pricing the risk.”

When Americans try to borrow money to buy a home, they expect that mortgage lenders will make them purchase and maintain a certain level of homeowners insurance coverage, even if they chose to self-insure against unlikely additional losses.

But thanks to climate change, risks are increasingly difficult to measure, and costs are increasingly catastrophic . It seems clear to me that a new paradigm is needed.

California provided the beginnings of such a paradigm with its Fair Access to Insurance program , known as FAIR. When it was created in 1968, its authors expected that it would provide insurance coverage for the few owners who were unable to get normal policies because they faced special risks from exposure to unusual weather and local climates.

But the program's coverage is capped at US$500,000 per property – well below the losses that thousands of Los Angeles residents are experiencing right now. Total losses from the wildfires' first week alone are estimated to exceed $250 billion .

This state of affairs isn't just dangerous for homeowners and communities - it could create widespread financial instability. And it's not just me making this point. For the past several years, central bankers at home and abroad have raised similar concerns. So let's talk about the risks of large-scale financial contagion.

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

In that event, the value of opaque bundles of real estate derivatives collapsed from artificial and unsustainable highs, leaving millions of mortgages around the US“underwater .” These properties were no longer valued above owners' mortgage liabilities, so their best choice was simply to walk away from the obligation to make their monthly payments.

Lenders were forced to foreclose, often at an enormous loss, and the collapse of real estate markets across the US created a global recession that affected financial stability around the world .

Forewarned by that experience, the US Federal Reserve Board wrote in 2020 that“features of climate change can also increase financial system vulnerabilities.” The central bank noted that uncertainty and disagreement about climate risks can lead to sudden declines in asset values, leaving people and businesses vulnerable.

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At that time, the Fed had a specific climate-based example of a not-implausible contagion in mind – global risks from sudden large increases in global sea level rise over something like 20 years. A collapse of the West Antarctic Ice Sheet could create such an event, and coastlines around the world would not have enough time to adapt.

In a 2020 press conference, Federal Reserve Chair Jerome Powell discusses climate change and financial stability.

The Fed now has another scenario to consider – one that's not hypothetical.

It recently put US banks through“stress tests” to gauge their vulnerability to climate risks. In these exercises, the Fed asked member banks to respond to hypothetical but not-implausible climate-based contagion scenarios that would threaten the stability of the entire system.

We will now see if the plans borne of those stress tests can work in the face of enormous wildfires burning throughout an urban area that's also a financial, cultural and entertainment center of the world.

Gary W Yohe is Huffington Foundation professor of economics and environmental studies, Wesleyan University

This article is republished from The Conversation under a Creative Commons license. Read the original article .

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