Pricing Climate Risk: The California Wildfires Provide a Stress Test for Financial Models

Opinion Piece

California has just entered its peak fire season. For anyone outside of America, you might be mistaken in thinking January is its peak season following the most recent wildfire catastrophe earlier this year where a series of 14 wildfires resulted in an estimated $250 billion worth of total economic damages including property losses, uninsured impacts and economic disruption.

The LA wildfires of January 2025 tore through over 17 000 structures leaving a path of smouldering destruction however this was more than just a natural disaster. It was a stress test for the financial sector’s ability to quantify and manage physical climate risk - the financial impact of climate-driven events and long-term changes. Unlike transition risk, which stems from policy and market shifts in the move to a low-carbon economy, physical risk arises directly from environmental events.

In a financial system still largely reliant on historical probability distributions and backward-looking risk models, America’s wildfires provide worrying insights for the rest of the world, where the pace of change may outstrip the responsiveness of traditional risk frameworks.

Physical Risk Is No Longer a Tail Event

Average temperatures in California have increased by more than 5% since the early 20th century. Combined with record-breaking drought conditions 2020 to 2022 marked the driest three-year period in over 1 200 years. These conditions significantly increase wildfire risk in the region.

For financial institutions, the consequences ripple across asset classes:

Residential mortgage portfolios in fire-prone areas typically face heightened default risk, as property values tend to decline following a disaster. However, this trend has not held true in LA. In the aftermath of recent fires, housing prices have surged rather than dropped. This unexpected rise is largely due to a sharp reduction in available supply, a strong leftward shift of the supply curve. In some neighbourhoods, home prices have climbed as much as 24%. Simultaneously, rental prices have also spiked, placing additional financial strain on renters and increasing the risk of missed payments or defaults on rental contracts.
Commercial real estate lending is undermined by increasing insurance premiums, reduced coverage, or outright exclusion from underwriting in high-risk zones. In the U.S., the top 20% of regions most exposed to climate-related disasters have seen home insurance premiums roughly double compared to national averages, highlighting the knock-on effects for lending and asset valuation.

Municipal bond markets are impacted as local governments face rising costs for fire mitigation, disaster response, and infrastructure resilience. This will pressure municipal credit market and push yields higher.

The core issue is becoming less related to whether there are increasingly risks or not, and rather as to how banks, insurers and other financial institutions accurately price these risks.

Modelling Failure: When Historical Data Becomes Noise

Traditional risk models are built on the assumption that the future resembles the past. Value-at-Risk (VaR), for example, depends on statistical regularity. But climate change is a regime shift, not a cyclical deviation.

Wildfire risk increasingly exhibits non-linear behaviour, making traditional risk models less reliable. Fire seasons in the Western U.S. are now over 70 days longer on average than they were in the 1970s. At the same time, fires have become more intense due to factors such as earlier snowmelt, drier vegetation, and stronger wind patterns. These shifts undermine the validity of probabilistic models that rely on fixed correlations or historical volatility.

As a result, actuarial tables traditionally used by insurers are becoming dangerously outdated. Reinsurers, recognising this shift, have started to reprice coverage or withdraw entirely from high-risk markets. This trend leaves banks increasingly exposed, as they are forced to hold more uninsured collateral tied to properties in fire-prone regions.

In the U.S., nearly a third of losses from natural disasters are uninsured. This is significantly lower than the European average where approximately three-quarters of economic losses from natural disasters are uninsured.

The Regulatory Catch-up Game

Supervisory authorities are beginning to acknowledge a modelling gap. The European Central Bank’s 2022 climate stress tests found that many banks lacked granular data and relied on static models unable to capture the dynamic nature of physical risks.

Similarly, the Bank of England’s Climate Biennial Exploratory Scenario (CBES) exercise revealed that few financial institutions were integrating physical risks such as wildfires or flooding into credit risk models in any meaningful way.

Basel’s latest publications on climate-related financial risk underscore that climate risk drivers (both physical and transition) must be considered within existing Pillar 1 (minimum required capital) and Pillar 2 (supervisory review process) frameworks, even if they are not yet formally mandated. The shift from disclosure to capital impact is underway.

Next Steps for Financial Institutions

Addressing this gap will require:

Forward-looking scenario models that incorporate climate science and dynamic hazard maps (e.g., from the Intergovernmental Panel on Climate Change (IPCC)r national climate agencies).

Geospatial analytics to assess portfolio exposure down to the individual asset or borrower level.

Recalibrated stress testing frameworks that simulate the cascading effects of a regional disaster across supply chains, housing markets, municipal finances, and insurance systems.

Some banks have begun incorporating wildfire risk maps from sources such as CAL FIRE or the First Street Foundation into loan origination and pricing decisions. But integration into capital planning, provisioning models, or ICAAP remains uneven.

From Bad to Worse?

The LA fires are a visible symptom of a deeper structural problem in financial risk management: climate instability is outpacing the models designed to contain it. For a sector built on the quantification of uncertainty, this presents an existential challenge. In this new environment, updating our frameworks is not just a regulatory requirement. It is a necessity for resilience.

In July 2025, South California’s fire chief warned that a season of devastating wildfires is all but guaranteed. With climate shocks becoming increasingly normal, financial services may face a dramatic shift that stretches beyond trying to manage risk into avoiding it entirely. Reduced insurance coverage and tightening credit conditions in the U.S. already offer a glimpse into how financial services may be forced to operate in the future if global climate risks continue to go unaddressed.

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