Cat bonds: fat tails and thin comfort?

Catastrophe bonds (“cat bonds”) are the most visible component of the broader insurance-linked securities (“ILS”) have started to attract renewed investor attention including from hedge funds. This is understandable as the Swiss Re Cat Bond Index delivered returns of nearly 20%^[1] in 2023 and another 17%^[2] in 2024, which presents a staggering rebound from the flat or negative years that followed the cluster of disasters between 2017 and 2022. Against a backdrop of inflation, geopolitical tension, and rate volatility, the promise of uncorrelated, double-digit returns is understandably appealing. But beneath the strong returns lies a deeper question: are we seeing the repricing of risk, or the beginning of uninsurability?

Cat bonds are yielding more, but not just because the world needs capital. They are yielding more because the risk has changed. Over the last decade, a series of events has forced the market to recalibrate: Hurricanes Harvey, Irma, and Maria in 2017; California wildfires in 2018 and 2020; the Texas freeze in 2021; Hurricane Ian in 2022. These were not statistical flukes. They were the impact of Climate Change signs that the tail risks in the catastrophe bond market are getting fatter.

In many of these cases, catastrophe models had failed to fully anticipate the scale or structure of the losses. The result? Multiple years of underperformance due to back-to-back catastrophes, unforeseen loss volatility, and models failing to capture the full scope of events. Investors found themselves trapped, literally, in some cases, as collateral was held pending claim resolution, and confidence in the asset class wavered.

Yet this recalibration may have been the best thing that could have happened to the market. Pricing shifted. Terms tightened. And investors, after a period of caution, returned in search of yield. The spreads in 2023 reflected this shift, with average spreads rising above expected loss among new catastrophe bonds climbed to around 10–11%, a record high^[3]. This pattern continued in 2024 with spreads remaining elevated, for example Q2 2024, saw spreads of 7.26% above expected loss^[4].

But these wider spreads should not be mistaken for a bargain. They are the price of climate uncertainty.

Climate change and the fragility of models

Catastrophe models have always been probabilistic tools, not crystal balls. They rely on historical event catalogues, assumptions about hazard frequency, and layers of underwriting data. But as the climate changes, the reliability of the past as a guide to the future weakens. Sea surface temperatures, precipitation patterns, wildfire risk zones, these are all shifting in real time.

And the market is responding. Model vendors are increasingly layering in climate-conditioned scenarios. Some ILS managers now explicitly run their own adjusted versions of vendor models, assuming higher baseline frequencies or faster storm intensification. Others are investing in climatology and hydrology talent and bespoke analytics.

Still, the question remains: how much uncertainty can a model tolerate before the whole premise of risk transfer breaks down? For cat bonds to work, risk must be quantifiable and priceable. The late 2010s saw a wave of trapped collateral and model surprises, but today’s market faces a deeper structural question: how do you price risk when the past is no longer predictive? As climate-driven volatility accelerates, the fundamental assumptions behind catastrophe modelling—such as frequency, intensity and return periods—are being rewritten in real time.

Investor appetite and portfolio construction

It’s tempting to view the recent surge in returns as a sign that the cat bond market is thriving. In some ways, it is. Assets under management across ILS funds are now at record highs, passing $100 billion^[5]. New issuances are diversifying beyond U.S. wind into perils like European windstorm, Japanese earthquake, even wildfire.

As noted in CAIA’s Top Hedge Fund Industry Trends for 2025^[6], over the past decade, many reinsurance-linked hedge fund managers experienced a boom-and-bust cycle. As catastrophe losses escalated and pricing remained too soft, performance deteriorated and capital withdrew from the sector. Since 2022, however, the market has undergone a sharp repricing: in some lines, reinsurance rates have doubled from their lows, leading to two consecutive years of strong returns. Crucially, even after this rebound, pricing remains well above historical averages, creating one of the most attractive entry points managers have seen in years. At the same time, traditional asset classes have become less appealing, equity valuations are stretched and credit spreads are tight, driving investors to seek uncorrelated yield. As a result, institutional appetite for ILS and catastrophe bonds is rising rapidly, and many expect significant capital inflows to continue over 2025 as hedge funds and large asset owners scale up allocations.

But the fundamentals haven’t changed: this is an asset class where a single event can cause outsized portfolio losses. And the more severe the event, the harder it becomes to model and price. Climate change makes that tail risk more pronounced.

Investors who allocate to cat bonds today must do so with eyes open: returns are attractive because the risks are high, and because the volatility of outcomes has increased. This is not a set-it-and-forget-it allocation. It requires active management, careful manager selection, and a clear understanding of what perils and geographies are in play.

There is also a question of time horizon. One good year, or even several can be undone by a single $100 billion event. What matters more is whether the premium collected over a full cycle adequately compensates for the risk taken. In that sense, 2023–2024 may not mark a regime shift, but a reset. An acknowledgment that if the world is more volatile and that the price of risk must rise accordingly.

The role of innovation

Despite these challenges, the ILS market is adapting. New instruments are emerging that tie insurance cover to resilience measures, such as the North Carolina cat bond that rebates premiums if home hardening targets are met. There is growing interest in resilience-linked bonds and parametric triggers that respond faster and more transparently than traditional indemnity structures.

This kind of innovation is not just a technical upgrade. It’s a recognition that in a changing climate, we must build mechanisms that incentivise mitigation, not just transfer risk. The future of cat bonds may depend on their ability to align private capital with public resilience goals.

The role of the public sector

As the cost of climate risk rises, public-private solutions are becoming more important. In the UK, Flood Re allows insurers to cede flood risk on high-exposure homes to a central pool, supported by a levy paid by household insurers across the market. This scheme was implemented after the 2014 Somerset floods and the scheme ensures access to affordable cover for properties that the private market might otherwise exclude.

In the United States, California’s FAIR Plan has become a last resort for homeowners in wildfire-prone regions, as major insurers pull back due to escalating risk. Like Flood Re, it is funded by assessments on private insurers rather than taxpayers. However, unlike Flood Re’s capped and time-limited structure, the FAIR Plan has seen its exposure balloon in recent years and now faces growing financial strain, with some analysts warning it could face insolvency if another severe wildfire season strikes^[7], leading to possible significant bill surcharges for homeowners. This comparison highlights a crucial difference: while both schemes rely on industry funding, Flood Re is widely seen as a more controlled and sustainable model, whereas the FAIR Plan reflects the mounting pressure when climate risk outpaces pricing and capacity.

These interventions acknowledge a critical truth: some climate risks are becoming economically unsustainable to insure without public support. For cat bonds to thrive in this environment, they may need to integrate more directly with public-sector frameworks, providing capital where it’s most needed, but with a clearer partnership around who bears the peak tail risk.

A market on the edge

Insurance linked securities are not going away. If anything, the demand for risk transfer will grow as climate volatility accelerates. Governments, insurers, and communities cannot bear the full cost of disasters alone. The capital markets will have to play a role.

But the long-term viability of this market hinges on a delicate balance: spreads must be wide enough to reward capital, but not so wide that cover becomes unaffordable. Models must be robust enough to inform pricing, but flexible enough to evolve with a warming world.

In short, the cat bond market is walking a tightrope. On one side: attractive yields and diversification. On the other: uncertainty, volatility, and the creeping edge of uninsurability.

So yes, the spreads are getting wider. But not because the risks are fewer. Quite the opposite.