LONDON (Reuters) - Growing risks posed by climate change are powering a surge in the sale of disaster insurance bonds, with the market forecast to grow in 2008 despite turbulence elsewhere in the credit market.

While the bottom fell out of the rest of the structured credit market last year, sales surged for catastrophe bonds or "cat bonds," which are issued by insurers to transfer the financial hit from natural disasters to investors.

The flow of people into disaster-prone areas such as Florida has raised the prospect of a $100 billion "mega-catastrophe," say analysts who see cat bonds providing a crucial source of capital to help pay the cost of such a crippling disaster.

Investors are being attracted to these bonds because their risks are fairly clear, in contrast to other structured credit products, whose values slumped last year as investors struggled to work out how much risk they contained.

"What has caused waves in other markets is that investors have lost money and they didn't know how," said Luca Albertini, Head of European ABS and insurance-linked securities origination and structuring at Swiss Re, a leader in this market.

"If there's a hurricane and you have to pay out, it's quite understandable."

New cat bonds totalling $7.7 billion were issued in 2007, versus $4.9 billion a year earlier and $2.1 billion in 2005.

Analysts see more growth for 2008 and say eventually cat bonds could mimic for example asset-backed securities and mortgage-backed securities, which in the US have grown into a $7 trillion market over the past two decades.

"We believe the use of securitised products is set to expand in 2008," said Laurent Dignant, head of UK and European capital markets at Guy Carpenter, an reinsurance broker owned by Marsh & McLennan Cos Inc..

"This will probably come from an extension of traditional insurance-linked securities and new structures that will be developed to leverage investors' increasing appetite for insurance risk," said Dignant.

The growing hunger for cat bonds is also being fuelled by their attractive returns.

The Swiss Re BB-rated Cat Bond Index delivered a total return of 29.5 percent between January 1 2005 and January 1 2008, compared to 16.9 percent for the Lehman Corporate BB High Yield Index — a benchmark of similarly rated bonds.

While the rest of the credit market was in spasm between June and November of last year, the price fetched by cat bonds in the secondary market remained largely flat.

Some spreads dipped even, despite it being hurricane season, as bruised investors sought to buy into them as a safe haven.

With around $15 billion dollars currently outstanding, cat bonds make up a fraction of the $105 billion reinsurance market, where insurers have traditionally laid off their disaster risks.

But more insurers, and reinsurers themselves, are turning to them to help manage their disaster exposures. Nearly 40 percent of the cat bonds sold last year, by value, were from first-time issuers.

The market saw its biggest ever deal — a $1.3 billion bond issued by US insurance giant State Farm — and there were also a string of new bonds by previous issuers covering different risks than they had previously.

One example was Allianz, which issued a $150 million bond covering UK flood risk as part of a planned $1 billion cat bond programme.

A lynchpin to growth in 2008 will be whether the industry can build a wider investor base after the issue of the first proper collateralised debt obligation (CDO) of disaster risks.

It was structured last May by Swiss Re and Goldman Sachs and managed by Nephila Capital, a Bermuda-based investment fund specialising in insurance risks.

"We would like to manage more of these (CDO) vehicles in future. But frankly, the biggest hurdle to us doing another one is not reinsurance market pricing, but capital markets pricing," said Barney Schauble, a partner at Nephila Capital. The CDO market is gigantically dislocated, there's a lot of concern about structured products generally and many buyers have put their expansion plans on hold," said Schauble.

An actively managed portfolio of a variety of catastrophe risks, the CDO issue was divided into five tranches, allowing investors the option to invest in a variety of securities to suit their risk appetite, with the upper tiers being investment-grade.

The deal's multi-tranche structure is an important step in the market's development because it opens the door to disaster risk for investors who only tend to buy investment-grade securities, such as life insurers and pension funds.

Even if a tough credit market presents hurdles to cat bond CDOs in the short term, however, market players say the sector is now on a firm footing.