The earthquake and tsunami that struck Japan last month gave the catastrophe bond market its biggest test since Lehman Brothers collapsed in 2008, and the early indicators suggest that it passed.

Insurers sell the bonds to help cover the kind of extreme risks they would have trouble holding enough capital against and would have to pay through the nose to reinsure through traditional methods.

The economic toll of the 9.0 earthquake that struck off the island of Honshu on March 11, and the tsunami it triggered off the eastern coast of the Tohoku region, could reach $300 billion. However, an April 12 estimate by Risk Management Solutions put the cost to the global insurance industry much lower, at between $21 billion and $34 billion.

By comparison, the attacks on the World Trade Center generated around $19 billion of claims; Hurricane Katrina generated $41 billion.

Catastrophe bond investors got off even easier from the Japanese earthquake. Most of the 10 deals totaling $1.7 billion with exposure to the earthquakes cover only losses in Tokyo.

Only the $300 million Muteki Ltd. Series 2008-1 bond placed by Munich Re defaulted. A second bond, the $200 billion Topiary Capital Ltd. Series 2008-1, received a downgrade Wednesday from Standard & Poor's, which said subsequent catastrophes could put investors at risk of losing their principal and interest. The bond provides Platinum Underwriters Holdings with coverage for secondary or subsequent events after an "activation event," and the Japanese earthquake qualified as an activation event.

In the relatively brief history of catastrophe bonds, the only other natural disaster to cause investors to lose their principal was Hurricane Katrina. Buyers of Zurich Financial Services' Kamp Re 2005 ceded $144 million of the $190 million issue. So when the Tohoku earthquake struck, investors scrambled to assess the possible impact on their portfolios.

The Swiss Re Cat Bond Total Return Index has dropped 3.9% since the disaster, and participants expect some upward pressure on risk premiums for Japanese earthquake risks.

But Katrina did not scare off big investors from the bonds, and bankers do not expect the earthquake to scare them off, either. "Today, there's a much more stable base of investors with a longer-term horizon" than there was before Katrina, said Paul Schultz, president of Aon Benfield Securities, which underwrites catastrophe bonds.

Pension funds' overall allocation to catastrophe bonds is still relatively small — on the order of 1% — so paying some loss will not have a material impact on their performance, Schultz said. "It's very different from the period following Katrina, Rita and Wilma, where a lot of hedge funds, multi-strategy funds, came in with a much more opportunistic view on returns."

William Dubinsky, a managing director at Willis Group's capital markets and advisory arm, said many diversified investors have a relatively small exposure to Japanese earthquakes, even as a percentage of their catastrophe bond portfolio, because more than two-thirds of the market consists of bonds with exposure to U.S. hurricanes. "So from an investor standpoint, they've lost money, but this is what they're here to do," he said.

The market has not experienced price drops or spread increases big enough to deter new issuance, Dubinsky said.

Market participants say a bond that triggers when it was not expected to would be a bigger turnoff for investors than the Muteki default, because it might indicate that the deals were not being modeled properly; likewise, a bond that does not trigger when it is expected to do so would be equally unsettling.

In addition to the Japanese earthquake, the catastrophe bond market is digesting changes Risk Management Solutions detailed at the end of last month to the way it models U.S. wind risk. In response to the new assumptions in that model about how quickly hurricanes lose speed over land, Standard & Poor's put the ratings of 16 tranches of catastrophe bond deals on review for a possible downgrade.

There is little anecdotal evidence to indicate how the model or the earthquake will affect new issuance. But Schultz cited $40 billion deal Allianz Re priced this month under its Blue Fin program as evidence that pricing has not changed much.

Like its predecessors, the deal had a coupon of 8.5 percentage points above the yield of U.S. Treasury money market funds. "Here's a case where U.S. risk prices more efficiently than last year, post-earthquake," he said.

Another market participant, who asked not to be named, said the latest Blue Fin deal is not the best benchmark for current market sentiment, because it uses a multi-event trigger, while bonds that make up the bulk of the market are triggered by a single event.

While investors appear to be taking the earthquake in stride, observers do not expect the disaster to spur kind of dramatic growth the catstrophe bond market experienced after Katrina. In 2007, issuance jumped 61.9% from 2006, to $7.2 billion, as insurers realized they had vastly underestimated their exposure to potential losses from U.S. windstorms.

The total amount of catastrophe bonds outstanding peaked that year at just over $14.1 billion, according to Willis Group. But issuance plunged in 2008 and 2009 after Lehman, which had acted as a counterparty in a number of transactions, filed for bankruptcy protection and investors eschewed all but the safest securities.

Though issuance picked up again in 2010, the total amount outstanding has held over the past three years at around $12 billion, or about 6% of the reinsurance market.

Over the past few years, funds dedicated to insurance-linked securities have been increasing their assets, but the market for catastrophe bonds has not grown much. Willis said in an April 12 report that it believes the funds have been putting most of their new money into private deals. These deals tend to have a term of one year or less (versus the three to five years typical for catastrophe bonds), can be arranged more quickly and have lower transaction costs than catastrophe bonds.

But investors tend to demand higher returns to compensate for the fact that the private deals are illiquid.

As catastrophe losses add up, the Willis report said, insurers may be more inclined

to offload risk through catastrophe bonds that provide multi-year coverage, hedging them against potential volatility in reinsurance prices.

Gary Martucci, a director at S&P, said the industrywide European catastrophe insurance data being compiled by PERILS AG, a firm formed about a year and a half ago, may help expand the market in Europe.

"We've rated a couple of bonds that were based on PERILS triggers," he said. "The market will have a more robust database, and it should eliminate a portion of the basis risk to European windstorms, where transaction triggers have been primarily parametric. It will be possible to align the exposures to make triggers more representative of an insurance portfolio."

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