Morgan Stanley to Lead Quake Bond Sales : Securities: The $1.5 billion in notes would help California overhaul its insurance system.

Morgan Stanley & Co. will lead a group of securities firms selling $1.5 billion in bonds that will help California overhaul its earthquake insurance system.

The securities would be the first to pay investors for assuming some of the risk of earthquake damage, said Jim Tilley, a managing director at Morgan Stanley who led the group that devised the plan. “This has never been done before,” he said.

The California Insurance Commission selected Morgan Stanley from a field of about 40 securities firms competing for the position as senior lead manager. Bear, Stearns & Co. and Goldman, Sachs & Co. will co-manage the underwriting group, Tilley said.

The state would use the proceeds of the bond sale to set up a $10.5-billion program to insure homeowners against quake damage.

Many insurance companies stopped issuing earthquake policies after the January 1994 Northridge temblor that rattled Los Angeles. Insured damage costs from the quake totaled $12.5 billion, according to the American Insurance Services Group Inc.’s Property Claim Services division.

In October, the Legislature proposed creating the California Earthquake Authority, which would allow insurance companies to provide limited insurance under a new type of policy.

Once the earthquake authority were established, participating insurers would have the option of transferring their earthquake liabilities to the authority. The authority would also issue new policies, and would receive premiums on both old and new policies.

Under the legislation, homeowners would have their maximum coverage reduced to $500,000; the maximum contents coverage on homes would be $5,000, and living expenses coverage would be limited to $1,500.

The lower coverage would also apply to policies transferred to the earthquake authority from insurance companies.

The caps in homeowners’ quake coverage would reduce insurers’ exposure to quake liabilities. For example, Allstate Corp.’s maximum quake liability would fall to $900 million from about $2.5 billion, according to a Merrill Lynch & Co. research report.

Under a plan proposed by Morgan Stanley, the authority would be funded by a combination of industry contributions, reinsurance, policy surcharges and sales of debt to the public. The first $1 billion of the $10.5 billion in the fund will be provided as “seed money” by insurance companies, said Morgan Stanley’s Tilley. It represents the “lowest layer of capital that stands ready to meet earthquake losses,” he said.

The next $3 billion is in money that insurers would promise to pay if it’s needed to make good on quake claims. That amount would be reduced starting in two years as interest accrues on the seed money and the agency takes in premiums. After 10 years, insurers’ liability disappears for the $3-billion layer.

“Above those is a $2-billion reinsurance layer,” Tilley said. The lead reinsurer is E.W. Blanch Holdings Inc., based in Minneapolis.

“E.W. Blanch and [California Insurance Commissioner] Chuck Quackenbush have been traveling on a roadshow” to meet with reinsurers in New York and Bermuda, and are headed to Europe to make more presentations, Tilley said.

The next $1 billion would come from the sale of tax-exempt special revenue bonds that would be issued if needed. The bonds would be backed by surcharges of as much as 20% on policies carried by the CEA, he said.

The new securities to be sold will make up the next $1.5 billion. The amount will probably be distributed through two or three types of securities, Tilley said.