NEW YORK, (Bloomberg) -- Top reinsurers in Bermuda are among those being approached in connection with a plan to improve the system of earthquake cover in California.

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 will 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 will use the proceeds of the bond sale to set up a $10.5 billion program to insure homeowners against damage caused by earthquakes.

Many insurance companies stopped issuing new 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 California legislature proposed creating the California Earthquake Authority, which would allow insurance companies to provide limited insurance under a new type of policy.

Once the CEA is established, participating insurers will have the option of transferring their earthquake liabilities to the authority. The CEA also will issue new policies, and will 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 also would apply to policies transferred to the CEA 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 CEA 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 travelling 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 percent 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, though a final plan hasn't been drawn up, Tilley said.

"Some will be structured in a form that appeals to equity income buyers and some will be structured to appeal to investment-quality bond buyers,'' he said.

The investment-grade bonds' principal would be guaranteed, while their interest would be partially guaranteed. The securities would probably be priced to yield "in the wide ballpark of about 200 or 300 basis points'' above Treasury notes.

Morgan Stanley is also considering selling debt whose principal and interest would be completely open to quake risk, Tilley said.

"If they were offered, they would have a very large interest-rate spread. It could easily be 1,000 basis points or more'' above Treasury note yields, he said. Still, "we're not convinced we're going to use those.'' It would take a bigger disaster than the 1994 Northridge quake for the liabilities to reach the securities, since the policy caps will roughly halve the insured quake liabilities in the state.

The remaining $3 billion of the $10.5 billion is similar to the first $3 billion, in that it represents a promise by insurers reduced over time.