* NZ govt support to AMI might cost up to NZ$1 bln
* NZ govt would only take control if in public interest
* Package to ensure no disruption to quake recovery (Adds quotes, detail, background)
WELLINGTON, April 7 (Reuters) - New Zealand's government has agreed to provide financial support for AMI, the country's second-largest residential insurer, after two major earthquakes threatened to deplete its capital, Finance Minister Bill English said on Thursday.
English said the potential cost for the government might be as much as NZ$1 billion ($775 million), straining the budget further, but would not scupper the government's plan to return the budget to surplus.
"This provides a financial backstop for policy holders so the rebuilding of Christchurch is not jeopardised by potential solvency or liquidity issues and so confidence is maintained in the insurance sector," he said in a statement.
A funding shortfall is threatening the insurer as a result of a flood of claims in the wake of two devastating earthquakes in the South Island city of Christchurch in the past year.
"This support package will give AMI the time to seek a market solution," English said.
Official estimates of the cost of the Christchurch earthquake on Feb 22 and an earlier quake in the region last September are around NZ$15 billion ($11 billion), about 7 percent of the economy.
The AMI package would be called on only as a last resort if AMI's own reserves have been exhausted - unless the government believes it is in the public interest to take control sooner, he added.
Christchurch-based AMI has 485,000 policy holders and 1.2 million policies across the country. The company is mutually owned, meaning that its customers are also its owners, limiting its ability to raise capital.
It said it had more than NZ$350 million in reserves but could not allow uncertainty about its financial position to remain.
"We could not allow such concerns to mount and it was for this reason that we asked government to stand behind us during this difficult period," Chief Executive John Balmforth said in a statement.
"We will not draw down on the capital facility from government unless we have to."
In Christchurch, its home base, it has more than 85,000 policyholders with 225,000 policies - or about 35 per cent of the residential insurance market in the city.
"This is an unusual situation requiring a special response," English said.
If the package is called on, it would involve the government investing up to NZ$1 billion in AMI, with the right to take ownership and assume control of the company if it needs to, the finance minister said.
English said the government's potential liability was uncertain and would depend on the extent of claims on the company.
"There's a range of estimates and they range from zero, that is the company may be able to meet all the claims, through to about NZ$1 billion more claims than they are able to meet," English told reporters.
Asked if the potential cost would delay the government's planned return to budget surplus by 2015/16, English said it would be another headwind: "It will not knock us off track," he said.
On March 24 insurer rating firm A.M. Best downgraded AMI's financial strength rating and issuer credit rating, with negative implications citing the impact of the earthquake on its capitalisation.
AMI said it would look to raise fresh capital, which could involve selling parts of the company.
New Zealand's insurance sector is dominated by Australian-owned companies, including IAG and AMP . (Reporting by Gyles Beckford, Adrian Bathgate; Editing by Balazs Koranyi)