Article updated with further commentary from AM Best.

NEW YORK ( TheStreet) -- The $3.2 billion merger of Transatlantic Holdings ( TRH) and Allied World Assurance ( AWH) might reignite deals in the reinsurance sector as companies seek to enhance balance sheets and diversify the earnings base, according to industry analysts.

On Sunday Transatlantic Holdings, a specialty reinsurer once majority owned by AIG ( AIG), announced its merger with Swiss-based Allied World Assurance in an all-stock deal. The merger would create an entity that will have total assets of $21 billion and a total capital of $8.5 billion.

The combination could leave reinsurers with a smaller capital base -- $3 billion or less -- hungry for scale, some analysts say.

"The reinsurance business has become more differentiated on size because of this most recent deal," said Kevin Lee, analyst at Moody's ( MCO), commenting on the Transatlantic deal. "On one hand, you have a group of companies with more than $5 billion in capital, some others with $2.5 billion to $5 billion in capital and then you have a group of companies below $2.5 billion. For companies in the lower end of the range, and given the extent of losses from first quarter, there is possibly more interest in M&A."

Companies with a total capital of less than $3 billion include Endurance Specialty ( ENH), Enstar group ( ESGR), Platinum Underwriters ( PTP) and Montpelier ( MRH), according to data available on Bloomberg.

"Over the past decade, there has been a drive for size," says Laline Carvalho, director and reinsurance analyst at Standard and Poor's. "There have been a lot of management teams that have pushed to become bigger."

Tracy Dolin, also an analyst at S&P points out that size might be more relevant for property catastrophe reinsurers where they can get better pricing terms for their size.

But other factors besides size also may drive more consolidation. According to Carvalho, reinsurers are also looking to diversify their earnings stream. "It has been a significant year of catastrophes for reinsurance companies," she says, noting the disasters in New Zealand, Australia and the U.S. "There is a desire for some management teams to become more relevant to their brokers, reduce exposure to catastrophic events and if they are more diversified they can choose to play those opportunities where they see the best returns for their capital."

Stocks of reinsurers such as Endurance Specialty, Platinum Underwriters and Montpelier trade at a price-to-book of less than 1. Such valuations are attractive to buyers but could result in lengthy battles over pricing of the deal as sellers will be reluctant if the offer price is too low.

Another challenge, according to Carvalho, is that businesses need to find a good match. Transatlantic and Allied were complementary businesses, with the former dealing chiefly in reinsurance and the latter in insurance. But other global reinsurers are more diversified and involved in all types of businesses, which could pose integration risks.

And while smaller companies might be inclined to consider mergers to grow bigger, size is not always an advantage, Carvalho adds. Smaller reinsurers can be more nimble and insurance companies continue to do business with smaller reinsurers because they wish to avoid counter-party concentration risk that could arise in working with only one or two big players.

Management's outlook for the market could also be a driver for deals, according to Moody' Lee. "In the past, deals have been more "soft market" transactions where the acquiring company has simply returned excess capital to shareholders.The Allied-Transatlantic deal is more of a "hard-market" transaction, where they are building a balance sheet to capture benefits of a potential hardening of prices in the reinsurance market," said Lee.

Analysts at A.M. Best said that while a soft pricing market tends to stimulate merger activity, deals with somewhat ideal conditions like the Transatlantic-Allied merger are hard to come by. "You have to find organizations that have complementary businesses, no overlap, clean succession plan in terms of senior management and similar cultures. Both these companies were born out of AIG and their cultures are similar. The managements have a long-standing relationship. Senior managements have to come together."

Shares of Transatlantic were climbing 10% to $48.50 Monday . Shares of Allied World were slipping 4% at $55.74.

--Written by Shanthi Bharatwaj in New York

>To contact the writer of this article, click here: Shanthi Bharatwaj.

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