LONDON (Reuters) - Shares in insurer Aviva (>> Aviva plc) fell more than five percent on Monday reflecting uncertainty about the potential benefits of the company's 5.6 billion pound (8.79 billion US dollar) plan to merge with rival Friends Life (>> Friends Life Group Ltd)

The two insurers have agreed outline terms for a possible all-share deal, in which Aviva would offer a 15 percent premium to Friends Life's share price to give those investors a 26 percent stake in the new company.

The proposed transaction, first announced on Friday, would create a market leader in British life insurance with a combined market capitalisation of about 20.2 billion pounds.

The deal aims to bolster the balance sheet of Aviva, helped by Friends Life's strong cash generation, as well as boosting assets under management and cutting costs.

Shares in Friends Life (>> Friends Life Group Ltd) rose as much as 8.2 percent. They were about 4.2 percent higher by 1425 GMT

Investors and analysts see the plan as a move towards much-needed consolidation in Britain's insurance industry given big pension changes that will give people more say over how they invest their retirement savings.

"The initial assessment suggests the valuation for the deal is fair," said Alessandro Valentini, fund manager at Causeway Capital, which owns Aviva shares.

But Aviva and Friends Life have not yet given figures on cost savings or other benefits from their merger plan.

Potential savings could come from rationalising management and staffing and closing Friends Life head office, analysts at Societe Generale said.

The proposed deal marks a significant step for Aviva boss Mark Wilson, who was hired as CEO of general and life insurer Aviva from Asian rival AIA (>> AIA Group Ltd) two years ago.

He has pushed through a restructuring, selling off businesses, cutting costs and improving profitability. Investors said Wilson had met with them at the weekend to discuss the deal.

Analysts at Bernstein estimated the merger should produce cost and revenue benefits of 1.7 billion pounds, more than offsetting the offer premium which they put at 700 million pounds.

The valuation for the combined company did not look expensive, with UBS analysts putting the 2015 price to earnings multiple at 11.3 times, compared with 10.1 times for Aviva currently. British insurers are trading at 12.6 times on average, according to Thomson Reuters StarMine data.

Eamonn Flanagan, analyst at Shore Capital, reiterated his "sell" recommendation on Aviva, saying the merger was a rights issue in disguise.

Flanagan said the plan raised concerns over the pace of progress within the Aviva's restructuring and turnaround, both in terms of cash generation and reducing debt. "The key question for us is why Aviva felt the need to do this deal now?"

The proposal has the backing of entrepreneur Clive Cowdery, who founded Friends Life in 2008 when it was known as Resolution. The company began buying up closed books of life insurance business and using its scale to make cost savings in managing them.

Cowdery stepped down this year but is still the 15th largest shareholder in Friends Life, according to Thomson Reuters data.

Most analysts did not expect a rival bid, with Canaccord Genuity putting the chances at below 20 percent, due to a lack of likely contenders.

(Additional reporting by Simon Jessop and Nishant Kumar; editing by Steve Slater and Jane Merriman)

By Carolyn Cohn

Stocks treated in this article : Aviva plc, Friends Life Group Ltd, AIA Group Ltd