TOKYO (Reuters) - Japan's Mitsui Sumitomo Insurance Group Holdings Inc, Aioi Insurance Co and Nissay Dowa General Insurance Co are in merger talks, a company source said, aiming to survive an economic downturn that has battered demand for car and housing insurance.

The three seek to reach a basic agreement by March on the deal, which would create Japan's top non-life insurer by revenue, the source said yesterday.

Automobile and housing sales have been sluggish amid the economic slump, hitting demand for car and fire insurance, while a slide in the value of securities holdings has weakened the financial standing of casualty insurers and other financial institutions.

The news sent shares in the three companies sharply higher, while those of current No. 1 non-life insurer Tokio Marine Holdings Inc also gained.

"Each of the three has its own unique strength. Mitsui Sumitomo is a well-known brand for individual clients and Aioi rakes in customers through Toyota car dealers," said Mitsubishi UFJ Securities analyst Nozomu Kunishige.

"If they come together with their existing operations, that would make an entity with a competitive edge."

Aioi is one-third owned by Toyota Motor Corp, the world's biggest automaker, while Nissay Dowa is held 35.4 percent by Nippon Life Insurance Co, Japan's largest life insurer.

Nissay Dowa's ties with Nippon Life enable them to work together closely, offering customers both life and casualty insurance, Kunishige said.

Japanese media, including the Nikkei business daily and public broadcaster NHK, said the three were in talks to merge as early as next autumn.

Along with the sharp slide in stocks and sluggish insurance demand, a surging yen has eroded the value of insurers' foreign-currency denominated assets such as US Treasuries.

Unlisted Yamato Life Insurance filed for bankruptcy protection in October with nearly $3 billion in debt as the financial market turmoil battered its investments, making it the first Japanese financial institution to fall victim to the global credit crisis.

Among the three companies in talks, Aioi fell into a net loss in the business year that ended in March due to sub-prime loan-related losses.

A merger of Mitsui Sumitomo, Japan's second-biggest non-life insurer, fourth-ranked Aioi and No. 6 Nissay Dowa would create the biggest player in the domestic market with net premium revenue of about 2.7 trillion yen ($30 billion).

That compares with 2.2 trillion yen at Tokio Marine.

Net premium revenue, a key indicator of non-life insurers' earnings strength, is roughly equivalent to income from policyholders minus the amount the company itself pays for reinsurance.

Tokio Marine, however, still leads the three companies combined in market value. Its market capitalisation comes in at 2.2 trillion yen ($24.28 billion), compared with 1.8 trillion yen for the other three.

The company source said specific steps towards the merger have not been decided, but Mitsubishi UFJ's Kunishige said Mitsui Sumitomo, the biggest among the three, is likely to take a leading role in any process.