The watchdog is concerned about the size of the sector, the complexity of the product and the way it is sold to consumers. It will launch its investigation in the New Year following a 'super-complaint' from Citizens Advice, the parent organisation behind local Citizens Advice Bureaux.

Expensive PPI has been labelled nothing less than a protection racket. It is more often than not sold to consumers when they take out a product even though they don't need it or could find a much cheaper deal by shopping around.

The policies often include restrictive clauses that prevent consumers from claiming. In its super-complaint, Citizens Advice estimated that 85% of clients who claimed were been turned down, compared to the industry assertion that it is just 15%.

It also said lenders were adopting high-pressure sales techniques to persuade customers to take out PPI.

A secret investigation by the Financial Service Authority last month found widespread mis-selling of PPI. Though the report found no evidence to suggest companies were selling PPI as a compulsory insurance, in many cases it was automatically included in the loan quote without customers being told cover was optional.

It is estimated there are 20m policies in force in the UK, which produce an annual revenue in excess of £5bn. Lenders view PPI as a money spinner as the margins on their products have been trimmed in the face of intense competition.

A recent report by investment bank Morgan Stanley suggested income from PPI is effectively propping up the Internet bank Egg. PPI profits were equal to 20% of its pre-tax profits last year.

They also accounted for 17% of pre-tax profits at Lloyds TSB, 12% at Alliance & Leicester, 11% at Halifax/Bank of Scotland, 7% at Barclays, 4% at HSBC and Northern Rock and 3% at RBS NatWest.

The OFT investigation will also look at the wide variation of pricing in the sector and how transparent the policies are to consumers.

OFT chief executive John Fingleton said: 'PPI is a complex product, often bought almost as an afterthought. Borrowers may shop around for credit, but the complex nature of PPI and a lack of choice mean that they are less likely to shop around for PPI.

'There is a high potential for consumer detriment - our study will look at whether consumers are getting a good deal or not.'

The OFT could ultimately take enforcement action against firms offering PPI if it finds they have breached consumer law, or refer the industry to the Competition Commission.

Copyright © 2005 First Mortgage Trust