LONDON (Reuters) - Britain's competition regulator will investigate the motor insurance market after a consumer watchdog found signs drivers are being overcharged, in a move that could dampen demand for the flotation of industry leader Direct Line.
The Office of Fair Trading (OFT), Britain's main consumer affairs watchdog, said on Friday it had referred the industry to the Competition Commission for an inquiry that could take up to two years.
The OFT said it had "reasonable grounds for suspecting that there are features of the market that prevent, restrict or distort competition".
The decision comes as Britain's biggest motor insurer, Direct Line, prepares to price an initial public offering (IPO) expected to value it at about 2.5 billion pounds ($4.1 billion).
The probe could "put a spanner in the works" of the IPO, London's biggest in over a year, Shore Capital analyst Eamonn Flanagan wrote in a research note.
Direct Line's owner, Royal Bank of Scotland (RBS.L), is selling the business to win European regulatory approval for government aid it received in the 2008 crisis that left it 82 percent state owned.
The OFT's concerns centre on how insurers provide replacement vehicles and repair services to customers involved in accidents they do not cause.
Insurers of drivers who are not at fault refer them to car hire firms and repair garages which charge more than the market rate in return for a fee, the watchdog said in a provisional finding in May.
That pushes up the claims bill for insurers of at-fault drivers, and inflates consumers' insurance premiums, it said.
"Competition appears not to be working effectively in the private motor insurance market," OFT Chief Executive Clive Maxwell said on Friday.
"The insurers of at-fault drivers appear to have little control over the bills they must pay, and this may be leading to higher costs for them and ultimately higher premiums for motorists."
Analysts have said competition regulators could order changes that would make it harder for insurers to boost profits through fees for ancillary services such as replacement vehicles.
Income from such fees accounted for about 30 percent of Direct Line's operating profit in the first half of 2012, Shore Capital estimated.
One of RBS's biggest 25 investors told Reuters the investigation could weigh on Direct Line's stock market valuation.
"This is just what the Direct Line float wanted," the investor said sarcastically. "There was already a lot of downward pressure on the Direct Line price. It only looked OK at the bottom of the range, even before this latest twist."
RBS had already been expected to set a price for the planned stock market listing towards the lower end of the 2.5 billion pounds to 3.5 billion pounds range of analyst estimates.
Direct Line announced its intention to float on September 14, and would under a typical timetable be expected to open its order book within two weeks.
Shares in rival motor insurer Admiral (ADML.L), which makes around 60 percent of its profit from ancillary products, were down 1.75 percent at 1035 GMT, making it the second-biggest FTSE 100 faller.
($1=0.6176 British pounds)
Additional reporting by Sinead Cruise; Editing by Elaine Hardcastle and Mark Potter