UPDATE 1-UK says loan insurance too costly, mulls price cap

(Adds analyst, Commission comments, details)

LONDON, June 5 (Reuters) - Britons are being overcharged by over 1.4 billion pounds a year from the sale of insurance to cover repayment of loans when they fall ill and industry price caps may be introduced, the UK competition watchdog said.

The Competition Commission said in a provisional findings report on Thursday that it was considering a list of measures to increase competition for payment protection insurance industry (PPI), including banning the sale of PPI at the same time a loan is arranged or the possible introduction of a price cap.

Banks have prepared for a significant clampdown on the industry, but a price-cap would be harsher than expected.

"(It is) unclear what the Competition Commission is going to do, but it has listed some quite draconian options," said Bruce Packard, analyst at Pali International.

PPI covers repayment of mortgages, credit cards, personal or other loans when people fall ill, are injured or unemployed and is a highly profitable area for banks, estimated to be worth over 5 billion pounds a year.

Restrictions could hurt profits for Alliance & Leicester ALLL.L, Lloyds TSB (LLOY.L) and most other UK banks, analysts have said.

There are more than 14 million PPI policies and most are taken out at the same time a product is bought. Consumers should be provided with more information about other policies and prices on offer, the Commission said.

"We've found serious problems with the PPI market and customers are paying for the lack of competition," said Peter Davis, head of the Commission's inquiry.

"We're ... looking at measures which will improve competition between providers, so that consumers who do compare products, or seek to switch, find better offers to choose from."

The Association of British Insurers acknowledged there have been problems in the PPI market but said changes have been introduced. "We are very concerned that the Competition Commission's proposed remedies could destroy this market, particularly while we are facing a period of economic uncertainty," it said. (Reporting by Steve Slater; Editing by David Cowell and Erica Billingham)