* RBS readies for UK stake sale in two years - Chairman Hampton
* Sale could include an offer for small investors - Hampton
* RBS quits asset insurance scheme, says protection not needed
* APS exit key step in returning RBS back to private sector -Osborne
* RBS shares up 2 pct
By Matt Scuffham and Sinead Cruise
LONDON, Oct 17 (Reuters) - State-controlled Royal Bank of Scotland is preparing for the British government to start selling its shares in the bank in two years, its chairman said on Wednesday.
"The exercise we're engaged in at the moment is to get the business into a shape that is most attractive for an offer for sale to the British public and internationally, probably, in 2014," Philip Hampton told Reuters.
The government owns 82 percent of RBS after rescuing the bank with 45 billion pounds ($73 billion) of capital pumped in when it neared collapse in 2008. The timing of any sale will be up to the Treasury.
Hampton said the structure of the sale would also be up to the government, but there could be an offer to smaller investors.
"We won't necessarily just be targeting sophisticated investors. We'll be targeting the public. The bank needs to be appropriately positioned for that," he said on the sidelines of the British Bankers' Association's annual conference.
Hampton's comments came hours after RBS pulled out from a government plan that insured its riskiest loans, clearing an important hurdle on its bumpy way to freeing itself from state control.
RBS will withdraw from the scheme as the protection is no longer needed, saving it 125 million pounds each quarter in insurance fees.
The company was forced to take the insurance as part of the state rescue four years ago, which left the government with an 82 percent stake.
It needs to show the bank has returned to good health, is less risky and has resolved several technical issues before the stake can realistically be reduced, investors and analysts said.
"The government's strategy remains to return RBS to the private sector when it is value for the taxpayer to do so. Today is a step in that direction," said finance minister George Osborne.
The government is sitting on a 20 billion pound loss on RBS and could sell a first tranche of shares at a loss, but there are several more milestones to pass before that is likely.
"My betting is first placement prior to (the) next election (in 2015) but it's a fluid situation," said one of the 10 biggest investors in the bank, who asked not to be named.
RBS has paid the minimum required premiums of 2.5 billion pounds ($4 billion) since joining the UK Government's Asset Protection Scheme (APS) in 2009.
The news was widely expected, but welcomed and RBS shares closed up 2.2 percent at 286.1 pence, one of the strongest gains made by European bank shares.
"This is positive news as it had been rumoured over the summer that the exit might be delayed into 2013," said the institutional investor in regard to the APS exit. "There is a small additional positive today in that there are no onerous conditions attached."
The specially designed insurance scheme capped potential losses on 282 billion pounds of RBS's most toxic assets after the 2008 bailout.
For the UK to start selling RBS shares the bank still needs to complete a complex capital restructuring, parts of which require approval from European regulators.
It would involve getting rid of a dividend access share - which gives the government the right to an enhanced dividend payout and could cost the bank about 1.8 billion pounds - and converting the government's B shares into ordinary shares.
The bank could also look to sell its U.S. business Citizens, and use the proceeds to buy back some of the government's shares, analysts said.
Those steps would improve the government's chances of selling RBS shares, creating a well capitalised bank with a clear UK focused strategy. That could appeal to a sovereign wealth investor such as Qatar, although the full turnaround is likely to take many more years, analysts said.
The bank continues to hit bumps. It last week successfully sold a first tranche of shares in its insurance arm Direct Line , but days later its 1.65 billion-pound deal to sell 316 bank branches to Spain's Santander collapsed.
It has to restart the sales process and may only get half that amount from a new buyer.
RBS is also under investigation by the U.S. and UK authorities over the Libor interest rate-rigging scandal and possible breaches of U.S. economic sanctions against Iran.
Those issues are threatening to overshadow the turnaround driven by Chief Executive Stephen Hester, who said earlier this month that there was "about 15 months of heavy lifting still to do" under its recovery plan.