A full investigation into payment protection insurance was launched yesterday after a study found that "many customers are failed" by the #5.5 billion sector.
The Office of Fair Trading said it would refer the PPI market to the Competition Commission after it found the insurance gave customers "a poor deal" and "less protection than they think".
The OFT added that steps being made to improve the situation "will not make major improvements to competition in the market".
Payment protection insurance is taken out by borrowers to cover debt repayments if they are unable to work due to illness, injury or if they lose their job.
It is often sold by banks and credit card issuers when people take out a new loan or card.
About seven million policies are taken out each year and the sector is estimated to be worth #5.5 billion.
The OFT launched a study into PPI in April amid fears that it may not be working well for customers.
OFT chief executive John Fingleton said: "Following the work we have undertaken it is clear that many customers are failed by PPI – insurance which gives them a poor deal and often less protection than they think.
"There is limited evidence the industry is taking steps to improve the situation, but we believe they will not make major improvements to competition in the market.
"Given our evidence and the scale of this market, our provisional view is that it would be appropriate for the Competition Commission to investigate further."
The OFT said that PPI could be "worthwhile for some consumers" but said that the way people bought PPI and their understanding of it "hinders competition".
The watchdog said customers did not shop around for the best deal on PPI while its "complex nature" made comparisons between different policies difficult.
It added that credit card firms and banks issuing new cards or loans had an advantage at the point of sale – further damaging competition.
"The evidence also shows that PPI has low claims ratios compared to other insurance products and, with no evidence to suggest costs are high, it seems reasonable to assume that distributor profitability is sizeable," said the OFT. "Evidence on commission rates, which look to be high compared with other general insurance products, reinforces this conclusion."
Just 15 per cent to 20 per cent of people with PPI claim on their policies compared with 74 per cent for motor insurance.
The OFT study followed a complaint from Citizens Advice which said consumers were paying excessively high prices for the insurance.
It said the policies were frequently mis-sold and there was evidence that high pressure and unfair sales tactics were being used, while the payment of claims was often slow and could leave consumers facing additional charges or serious debt enforcement action.
Liberal Democrat treasury spokesman Vince Cable said: "The OFT's announcement proves what many have been saying for years. PPI is complex, expensive and often fails those who need it most."