Financial services firms that sell Payment Protection Insurance (PPI) have been told they must improve their selling methods.
The regulator has demanded urgent action to stop mis-selling
The Financial Services Authority (FSA) demanded urgent action after visiting firms and a mystery shopping exercise.
About a third of the 45 firms surveyed sold policies on which customers could not claim or which gave limited cover.
PPI is supposed to help people continue with repayments on loans if they fall ill or lose their jobs.
This summer the FSA asked a market research company to carry out the mystery shopping survey of firms selling PPI.
Those selling PPI policies with mortgages were found generally to be following the rules.
However, at about half of the remaining 30 firms examined it found evidence of considerable problems. It found they were mis-selling the policies alongside such products as credit and store cards, and secured and unsecured loans.
Clive Briault, the FSA's managing director of retail markets said, "compliance standards in other areas of the market, notably single premium PPI business, are generally weak".
"Those firms where these problems exist must take urgent action to address them" he added.
The FSA found there was a serious risk to consumers.
In particular it discovered:
- poor disclosure of product and price details.
- the possibility that consumers may not be eligible to claim against their policies.
- that customers might not be aware they could receive little money back if they cancelled their policies early.
The FSA said advice given on buying PPI was likely to be poor.
Among the reasons were a lack of proper monitoring and training, which meant staff in around half the 30 firms in question were not competent.
But the regulator also pointed out that the use of sales commissions or bonuses to pay employees were encouraging some staff to mis-sell the policies.
The financial services industry said it would take the FSA's criticisms seriously.
The Association of British Insurers, the British Bankers Association and payment services body APACS said they were "keen to establish that the FSA's report should not be seen as indicative of the whole industry".
Stephen Haddrill, the ABI's director general, added that "payment protection insurance is a valuable product. Insurers and lenders are committed to driving up selling standards."
However, Citizens Advice, the umbrella body for the citizens advice bureaux, repeated its recent claim that the business of selling PPI policies is little more than a protection racket.
In September it launched a so-called "super complaint", asking the Office of Fair Trading to investigate the selling of PPI.
"We badly need an official investigation of how this market is operating," said Dan Vale, the head of policy at Citizens Advice.
"The FSA report highlights the extent to which poor sales practices are endemic within the industry."
But he added, "the FSA report does not deal with all the issues, namely the cost of PPI and the content of the policies".
The OFT will have to decide by December if it will accede to the super complaint.
But the FSA said it would carry out a second round of checks early next year.
It warned that the most serious cases it had uncovered would receive further investigation with possible enforcement action - which could mean hefty fines for offending firms.