Deutsche Bank's Abbey Life sale faces delay over regulatory inquiry - sources

* UK watchdog investigation could lead to fines, compensation

* Swiss Re (LSE: 0QL6.L - news) , Phoenix, Legal & General (LSE: LGEN.L - news) performing due diligence

* Deutsche Bank (LSE: 0H7D.L - news) could take on risk of any compensation payment

By Pamela Barbaglia, Carolyn Cohn and Arno Schuetze

LONDON/FRANKFURT, June 03 (Reuters) - Deutsche Bank's sale of its British insurer Abbey Life Assurance Co is facing delays as bidders struggle to decide on a valuation due to an investigation by Britain's financial watchdog into the firm, sources familiar with the matter said.

They said Swiss Re unit Admin Re, Phoenix and Legal & General have made it to the final stages of an auction which kicked off at the beginning of the year.

The German lender started weighing the sale of its British insurance unit in October, attracting interest from a series of rival insurers including China's Anbang Insurance Group.

But in March the Financial Conduct Authority (FCA) launched an investigation into Abbey Life's treatment of long-time life insurance customers which could result in compensation payments to policyholders or fines to the British insurer.

"This is a large risk," one of the sources said. "It (Other OTC: ITGL - news) 's too big to solve it just by offering a discount. Unless this probe is out of the way the sale won't go ahead."

Deutsche Bank, Swiss Re, Phoenix and L&G declined comment.

Abbey Life is valued at around 1 billion pounds ($1.5 billion), the sources said. It has made no comment on the FCA inquiry.

Swiss Re, Phoenix and L&G recently got access to the company's books but are looking to hedge themselves against the risk the British watchdog could impose a fine or compensation, causing a delay to the process, the sources said.

The inquiry, which targets five other British insurers, is trying to establish whether insurers have treated customers locked into pension and other savings plans fairly compared with new customers.

Abbey Life, along with Old Mutual (Other OTC: ODMTY - news) , is also subject to a further investigation on whether it contravened other regulatory requirements related to the treatment of long-standing customers, the FCA said in March. Old Mutual has said it is cooperating with the review.

VALUATION RISK

Stricter European capital rules for insurers which came into force this year have encouraged financial services firms to offload insurance businesses.

Deutsche Bank, which bought Abbey Life from Lloyds TSB for 977 million pounds in 2007, is now keen to find a new owner for the business as part of its restructuring efforts.

Swiss Re, Phoenix and L&G have consistently showed interest in buying closed books of life assurance business in Britain with the Swiss firm securing control of Guardian Financial Services in a 1.6 billion pound deal in September.

The three insurers are now expected to ask Deutsche Bank to take on the risk of any compensation payments that the FCA would impose on Abbey Life while negotiating on price, the sources said.

One of the sources said the process was still far from the finishing line as the bidders have several weeks of due diligence ahead and need to factor in the possible consequences of the regulatory inquiry.

Phoenix and L&G have been busy with other deals in recent weeks, potentially adding to any delay, two of the sources said.

On May 27 Phoenix bought French insurer AXA (Paris: FR0000120628 - news) 's UK life business for 375 million pounds, while on May 23, L&G bought from Dutch insurer Aegon (Swiss: AGN.SW - news) a 3 billion pound book of annuities, which pay pensioners a fixed income for life, for an undisclosed sum.

($1 = 0.6878 pounds) (Editing by Rachel Armstrong/Mark Heinrich)