SYDNEY (Reuters) - Commonwealth Bank of Australia (>> Commonwealth Bank of Australia) has agreed to sell its life insurance unit to Hong Kong-based AIA Group (>> AIA Group Ltd) for $3.1 billion (2.3 billion pounds), in the biggest Asian buyout of an Australian financial firm.

The deal, which ranks among the top 10 insurance M&A in the Asia Pacific region excluding Japan, will see AIA acquiring CBA’s life insurance business in Australia and life and health insurance businesses in New Zealand.

CBA also flagged a possible wealth management IPO as Australia's major lenders come under regulatory pressure to achieve "unquestionably strong" capital ratios, driven by concerns about their exposure to foreign borrowing and a frothy property market.

The divestment of CBA's CommInsure insurance business is part of a trend of asset sales across Australia's banking sector, with a particular focus on insurance as the country's lenders struggle to cope with growing competition from large foreign firms.

For pure-play global insurers including AIA, MetLife (>> MetLife) and Zurich Insurance Group AG (>> Zurich Insurance Group), Australia is an attractive market with relatively low life-insurance penetration.

It also has a large mortality protection gap - the difference between the amount of life insurance people carry and the amount they need - estimated at $1.1 trillion, which is the fifth-biggest in the Asia-Pacific region.

For CBA, the CommInsure sale follows damaging media revelations last year that it had used discredited methods to refuse legitimate payouts, leading to policy cancellations.

The scandal was one of a series of crises that has rocked CBA in recent times, culminating in allegations of systemic breaches of money-laundering and terror-financing laws that could expose it to billions of dollars in fines.

"CBA has done well selling CommInsure on a good multiple," Shaw and Partners analyst David Spotswood said in a note to clients, adding it gave the bank "flexibility" in the event of hefty fines stemming from the money-laundering civil case.

CBA shares were down 0.4 percent by mid-afternoon, outperforming a broader market decline of 1.2 percent. The stock has dipped about 10 percent since the money-laundering allegations broke on Aug. 3.

AIA shares were nearly unchanged from their previous close at 0302 GMT.

Even after the CBA deal is completed some time next year, the M&A activity in the Australian insurance sector is expected to remain strong.

Australia and New Zealand Banking Group (>> Australia and New Zealand Banking Group) has said it may sell its life insurance and wealth divisions, while Westpac Banking Corp (>> Westpac Banking Corp) also has started exploring a possible life insurance sale, according to reports in the Australian media.

DIVERSIFICATION

The latest transaction comes after National Australia Bank Ltd (>> National Australia Bank Ltd.) sold an 80 percent stake of its life insurance unit to Japan's Nippon Life Insurance last year.

Under the AIA deal, CBA said it would continue to sell life insurance products through its branches on behalf of AIA for 20 years, and customers would keep their existing benefits.

The acquisition will help AIA, which had free surplus cash of nearly $11 billion as of end May, diversify its main markets with Hong Kong and China together accounting for about half of new business growth now at the insurer.

The deal is AIA's second-biggest acquisition since it listed in Hong Kong in 2010. It had bought ING Groep's (>> ING Groep) Malaysian insurance unit for $1.7 billion in 2010.

AIA said in a separate statement the final net cash outflow for the CBA transaction would be about $1.5 billion after taking into account the proceeds from reinsurance agreements and the free surplus within CommInsure Life and Sovereign.

CBA also said it was considering spinning off asset management business Colonial First State Global Asset Management in an initial public offering. Colonial has A$219 billion in assets under management.

CBA did not give further details about the plan but said its wealth management chief executive, Annabel Spring, would leave the company in December.

(Additional reporting by Sandhya Sampath in Bengaluru and Sumeet Chatterjee in Hong Kong; Editing by Stephen Coates)

By Byron Kaye and Paulina Duran