The closer, the better

Outsourcing under Solvency II: Managing your custody risk

Presented by Patricia Burgess27 January, 2011

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Agenda

Global custody – Core services

Outsourcing under Solvency II – Directive 2009/138/EC - Key articles

Article 41 – General governance requirements

Article 49 – Outsourcing

Article 38 – Supervision of outsourced functions and activities

Article 44 – Risk management

Overview

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What is a custodian?

A service provider which holds, safeguards and services an owner’s assets

Institutional investors and professional intermediaries

Advise clients on all local markets Perform all post-trading activities and protect the interests of the investor Provide value added services

Direct access to markets globally through a scalable and robust infrastructure Clear control and reporting of activities with tight risk management Access broad scope of services with reduced need for investment

Who are the clients?

What is the custodian’s role?

How do clients benefit?

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Core custody services

Safekeeping / SettlementSafekeeping / Settlement

The list of services offered grows on a yearly basis

Examples of other value-added services are securities lending and tri-party repo

Cash management / FXCash management / FX

Asset servicingAsset servicing

Tax servicingTax servicing

Information / MIS / ReportingInformation / MIS / Reporting

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Outsourcing under Solvency II – Directive 2009/138/ECKey articles applied to global custodians

Article 38 Supervision of outsourced functions and activities

All outsourced activities need to be fully understood and managed as any other part of the business

Article 41 General governance requirements

Article 44 Risk management

Article 49 Outsourcing

Chapter III: Supervisory authorities and general rules

Chapter IV: Conditions governing business – Section 2: System of governance

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Article 41 – General governance requirements

Sound and prudent management of the business

Adequate transparent organisational structure

Allocation and appropriate segregation of responsibilities

Fluid transmission of information

List of written policies reviewed, at least, annually

“Open door” policy for supervisors

Includes compliance with articles 42 to 49 Article 44 – Risk management Article 49 – Outsourcing

This article sets the tone around governance and communication (both internal and with supervisors)

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Article 49 – Outsourcing (Part I)

Member states shall ensure that insurance and reinsurance undertakings remain fully responsible for discharging all of their obligations under this directive when they outsource functions or any insurance or reinsurance activities

Source: Directive 2009/138/EC

In principle, all activities can be outsourced except core management functions

Include considerations of the impact of outsourcing on the business and the reporting and monitoring arrangements

Maintain in-house the competence and ability to assess whether the service provider delivers according to contract

The (re)insurer is still fully responsible for all activities whether performed in-house or outsourced

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Article 49 – Outsourcing (Part II)

Outsourcing of critical or important operational functions or activities shall not be undertaken in such a way as to lead to any of the following:

Materially impairing the quality of the system of governance of the undertaking concerned

Unduly increasing the operational risk

Impairing the ability of the supervisory authorities to monitor the compliance of the undertaking with its obligations

Undermining continuous and satisfactory service to policy holders

Source: Directive 2009/138/ECInvestment activities are considered critical or important operational functions

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Article 49 – Outsourcing (Part II)

Understand the financial strength of the custodian Quantitative - Capital, assets, management, equity, liability and liquidity Qualitative - Diversity of earning streams, track record, external ratings,

market perception, contingency model

Key risks associated with global custody Managed by the insurer

Investment risk (country/market/issuer) Trading counterparty risk

Managed by custodian Operational risk Liquidity risk Legal, regulatory and tax risk

There needs to be a detailed selection process to determine the ability and capacity of the service provider

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Article 49 – Outsourcing (Part II)

These are some key measures that should be taken by global custodians to mitigate risks

Asset segregation and reconciliation Ring fencing of client assets at all levels Daily automated reconciliation across the portfolio Understanding of local market laws and

regulations

Network management Internal network – Minimise exposure Robust sub-custodian selection process

Credit ratings / internal controls Reputation, expertise and influence Acceptability of contract terms Market leading capabilities

Ongoing oversight and management of services Onsite due diligence, self assessment reporting

Transaction risk management Timeliness, quality and transparency of

transaction processing including settlement, asset servicing, cash management, tax and FX

Clean control environment with clear reporting and escalation processes

Legal, regulatory and tax Participation in industry association and

market activities to access information and help shape the environment

Influence and thought leadership

Operational and liquidity risks Legal, regulatory and tax risks

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Article 49 – Outsourcing (Part II)

A strong written agreement, including SLAs and KPIs, is key

Standard of care Liability provision and indemnities Warranties Lien provisions Cash management Amendments and termination

Key provisions

Conflicts of interest Separation of client securities and monies Voting Stock lending Foreign exchange

Full collaboration with authorities, internal/external auditors and the (re)insurer needs to be discussed

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Article 49 – Outsourcing (Part III)

Insurance and reinsurance undertakings shall, in a timely manner, notify the supervisory authorities prior to the outsourcing of critical or important functions or activities as well as of any subsequent material developments with respect to those functions or activities

Source: Directive 2009/138/EC

Advising the regulatory authorities six weeks in advance is considered enough time for the regulator to perform the required review

Custodians are FSA regulated and therefore already well known to and followed by the regulator

There needs to be open and continuous dialogue between the supervisor, the (re)insurer and the service provider

This statement ties with Article 38 regarding supervision of outsourced functions

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Article 38 – Supervision of outsourced functions and activities

There needs to be open and continuous dialogue between the supervisor, the (re)insurer and the service provider

Without prejudice to article 49 […] the following conditions are satisfied: The service provider must cooperate with the supervisory authorities … The insurance and reinsurance undertakings, their auditors and the supervisory authorities must have effective access to data related to the outsourced functions or activities The supervisory authorities must have effective access to the business premises …

The member state where the service provider is located shall permit the supervisory authorities of the insurance or reinsurance undertaking to carry out […] on-site inspections at the premises of the service provider

Source: Directive 2009/138/EC

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Article 44 – Risk management (Part III)

As regards investment risk, insurance and reinsurance undertakings shall demonstrate that they comply with chapter VI, section 6

Chapter VI, section 6 – Article 132 – Prudent person principle (Parts II and VI)

Part IIWith respect to the whole portfolio of assets […] only invest in assets and instruments whose risks the undertaking concerned can properly identify, measure, monitor, manage, control and report and appropriately take into account in the assessment of its overall solvency needs […]

All assets […] shall be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole […]

Assets to cover the technical provisions shall also be invested in a manner appropriate to the nature and duration of the insurance and reinsurance liabilities […]

Part IV[…]Assets shall be properly diversified in such a way as to avoid excessive reliance on any particular asset, issuer or group of undertakings, or geographical area and excessive accumulation of risk in the portfolio as a whole

Source: Directive 2009/138/EC

The directive implies full visibility and understanding of your portfolio of assets

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Article 44 – Risk management (Part III)

The directive implies full visibility and understanding of your portfolio of assets

This can only be achieved through full visibility of the portfolio

Internally managed portfolio or single asset manager – Centralised and straight forward

Multiple asset managers – The global custodian can act as centraliser of data and contribute to the enhancement and harmonisation of the information received from all sources

Achieving consistent quality and granularity of data across all sources of information will be the key challenge!

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Overview

Outsourcing of functions, particularly critical or important operational functions, will be closely monitored by the regulator. Investment and investment-related activities are considered critical

The (re)insurer needs to understand the risks associated with all outsourced activities and keep an in-house team capable of assessing the service received. Key risks to keep in mind when managing a custodian are operational, liquidity and legal/regulatory/tax risks

The service provider will need to fully collaborate with the relevant authorities and provide maximum transparency around all activities related to the outsourcing. Custodians are FSA regulated and therefore well-known to and familiar with the regulator

Custodians data-gathering and data-analysing capabilities are very important to ensure that investment guidelines and risk limits are being followed

The closer, the better

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