Transcript Patricia Burgess - Association of Financial Mutuals

Outsourcing under Solvency II:
Managing your custody risk
Presented by Patricia Burgess
27 January, 2011
The closer, the better
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
2
What is a custodian?
A service provider which holds, safeguards
and services an owner’s assets
Who are the clients?
Institutional investors and professional intermediaries
What is the custodian’s role?
 Advise clients on all local markets
 Perform all post-trading activities and protect the interests of the investor
 Provide value added services
How do clients benefit?
 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
3
Core custody services
The list of services offered grows on a yearly basis
Safekeeping / Settlement
Cash management / FX
Asset servicing
Tax servicing
Information / MIS / Reporting
Examples of other value-added services are securities lending and tri-party repo
4
Outsourcing under Solvency II – Directive 2009/138/EC
Key articles applied to global custodians
All outsourced activities need to be fully understood
and managed as any other part of the business
Chapter III: Supervisory authorities and general rules
Article 38
Supervision of outsourced functions and activities
Chapter IV: Conditions governing business – Section 2: System of governance
Article 41
General governance requirements
Article 44
Risk management
Article 49
Outsourcing
5
Article 41 – General governance requirements
This article sets the tone around governance and
communication (both internal and with supervisors)
 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
6
Article 49 – Outsourcing (Part I)
The (re)insurer is still fully responsible for all activities
whether performed in-house or outsourced
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
7
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/EC
Investment activities are considered critical or important operational functions
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Article 49 – Outsourcing (Part II)
There needs to be a detailed selection process to determine
the ability and capacity of the service provider
 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
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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
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Ring fencing of client assets at all levels
Daily automated reconciliation across the
portfolio
Understanding of local market laws and
regulations
Network management
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Internal network – Minimise exposure
Robust sub-custodian selection process
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Credit ratings / internal controls
Reputation, expertise and influence
Acceptability of contract terms
Market leading capabilities
Transaction risk management
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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
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Participation in industry association and
market activities to access information and
help shape the environment
Influence and thought leadership
Ongoing oversight and management of services
Onsite due diligence, self assessment reporting
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
Key provisions
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Standard of care
Liability provision and indemnities
Warranties
Lien provisions
Cash management
Amendments and termination
 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)
There needs to be open and continuous dialogue between
the supervisor, the (re)insurer and the service provider
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
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
13
Article 44 – Risk management (Part III)
The directive implies full visibility and
understanding of your portfolio of assets
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 II
With 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
14
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!
15
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
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The closer, the better