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Outsourcing under Solvency II: Managing your custody risk Presented by Patricia Burgess 27 January, 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 - 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 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 infrastru 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 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 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 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 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 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 Investment activities are considered critical or important operational functions Source: Directive 2009/138/EC 8

Article 49 – Outsourcing (Part II) There needs to be a detailed selection process 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 9

Article 49 – Outsourcing (Part II) These are some key measures that should be Article 49 – Outsourcing (Part II) These are some key measures that should be taken by global custodians to mitigate risks Asset segregation and reconciliation Transaction risk management Ring fencing of client assets at all levels Daily automated reconciliation across the portfolio Understanding of local market laws and regulations 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 Network management Legal, regulatory and tax Internal network – Minimise exposure Robust sub-custodian selection process Participation in industry association and market activities to access information and help shape the environment Influence and thought leadership 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 Operational and liquidity risks Legal, regulatory and tax risks 10

Article 49 – Outsourcing (Part II) A strong written agreement, including SLAs and KPIs, Article 49 – Outsourcing (Part II) A strong written agreement, including SLAs and KPIs, is key Key provisions 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 11

Article 49 – Outsourcing (Part III) There needs to be open and continuous dialogue 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 12

Article 38 – Supervision of outsourced functions and activities There needs to be open 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 13

Article 44 – Risk management (Part III) The directive implies full visibility and understanding 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 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 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 16

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