Commentary

1. Introduction

The past year has been one of importance and significant activity for Discovery. The Group’s results were pleasing, despite the uncertain macro-economic environment. Given this instability and the prospect of further economic decline, Discovery focused, in both its established and emerging businesses, on ensuring the Group remains strongly positioned for continued growth and profitability.

While effort has been invested during the period to grow the Group’s geographical footprint, Discovery’s local businesses remain central to its strategy and command the lion’s share of capital and operational investment. At the core of Discovery’s model is its commitment to making people healthier and enhancing their lives. Each of the Group’s subsidiaries, in South Africa and offshore, leverage off the platform of wellness and consumerengagement created by Vitality. The result is an integrated approach that melds together wellness and risk management, creating highly differentiated and consumer-centric financial services offerings.

This approach has resulted in a strong financial performance during the period under review, with new business growing by 32% to a record level of R7.6 billion and operating profit increasing by 36% to R2.5 billion. Headline earnings increased by 24% to R1.5 billion and the group embedded value increased by 8% from December 2009 to R22.6 billion. Importantly, significant positive experience variances were achieved within the embedded value, illustrating clearly that Discovery continues to exceed the actuarial expectation in its performance.

2. Local operations

In Discovery’s local businesses, the year featured substantial investment in innovation and infrastructure to support future growth and work was done on potential new businesses in this market.

Discovery Health

Discovery Health’s performance exceeded expectations across all key performance indicators, with new business levels at the highest in the company’s history. Despite the impact of economic pressure on consumers, the increase in new business derived from entirely new members and companies joining the Discovery Health Medical Scheme was 95% to R2.5 billion.

During the period, Discovery Health focused on four distinct strategic thrusts:

1. Significant investment in people and infrastructure: Given the record levels of new business, low lapse rates and the efficiencies achieved in previous years, Discovery Health focused on building its infrastructure in the period to facilitate future growth.
   
   
2. Building a better quality, more cost-efficient healthcare system for members of the schemes Discovery Health administers: Discovery Health has created unique and sustainable healthcare assets that enable the company to achieve greater scale and sophistication relative to competitors. During the past year, the company continued to build and grow these assets. Discovery Health’s GP network and proprietary direct payment arrangements with specialists, for example, have continued to grow with the percentage of GP and specialist visits covered this way now exceeding 86% and 87% respectively. The combination of these assets has increased value and lowered healthcare costs for consumers, with the costs for Discovery Health members estimated at about 8% lower than competing companies. During the period, the competitive advantage in these areas has attracted a number of large closed medical schemes to Discovery Health, including Altron Medical Scheme and Remedi Medical Scheme.
   
   
3. Balancing clinical and actuarial management to lower costs for all schemes under management: Healthcare is uniquely skewed in that 19% of the membership base consumes 80% of the healthcare bill. To ensure sustainability, it is therefore critical to keep healthy members in the system. Vitality plays a key role in maintaining an appropriate balance between cost and value for both healthy and sick members. Members who engage in managing their health are able to enjoy benefits within the Discovery Health system. Importantly this is true regardless of their health status. The combination of the benefits offered through the medical scheme and Vitality therefore encourages both healthy and sick members to stay in the system. Vitality’s role in retaining healthy members is evident from the lapse rate, which during the period reduced to 4.1%.
   
   
4. Engaging with stakeholders to help build a better healthcare system: Importantly, in the context of ongoing public debates around potential healthcare reform, Discovery Health continues to play a positive role in helping to build an inclusive and successful healthcare system for all South Africans, fundamental to our country’s future.

Discovery Life

During the year under review, Discovery Life maintained and enhanced its leadership position through a continued focus on the quality and efficiency of the business, thereby ensuring its robustness during periods of economic uncertainty. This resulted in operating profit growing by 9% to R1.4 billion. To allow Discovery to grow without recourse to additional external capital, the Group has utilised a portion of Discovery Life’s negative reserves through appropriate financial reinsurance structures. The benefits of this approach are a de-risking of that part of the negative reserve asset, a reduction in the overall capital required and an increase in the return-on-capital. However, at the Discovery Life level, there is a reduction in earnings as Discovery Life does not get the benefit of the portion of the negative reserve used for this purpose. The cost to Discovery Life in the year under review was R127 million. Normalised operating profit grew 15% to R1.6 billion. Core new risk business grew by 10% to R853 million with overall new business up 2%. This reflects the effect of reducing inflation on contribution increases (accounted for in the overall new business volumes).

From a strategic perspective, Discovery Life focused on three key areas during the financial year:

1. Innovation and new product growth: Discovery Life continued to focus on product innovation with the launch of the Financial Integrator during the first half of the financial year, and the launch of the lowerpriced Essential Plans in the latter half. The strategy has proven successful, with 27% of new business taking up the Financial Integrator.
   
   
2. Structural changes to reduce policy lapses: Discovery Life undertook significant analysis to understand and address the key factors that impact on lapse rates. The analysis showed clients with lower credit ratings are more likely to lapse their policies in a difficult economic environment, whereas clients who integrate their policies with Vitality and use more benefits across Discovery’s product range are less likely to lapse. As a result of these findings, Discovery Life did considerable work in the period to incorporate credit risk in underwriting and risk management, while enhancing and promoting integration opportunities for customers across the Discovery product range. This strategy, coupled with a lessening of pressure in the economic environment during the period, has resulted in a reduction in lapse rates of 1.2% in the second half of the year.
   
   
3. Increasing Vitality engagement to positively impact on mortality and morbidity: Discovery Life also focused on encouraging positive selection to ensure superior mortality and morbidity experience. While premium pricing is fundamental, management of lapses and the integration of Vitality were important in this regard. Vitality and its integration ability not only reduced lapses among healthy lives by providing them with value, but it also engaged people in managing their health, which improved morbidity and mortality experience. As a result, the overall risk experience of Discovery Life was significantly better than expected with mortality experience running at 87% of expectation.

The combination of innovative products, competitive pricing points, lower lapse rates and better mortality experience has created a robust platform for future growth.

Discovery Vitality and DiscoveryCard

In terms of Vitality’s performance, two key themes emerged during the year. Firstly, the period saw continued investment in understanding and enhancing the wellness and behavioural science that underlies Vitality. During the period, the Vitality team in collaboration with experts from leading academic and scientific institutions continued to study Vitality’s effects on behaviour and the correlation between engagement in the programme and health outcomes. Across Discovery’s businesses, clear evidence is emerging that engagement in Vitality reduces health-related risk, lowers healthcare costs and, as a by-product of the programme’s powerful benefits, improves customer retention rates. As a result, the Vitality model represents a unique and significant asset that Discovery is able to export into diverse international markets like the USA, UK and China.

Secondly, the scale and usage of Vitality is increasingly substantial, demonstrating the tremendous value generated for Discovery clients through the programme. Over 1,6 million clients internationally make use of the programme’s health and lifestyle benefits. Locally, Vitality members represent a significant proportion of our Vitality partners’ client bases.

DiscoveryCard has similarly proven itself an important value creator for Discovery clients. During the year, DiscoveryCard’s market share increased to 8%, making it the fifth largest player in the South African credit card market and the only significant non-bank competitor in this sector. Despite the continuing economic pressure faced by consumers and the concomitant strain on many lending institutions, DiscoveryCard’s credit experience has improved considerably and the quality of the client base provides opportunities for additional value propositions to consumers. The period saw extensive focus on ensuring a cutting-edge service offering for clients, and on positioning the DiscoveryCard as a premier card offering. This drive will continue into the future, with further innovation in this regard planned for the period ahead.

Discovery Invest

Discovery Invest’s performance was exceptional and exceeded expectation, with the company generating its maiden profit in the second half of the financial year. Discovery Invest operates in the retail long-term savings market, where, despite lower volumes of business, margins are higher. In this context, gross inflows increased by 109% to over R6 billion with assets under management increasing by 262% to R11 billion. New business increased by 90% to R761 billion on an annual premium equivalent basis, with single premiums written during the period amounting to R4.8 billion.

The company generated an operating profit of R7 million compared with an operating loss of R119 million during the previous period. Importantly, the take-up of Discovery Invest’s products has been remarkable, with positive feedback from the independent intermediary community. During the latest Financial Intermediaries’ Association survey, Discovery Invest achieved the highest scores in terms of broker feedback across virtually every category – a reflection of the quality of the business being built.

From a distribution perspective, Discovery Invest continues to gain traction rapidly with the number of supporting brokers increasing during the period by 41% to over 2 500 brokerages. Of the top 1 000 supporting brokerages, 48% had increased their Discovery Invest business written with a further 37% writing Discovery Invest business for the first time.

With regard to profitability, the percentage of funds allocated to Discovery Funds exceeded the premium-basis expectations, increasing Discovery Invest’s profit margin as a percentage of premium from 2.5% to 2.8%.

The company continues to enhance its profile with initiatives such as the Discovery Invest Leadership Summit and its links to Moneyweb. Based on the increasing distribution support for Discovery Invest, its increasing brand credibility and the positive response to its product offerings, the prospects for continued growth and profitability are positive.

3. International operations

In the United Kingdom: PruHealth and PruProtect

Discovery’s strategy in South Africa of building quality business of scale with significant integration capability is increasingly mirrored by our approach in the UK, where we plan to leverage the wellness and integration foundation of Vitality to offer enhanced health and protection offerings.

During the period, Discovery restructured its business to facilitate this approach and significantly increased its shareholding in the UK joint venture with Prudential plc from 50% to 75%, thereby boosting the scale and capability of its business in the UK market. This was achieved by Discovery purchasing Standard Life Healthcare and merging it into PruHealth, in return for a 25% increase in its share of PruProtect and PruHealth.

PruHealth

PruHealth’s operating losses widened during the past financial year, exacerbated by the economic recession, which has been shown to result in declining membership and increasing loss ratios. In terms of PruHealth’s long-term prospects, this was a period of significant restructuring of the business and the implementation of a number of initiatives aimed at liberating the powerful franchise built in the UK.

Although the short-term effect of the difficult macro-economic conditions has been to decrease demand for private medical insurance, in the longer term it presents a significant opportunity. This is because increased public debt and budget deficits in the UK and the government’s austerity measures to address these problems are likely to result in less public spending on the NHS. Government expenditure on healthcare is unlikely to keep pace with increasing healthcare costs, creating a greater need for privately funded healthcare.

To address the environmental and performance issues experienced and to ensure PruHealth is positioned to capitalise on the market opportunities, a number of key strategies were employed during the period:

1. PruHealth focused on attracting and retaining quality new business. Actuarial estimates show the quality of new business was significantly enhanced as a result.
   
   
2. During the previous financial year and the first six months of the reporting period, work was done around Vitality and product features to bring down the cost of benefits. These measures were put in place for policies renewing from 1 January 2010. The effects will therefore not be felt during the period under review, but will materialise from the second half of the 2011 financial year.
   
   
3. During the period under review, certain operational functions were incorporated into the South African operational environment leading to a significant reduction in operational costs per life. The business also incurred further restructuring costs that will position PruHealth for future operational cost reductions. As above, the positive effects of this strategy will materialise in the next 6 to 12 months.
   
   
4. Finally, PruHealth’s acquisition of Standard Life Healthcare – given the quality of the business, its low loss ratios and established infrastructure – presented an excellent opportunity for PruHealth to increase its scale. Standard Life Healthcare offers many complementary assets to PruHealth and collectively, the combination of the two creates a compelling new business. Standard Life’s product strategy is based on modular ancillaries and the company focuses strongly on service and distribution through agency and direct channels. These strengths complement PruHealth’s Vitality and integration assets, product and innovation capabilities and independent financial adviser distribution channel. While Standard Life Healthcare’s distribution is weighted more towards the individual market and smaller groups, PruHealth has attracted larger SMEs and corporates. The result of combining the businesses is a complementary model and expanded distribution footprint with the ability to yield substantial volumes of new business. Importantly, increased scale also provides the opportunities for expense economies and greater negotiation power with healthcare providers. The acquisition has seen a significant and substantial transformation of the PruHealth business from 226 000 lives to 700 000 lives. While some of the effects of these strategies applied in the period are already starting to filter through, the full benefits will only be realised in the next 18 to 24 months. As they come to fruition, PruHealth is expected to grow significantly and, in the longer term, to achieve a margin of 4% to 5%.

PruProtect

PruProtect performed exceptionally well, exceeding expectation with the company reducing its operating losses significantly and moving rapidly towards profitability. New business increased by 116% to R227 million and operating losses were cut by 70% to R40 million. Importantly, the rate of new business increased – the average daily applications for the second half of the financial year amounted to 275 applications, compared to 200 applications received for the first six months of the financial year and around 130 for the previous period.

During the period under review, PruProtect took a number of innovative products to market – most notably the Health Cover Optimiser that extends Discovery’s approach of integrating products. The Health Cover Optimiser combines PruHealth’s private medical insurance cover with PruProtect’s severe illness benefit and offers the savings from expense economies and benefit overlap to policyholders. Although early in the product’s roll-out, the company is optimistic about the potential growth of the first integrated product in the UK market.

In China and the USA

Discovery in the period announced its acquisition of a 20% stake of Ping An Health – the health subsidiary of China’s Ping An Group. The joint venture will see Ping An Health deploy Discovery’s product innovation and consumer-engaged model to a potential market of 83 million families. Given the ability for Discovery to tap into Ping An’s brand credibility and distribution footprint, and based on the Chinese government’s regulatory support of private healthcare, the opportunity in China is compelling.

Discovery has also maintained a small US presence over the past three years, where it markets the Vitality wellness programme as a standalone offering to corporate firms and health insurers. This approach of strategic partnerships, coupled with US regulatory reforms that place the emphasis on cost management through wellness and prevention, create opportunities for Discovery to deploy Vitality’s assets without requiring capital or incurring significant fixed costs.

4. Prospects

The work done over the past financial year positions the Discovery Group strongly for continued growth and profitability into the future.

MI Hilkowitz	A Gore
Chairperson	Chief Executive Officer