Commentary

Introduction

Discovery performed strongly during the past financial year. Despite economic uncertainty, considerable policy debates and volatile markets both locally and internationally, the year under review was a seminal one for Discovery - it achieved considerable success in the context of growth, innovation and quality across virtually all areas of the business. Not only did Discovery's businesses perform better than expected, but it also made significant progress in furthering the development of the Vitality framework and its alternate applications locally, and in translating Discovery's business model into a 'repeatable' construct that underpins its expansion into new markets. This manifested in a decisive year:

• Discovery acquired Standard Life HealthCare, the UK's fourth largest health insurer and began its integration into PruHealth.
• Discovery increased its shareholding in the Prudential plc joint venture from 50% to 75%.
• Discovery concluded the joint venture with the US health insurer Humana and launched HumanaVitality on 1 July 2011.
• Discovery launched Discovery Insure, its short-term insurance business.

In addition, the period under review saw Discovery consolidating its capacity and potential for growth going forward. Discovery's capital base was strengthened by the issuing of R800 million of perpetual preference shares, placing the Group in a strong position to experience continued growth without recourse to additional capital.

Notable highlights over the period include:

• Financial performance: Discovery's financial performance exceeded expectation. Normalised profit from operations grew 32% with normalised headline earnings growing 31%. In addition, the period under review saw embedded value increasing by 19%, coupled with positive experience variances.
• Existing businesses: Discovery's existing businesses performed well. Its focus on quality manifested in strong embedded value growth, improved new business margins and significant positive experience variances. These outcomes illustrate how these businesses have outperformed the actuarial assumptions made.
• Emerging businesses: Discovery's emerging businesses (PruHealth, PruProtect, and Discovery Invest) performed better than expected, with all three generating profits and positioning themselves strongly for profitability going forward. The scale of these emerging businesses is demonstrated by the fact that their combined run rate of new business at the end of the financial year now accounts for almost a third of Discovery's new business.
• New international businesses: Discovery's new international business, HumanaVitality - a joint venture with the US insurer Humana - has been exceptionally well received with over 480 000 members committed to Vitality in the United States. This brings the total committed Vitality membership in the United States to 680 000. Ping An Health, Discovery's joint venture with the Ping An Insurance Group of China, Ltd is showing early signs of the benefits of Discovery's health and wellness platform. Although still young, the business now covers 300 000 lives, generating R155 million revenue over the six-month period to June 2011.
• New local businesses: Discovery's entry into the short-term insurance market with Discovery Insure exceeded expectation, with strong market receptivity of the business manifesting in a new business run rate in excess of R1 million per day in just 12 weeks since its launch in May this year.
• Development of the Vitality model: Underpinning Discovery's performance is its integrated business model of which Vitality forms the basis. During the period under review, Discovery made considerable advances in furthering its understanding of the effect of consumer engagement and wellness on health and life insurance. In both cases, the scientific evidence is clear: Vitality creates better selection, more accurate pricing, better mortality and morbidity, and superior selective lapsation. The effect of this in both health and life insurance is significant as it not only provides greater actuarial stability but also adds unique value to Discovery's customers. During the period under review, work was done on the Vitality model to ensure its repeatability in markets such as China, the United States and the United Kingdom. In addition, the model was used as the basis for Discovery Insure, applying the principles of behavioural economics to the science of driving, resulting in significant value for consumers. While still embryonic, this model forms the foundation for the internationalisation of Discovery's assets and business.

Discovery Health

Discovery Health's performance was pleasing and exceeded expectation. The period under review saw strong growth in individual business with a 24% increase in individual new business. In addition, operating profits increased by 14% to R1 357 million, with the total medical scheme membership managed by Discovery Health increasing by 6% to 2.5 million lives, and the Discovery Health Medical Scheme annualised lapse rate decreasing to 4.07%. New business decreased by 13% compared to the previous year. This was however in line with expectation: the previous year's new business performance was off a high base, attributable to the acquisition of the administration contracts for two large restricted schemes and a large corporate scheme in DHMS that resulted in a 48% increase in the quantum of new business since the 2009 period.

Discovery Health's primary role is to ensure that the members of the schemes under its management have access to quality healthcare on a sustainable basis. This requires the management of clinical, actuarial, technological and regulatory challenges. In addition, Discovery Health must play a fundamental role in building the healthcare system, not only for its members, but for all South Africans. Discovery Health remains acutely aware of this responsibility. Its primary strategy has been to use its scale and expertise and invest significantly in its assets to fulfil this responsibility. During the year under review, the success of this strategy continued to manifest with strong membership growth, lower and decreasing lapse rates, and the rollout of enhanced services for members such as MedXpress, Discovery Health's pharmacy delivery service.

Most importantly, Discovery Health's risk management capabilities and direct payment arrangements with healthcare professionals as well as hospital arrangements resulted in a low rate of medical inflation for the Discovery Health Medical Scheme, compared to competitor schemes in the market. Over the last four years, for a common basket of medical procedures, the Discovery Health Medical Scheme experienced an effective medical inflation rate of 8.3%, versus a market average of 11.6%. The cumulative effect of this over the four-year period is a difference of 13%.

In addition, Discovery Health invested considerably in tools that enhance the quality and minimise the cost of care for members. Most notably, it began rolling out PracticeXpress - a comprehensive suite of technologies, based initially on the iPad, that gives healthcare professionals access to patients' electronic health records at the point of care, and allows them to interface online with Discovery Health, and with various aspects of the healthcare system such as pharmacies, MedXpress and other healthcare professionals. The purpose of this is to ensure better coordination of care and to improve efficiency and quality. Going forward, Discovery Health will be rolling out this technology proactively to ensure its take-up nationally with healthcare professionals.

From a regulatory perspective, the period under review saw the National Health Insurance (NHI) policy debate mature considerably, manifesting in the release of the Department of Health's Green Paper - the policy proposal for the implementation of comprehensive NHI for all South Africans. Discovery Health strongly supports the rollout of an NHI system, as we believe that South Africa needs healthcare reform to ensure a comprehensive healthcare system for all South Africans. The policy proposals set out are rational, appropriate and bold. Importantly, they seek to address human resource shortages in the healthcare system, raise additional revenue for healthcare delivery and recognise the role of both the public and private healthcare sectors. Discovery Health is confident that if properly executed, South Africa's healthcare system will be strengthened. Discovery Health remains confident of its role in this emerging environment.

Discovery Life

Discovery Life's performance was excellent with the value of in-force business increasing by 25% from R9 437 million to R11 764 million and operating profit growing by 16% from R1 341 million to R1 558 million. New business grew 5% from R1 542 million to R1 620 million, and Core risk new business (excluding Automatic Contribution Increases) increased by 10%. Given the scale of the business and its rapid growth, Discovery Life's primary strategy during the year was to focus on the quality of the business. The success of this strategy manifested in a number of key areas:

• The rate of policy lapsation reduced significantly and came within the level of the long-term lapse assumption inherent in the embedded value calculation. This was a fundamental and important outcome given the elevated lapsation rates that the industry has experienced during the financial crisis over the last few years.
• Work done by Discovery Life at statistically predicting the causes of lapses illustrated clearly that a primary antidote to the consumer problem of lack of affordability was the Vitality integrated model. Pleasingly, during the year under review, engagement in Vitality among Discovery Life policyholders continued to increase, and the effects of engagement, even at the blue Vitality Status level, are significant.
• Expense levels were significantly reduced during the period, with a significant change in unit costs resulting in increasing new business margins and strong experience variances.
• A focus on innovation to meet the complex and unique needs of the Discovery Life client base continued. During the period, a number of new products were launched, most notably, the AccessCover™ product, which makes life cover fungible and gives policyholders the choice to cash in life cover during life-changing events such as severe illness and disability; and the Philanthropy Fund, allowing policyholders to buy additional life cover to meet their specific philanthropic needs.

These combined strategies manifested in the new business margin increasing by 1.4% from 8.4% to 9.8%.

Discovery Invest

Discovery Invest's performance was exceptional, with the business turning significantly profitable with an operating profit of R101 million. Assets under management exceeded R17,2 billion and importantly, Discovery Funds performed exceptionally well with more fund choices made towards Discovery Funds, resulting in improved margins.

Discovery Invest's primary strategy is to provide products and services that enable its investors to take advantage of an open architecture investment environment, while being protected against volatile markets or poor investment choices. A fundamental test of Discovery Invest's value proposition is to consider the performance of its products since inception, a perfect test of efficacy given market volatility and the financial crisis. A test in aggregate of this approach, is that a hypothetical client investing in a basket of Discovery Funds would have outperformed the equivalent benchmark of funds by a cumulative 7.1% over four years, with the unique Discovery Invest features adding a further cumulative 5.5%.

During the period under review, Discovery Invest continued to launch new products, predicated on the same philosophy. The Guaranteed Escalator Annuity is a strong example of this, enabling customers to invest in equitylinked annuities while enjoying a strong guaranteed underpin and financial protection for longevity. The cumulative effect of Discovery Invest's increasing scale, competitiveness, unique product propositions and fund choices led to a significant increase in new business margins and business profitability.

PruHealth

The year under review was a defining one for Discovery's UK businesses. During the period, Discovery acquired Standard Life HealthCare (SLH), the UK's fourth largest health insurer and contributed this to the joint venture, thereby increasing Discovery's shareholding of both PruHealth and PruProtect from 50% to 75%. This gave Discovery the opportunity to focus on building both PruHealth and PruProtect along the lines of its Vitality-integrated model, thereby providing a unique value proposition in a market characterised by strong competition and product commoditisation. PruHealth's performance during the period exceeded expectation despite the particularly difficult economic environment in the UK, which has a dramatic effect on the Private Medical Insurance market. During the period under review, PruHealth focused on four important strategic thrusts. PruHealth:

• Successfully decreased its loss ratio and expense levels.
• Successfully completed the SLH acquisition with the business performing better than the assumptions made during the due diligence.
• Rolled out a best-of-breed product range incorporating the relative merits of both the PruHealth and SLH product offerings.
• Began work on rolling out Vitality to the entire combined membership base.

These strategies resulted in strong performance: the 2011 expense base of the combined book decreased by 11% off the 2010 base; new business (including the contribution of the ex-Standard Life HealthCare book) increased by 49%, and R61 million operating profit was achieved for the combined business.

PruProtect

PruProtect's performance was exceptional across all performance metrics. The company turned to profitability during the last six months of the financial year, while capturing an estimated 6% to 8% of broker new business in the UK life insurance market. Importantly, the PruProtect business model closely resembles the Discovery Life model and demonstrates strongly the power of Discovery's ability to replicate the model in other markets. This performance was underpinned by the Vitality chassis that enables dynamic pricing; innovative risk benefits that led to multiple ancillary benefits per policy; the franchise broker distribution model that enables high advice with variable costs; and an efficient capital model utilising the Prudential Life Insurance Fund. The combination of these manifested in policies in-force increasing by 92% from 35 915 to 68 880 and the average daily new business application count increasing from 163 to 241. In addition, mortality experience was significantly lower than expected and the number of policies indexed to inflation increased from 5% to 20%, thereby generating higher new business margins.

PruProtect continues to pursue rapid and focused innovation, with the product launch during the period incorporating a number of powerful, new product concepts, resulting in positive market receptivity and strong new business growth. PruProtect saw new business API increasing 28% from R228 million to R290 million; and a maiden half-year after-tax profit of R7 million.

Vitality

Vitality's performance was excellent and its role in product integration, engagement and achieving superior levels of mortality and morbidity experience was further enhanced during the period under review. Engagement levels of key Vitality activities increased dramatically, with gym membership increasing to 400 000 members; HealthyFood™ activations exceeding 260 000 and almost 12.5 million trolleys purchased since inception; as well as over R200 million in HealthyFood™ cash backs paid out since the launch of HealthyFood™ in February 2009.

The period under review also saw Vitality continue its work in understanding the academic and scientific link between Vitality engagement and mortality and morbidity experience, and the resulting impact on hospital-related costs.

• In support of the cross-sectional studies published in 2009 and 2010 which found evidence for the link between fitness engagement and reduced hospital costs over time, a longitudinal study published in the Journal of Health Promotion during the period validated Vitality's ability to get people engaged in complex fitness activities, and sustain this engagement over time.
• In addition, further work was done to leverage existing Health and Vitality data to assess the impact of Vitality on health systems. By levels of engagement, further evidence was found for the proposition that the probability of hospitalisation decreases as engagement increases, and engaged members make for better patients on a yearly cost-per-life basis. Furthermore, with regards to cancer-specific inquiries, Vitality research found that engaged members have a far higher rate of early detection of cancer incidence as a result of active screening, and screened members experience significantly lower treatment costs when compared to non-screened members.
• The period under review also saw the conclusion of the first Healthy Company Index, with over 100 companies participating in this survey on employee wellness. Through the process, Vitality obtained additional evidence to validate Vitality Age as a predictor of morbidity risk. Respondents whose Vitality Age was greater than their actual age, experienced 35% more doctor visits in the past month, 26% more hospital days in the last year, and missed 28% more work days than their peers whose Vitality Age was less than or equal to their actual age.

It is this significant and continually evolving knowledge and capability that has been used to underpin both Discovery's local and international businesses.

The DiscoveryCard performed pleasingly during the period under review and reflected both the quality of Discovery's client base and the improving economic environment. The DiscoveryCard captured 8.9% of the point-of-sale market share and the quality of the credit experience remained above expectation. It is providing a further integration platform for the Discovery Insure product. In addition, the period under review saw the launch of the Discovery Purple Card aimed at providing the higher end market segment with unique value.

Ping An Health

The strategic vision of Ping An Health is to create the premier specialist health insurer in China, offering innovative, consumer-centric products and services. During the period under review, the Ping An Health team put in a significant amount of work to build the operational and product structures that will set up the company for strong growth, focusing on injecting Discovery's intellectual property and know-how into Ping An Health. Progress has been made in a number of key areas of the business:

• Ping An Health has built its products through an iterative process in order to best understand the needs of the Chinese consumer. Additionally, the Discovery Vitality chassis is being built in China and Ping An Health's products are being supported by innovative technical marketing campaigns.
• The branch network is expanding. Three new branches were added in the last year.
• Discovery has injected systems, risk management and clinical tools that will allow Ping An Health to offer consumers an integrated and efficient experience and to gather and collect accurate and up-to-date data for analytics, thereby transforming Ping An Health's extensive medical network and service infrastructure into powerful assets in the Chinese health insurance market.

Although still early in the joint venture, the business has shown rapid growth in its premium income over the first half of 2011, compared to previous periods and has accelerated its membership growth in 2011. Ping An Health will continue to build from a strong foundation - the company now offers services to 1 500 group clients and administers a total of 300 000 lives.

Discovery Insure

Discovery Insure's strategic rationale for entering into short-term insurance was to leverage its behavioural economics experience built off the Vitality chassis to encourage good driving behaviour and improved road safety. Fundamental to this approach is the use of incentives in encouraging good driving behaviour. The result is a telematics-enabled product construct that allows for tailored driver feedback and education on a driver's unique driving style and patterns, coupled with a dynamic reward structure to initiate and sustain good driving behaviour.

Discovery Insure launched in May 2011, and the market's receptivity towards the product and service offering has been overwhelmingly positive. In the third month since launch, average daily new business API exceeded R1 million. Furthermore, Discovery's intent to further its integrated model through alternate business model applications of Vitality has been successful, with 98% of Discovery Insure policyholders having a Vitality policy, over 80% being Discovery Health members, over 60% having a DiscoveryCard, and over 35% having a Discovery Life policy.

Going forward, Discovery Insure will focus on driving new business volumes, thereby accelerating mainstream adoption of the technology; and operationally delivering on the distinctive service platform. The goal is a societal one, making good driving within everyone's grasp, and making South Africa's roads safer for everyone's benefit.

The Vitality Group and HumanaVitality

Over the past financial year, The Vitality Group (TVG) has developed a strong foundation for building a meaningful business in the US, achieving the following:

• Developing strategic partnerships through Johnson&Johnson in the business-to-business channel and HumanaVitalityin the insurance channel.
• Maturing systems and operations infrastructure to support scale.
• Developing the largest network of access through health clubs, devices and retail outlets in the United States.
• Driving a level of member engagement with Vitality that is the highest among Discovery member companies (around 60% HRA completion rate amongst its ten largest clients).
• Delivering strong membership growth (over 200 000 committed members).

Furthermore, the considerable work done to evolve the science of Vitality, coupled with TVG's proactive thought leadership drive to showcase the Vitality programme and build corporate reputation, led to strong external recognition for the Vitality model over the period under review. One of TVG's clients - Alcon Laboratories - was awarded the C. Everett Koop National Health Award for its use of Vitality in promoting wellness. This is a highly prestigious award recognising outstanding workplace health improvement programmes that demonstrate the ability to improve health risk status and reduce costs. This esteemed award goes a long way in establishing both TVG's and Vitality's credibility in the market.

In addition, a further chapter in the international deployment of Vitality was concluded during the period, with HumanaVitality launching to market just six months after signing the contract. With over 480 000 HumanaVitality members committed to the programme, Vitality's membership in the United States is now over 680 000, forming part of the two-million global Vitality membership base.

Prospects

The work done over the past financial year has ensured that the Discovery Group is both well positioned and capitalised for continued growth and profitability into the future.