Embedded value statementfor the year ended 30 June 2011

The embedded value of Discovery at 30 June 2011 consists of the following components:

• the free surplus attributed to the covered business at the valuation date;
• plus: the required capital to support the in-force covered business at the valuation date;
• plus: the present value of expected future shareholder cash flows from the in-force business;
• less: the cost of required capital and secondary tax on companies (“STC”).

The present value of future shareholder cash flows from the in-force covered business is calculated as the value of projected future after-tax shareholder cash flows of the business in force at the valuation date, discounted at the risk discount rate.

The value of new business is the present value, at the point of sale, of the projected future after-tax shareholder cash flows of the new business written by Discovery, discounted at the risk discount rate, less an allowance for the reserving strain (for Life), initial expenses, cost of required capital and STC. The value of new business is calculated using the current reporting date assumptions.

For Life, the shareholder cash flows are based on the release of margins under the Statutory Valuation Method (“SVM”) basis.

The embedded value includes the insurance and administration profits of the subsidiaries in the Discovery Holdings Group. Covered business includes business written through Discovery Life, Discovery Invest, Discovery Health, Discovery Vitality, PruHealth and PruHealth Insurance Limited (previously Standard Life HealthCare) in the United Kingdom. Due to the increased scale and stability of the business, business written through PruProtect is now included as covered business, and Discovery’s 75% share of the PruProtect value of in-force business is included in the Discovery Group embedded value. For The Vitality Group (USA) and Discovery Insure, no published value has been placed on the current in-force business.

As PruHealth Insurance Limited and PruProtect are only included in the value of in-force with effect from 30 June 2011, the profit from new business for these entities is excluded from embedded value earnings.

During the past financial year, Discovery acquired Standard Life HealthCare and increased its shareholding in the Prudential joint venture from 50% to 75%, announced a venture with Humana in the United States, and launched a short term insurer, Discovery Insure. Put options were granted to the non-controlling interests in these subsidiaries. The put option entitles the non-controlling interest to sell its interest in the subsidiary to companies within the Discovery Group at specified future dates.

For accounting purposes, in accordance with IAS32, Discovery has consolidated 100% of the subsidiaries results and has recognised the fair value of the non-controlling interest, being the present value of the estimated purchase price, as a financial liability in the Statement of Financial Position (Puttable non-controlling interest). For embedded value purposes at 30 June 2011, the financial liability in excess of the non-controlling interest in the net asset value and the non-controlling share of the losses included in retained earnings over the reporting period were added back to the adjusted net worth. The values for PruHealth, PruHealth Insurance Limited and PruProtect at 30 June 2011 reflect Discovery’s 75% shareholding at that date (values for PruHealth in prior periods reflect Discovery’s 50% shareholding).

The auditors, PricewaterhouseCoopers Inc., have reviewed the consolidated value of in-force business and value of new business of Discovery Holdings Limited and its subsidiaries as included in the embedded value statement for the year ended 30 June 2011. A copy of the auditors’ unqualified report is available for inspection at the company’s registered office.

Table 1: Group embedded value

(1) The published shareholders’ funds was decreased to eliminate net assets under insurance contracts, deferred tax and deferred acquisition costs at June 2011 of R6 126 million (June 2010: R4 858 million) in respect of Life, R93 million (June 2010: R25 million) in respect of PruHealth and PruHealth Insurance Limited and R45 million in respect of PruProtect. The June 2011 shareholders’ funds was decreased by R1 510 million representing Discovery’s share of goodwill and intangible assets (net of deferred tax) relating to the acquisition of Standard Life HealthCare and the Prudential joint venture. The June 2011 shareholders’ funds was increased by R1 301 million reflecting the value of the puttable non-controlling interest liability in excess of the non-controlling interest in the net asset value and R92 million reflecting the non-controlling share of the losses included in retained earnings over the reporting period.

(2) The required capital at June 2011 for Life is R610 million (June 2010: R550 million), for Health and Vitality is R437 million (June 2010: R395 million) for PruHealth and PruHealth Insurance Limited is R730 million (June 2010: R114 million) and for PruProtect is R115 million. For Life, the required capital was set equal to two times the statutory Capital Adequacy Requirement (“CAR”). For Health and Vitality, the required capital was set equal to two times the monthly renewal expense and Vitality benefit cost. For PruHealth, the long-term required capital amount has increased from 18% to 19.8% of annualised premium income. Allowance has also been made for additional capital required by PruHealth over the next 18 months. For PruHealth Insurance Limited, the required capital amount was set equal to 18% of annualised premium income. For PruProtect, the required capital was set equal to the UK Pillar 1 capital requirement.

(3) Following publication of the draft Taxation Laws Amendment Bill, 2011, it is expected that STC will be replaced by a dividend withholding tax with effect from 1 April 2012. The cost of STC at 30 June 2011 has been calculated based on the dividends expected to be declared prior to 1 April 2012.

(4) The diluted embedded value per share allows for Discovery’s BEE transaction where the impact is dilutive i.e. where the current embedded value per share exceeds the current transaction value.

Table 2: Value of in-force covered business

(1) Included in the Life and Invest value of in-force covered business is R345 million (June 2010: R226 million) in respect of investment management services provided on off balance sheet investment business. The net assets of the investment service provider are included in the adjusted net worth.

(2) The value of in-force has been converted using the closing exchange rate of R10.84/GBP (June 2010: R11.48/GBP). The values for PruHealth at 30 June 2011 reflect Discovery’s 75% shareholding at that date (values in prior periods reflect Discovery’s 50% shareholding).

(3) This includes Discovery’s 75% share of the value of the PruHealth Insurance Limited business in-force at 30 June 2011 (R708 million), less the cost of required capital (R78 million) and less the cost of STC (R1 million).

(4) The value of in-force has been converted using the closing exchange rate of R10.84/GBP. The values for PruProtect reflect Discovery’s 75% shareholding in PruProtect.

Table 3: Group embedded value earnings

Table 4: Components of Group embedded value earnings

(1) The changes in methodology and assumptions will vary over time to reflect adjustments to the model and assumptions as a result of changes to the operating and economic environment. The current period’s changes are described in detail in Table 5 below (for previous periods refer to previous embedded value statements).

(2) This item reflects Group initiatives including expenses relating to the acquisition of Standard Life HealthCare, the investment in Ping An Health, the establishment of The Vitality Group in the United States, PruProtect, Discovery Invest and Discovery Insure.

(3) Non-recurring expenses include Group costs related to one-off marketing events and one-off remuneration costs payable on the relocation of senior executives.

(4) Acquisition costs relate to commission paid on Life business that has been written over the period but that will only be activated and on risk after the valuation date. These policies are not included in the embedded value or the value of new business and therefore the costs are excluded.

Table 5: Methodology and assumption changes

(1) The Life and Invest modelling changes relate mainly to a change in the statutory reserving methodology for Invest policies and to the modelling of waiver of premium claims.

(2) Following publication of the draft Taxation Laws Amendment Bill, 2011, it is expected that STC will be replaced by a dividend withholding tax with effect from 1 April 2012.

(3) The reinsurance item relates to the impact of the financing reinsurance arrangements.

Table 6: Experience variances

(1) The total Health and Vitality lapse experience variance of R477 million consists of a positive variance of R118 million due to lower than expected lapses and a positive variance of R359 million due to the net growth in existing employer groups (i.e. R927 million in respect of members joining existing employer groups during the period offset by an amount of R568 million in respect of members leaving existing employer groups).

(2) Policy alterations relate to changes to existing benefits at the request of the policyholder.

(3) The tax variance for Life and Invest arises due to a movement in the deferred tax asset which delays the payment of tax.

(4) For Life and Invest, the economic assumptions variance relates primarily to lower than expected premium and benefit increases due to lower than expected inflation over the period.

Table 7: Embedded value of new business

(1) Health new business annualised premium income is the gross contribution to the medical schemes. For embedded value purposes, Health new business is defined as individuals and members of new employer groups, and includes additions to first year business. There have been no changes to the definition of new business since the previous valuation. The new business annualised premium income shown above excludes premiums in respect of members who join an existing employer after the first year, as well as premiums in respect of new business written during the period but only activated after 30 June 2011.
The total Health and Vitality new business annualised premium income written over the period was R4 086 million (June 2010: R4 679 million).

(2) Included in the Life and Invest value of new business is R11 million (June 2010: R22 million) in respect of investment management services provided on off balance sheet investment business. Risk business written prior to the valuation date allows certain Invest business to be written at financially advantageous terms, the impact of which has been recognised in the value of new business.

(3) Life new business is defined as Life policies or Discovery Retirement Optimiser policies which incepted during the reporting period and which are on risk at the valuation date. Invest new business is defined as business where at least one premium has been received and which has not been refunded after receipt. The new business annualised premium income of R1 724 million (June 2010: R1 621 million) (single premium APE: R478 million (June 2010: R480 million)) shown above excludes automatic premium increases and servicing increases in respect of existing business. The total Life new business annualised premium income written over the period, including both automatic premium increases of R403 million (June 2010: R392 million) and servicing increases of R347 million (June 2010: R290 million) was R2 474 million (June 2010: R2 303 million) (single premium APE: R502 million (June 2010: R486 million)). Single premium business is included at 10% of the value of the single premium. Policy alterations, including Discovery Retirement Optimisers added to existing Life Plans are shown in Table 6 as experience variances and not included as new business.
Term extensions on existing contracts are not included as new business.

(4) The annualised profit margin is the value of new business expressed as a percentage of the present value of future premiums.

(5) PruHealth new business is defined as individuals and employer groups which incepted during the reporting period. The new business annualised premium income shown above has been adjusted to exclude premiums in respect of members who join an existing employer group after the first month as well as premiums in respect of new business written during the period but only activated after 30 June 2011. There have been no changes to the definition of new business since the previous valuation.

(6) As PruHealth Insurance Limited and PruProtect are only included in the value of in-force with effect from 30 June 2011, the profit from new business for these entities is excluded from embedded value earnings.

Table 8: Embedded value economic assumptions

Life and Invest mortality, morbidity and lapse and surrender assumptions were derived from internal experience, where available, augmented by reinsurance and industry information. An additional lapse rate is assumed over the next 6 months to allow for the potential impact of the current economic climate on policyholder lapses.

The Health lapse assumptions were based on the results of recent experience investigations. The lapse rate for the projection term after 10 years was set above current experience.

The PruHealth and PruHealth Insurance Limited assumptions were derived from internal experience augmented by industry information. Best estimate morbidity assumptions allow for the impact of management actions. The lapse rate over the short-term is assumed to be higher than the long-term expected lapse rate to allow for the impact of the current economic climate on lapses.

PruProtect assumptions were derived from internal experience, where available, augmented by reinsurance, industry and Discovery group information.

Renewal expense assumptions were based on the results of the latest expense and budget information.

The initial expenses included in the calculation of the value of new business are the actual costs incurred excluding expenses of an exceptional or non-recurring nature.

The South African investment return assumption was based on a single interest rate derived from the risk-free zero coupon government bond yield curve. Other economic assumptions were set relative to this yield. The current and projected tax position of the policyholder funds within the Life company has been taken into account in determining the net investment return assumption. The PruHealth and PruHealth Insurance Limited investment return assumption was derived from the sterling swap curve. The PruProtect investment return assumption was set with reference to the expected return on matching assets (or liabilities in the case of negative reserves) held on the Prudential balance sheet.

It is assumed that, for the purposes of calculating the cost of required capital, the Life and Invest required capital amount will be backed by surplus assets consisting of 100% equities and the Health, Vitality, PruHealth and PruHealth Insurance Limited required capital amounts will be fully backed by cash. The PruProtect required capital amount is assumed to earn the same return as the assets backing the PruProtect policyholder liabilities. Allowance has been made for tax and investment expenses in the calculation of the cost of capital. In calculating the capital gains tax
(“CGT”) liability, it is assumed that the portfolio is realised every 5 years. The Life and Invest cost of capital is calculated using the difference between the gross of tax equity return and the equity return net of tax and expenses. The Health, PruHealth and PruHealth Insurance Limited cost of capital is calculated using the difference between the risk discount rate and the net of tax cash return. The PruProtect cost of capital is calculated using the difference between the risk discount rate and the net of tax asset return assumption.

Sensitivity to the embedded value assumptions

The embedded value has been calculated in accordance with the Actuarial Society of South Africa’s Professional Guidance Note PGN 107: Embedded Value Reporting. The risk discount rate, calculated in accordance with the guidance note, uses the CAPM approach with specific reference to the Discovery beta coefficient. The Discovery beta coefficient reflects the historic performance of the Discovery share price relative to the market and infers a lower allowance for non-market related and non-financial risk. Investors may want to form their own view on an appropriate allowance for the non-financial risks which have not been modelled explicitly. The sensitivity of the embedded value and the value of new business at 30 June 2011 to changes in the risk discount rate is included in the tables below.

For each sensitivity illustrated below, all other assumptions have been left unchanged. No allowance has been made for management action such as risk premium increases where future experience is worse than the base assumptions.

Table 9: Embedded value sensitivity

(1) All economic assumptions were reduced by 1%.

The following table shows the effect of using different assumptions on the value of new business.

Table 10: Value of new business sensitivity