Review of Group results

Value creators

New business annualised premium income

New business annualised premium income includes flows of the schemes Discovery administers and 100% of the business conducted together with its joint venture partners.

New business annualised premium income decreased 2% for the year ended 30 June 2011.

New business API is calculated at 12 times the monthly premium for new recurring premium policies and 10% of the value of new single premium policies. It also includes both automatic premium increases and servicing increases on existing policies.

Gross inflows under management

Gross inflows under management measures the total funds managed and received by Discovery which is an accurate measure of the continual growth of Discovery. Gross inflows under management increased 21% for the year ended 30 June 2011. 6% of the increase is attributable to the gross inflows from PruHealth Insurance Limited (previously Standard Life Healthcare) being included from 1 August 2010.

Profit from operations

The following table shows the main components of the increase in Group profit from operations for the year ended 30 June:

From 1 August 2010, PruHealth and PruProtect have been accounted for as subsidiaries in the Group results, previously accounted for as joint ventures. This means that the comparatives disclosed include the income, expenses, assets and liabilities of these companies at 50%, but at 100% in the current results, from 1 August 2010.

Acquisition of Standard Life Healthcare and related capital restructureBackground

On 31 July 2010, Discovery acquired the entire share capital of Standard Life Healthcare (SLHC), a wholly-owned subsidiary of the Standard Life Group, for R1.56 billion (GBP137.8 million).

Discovery’s joint venture with Prudential has created a strong foothold in both the health insurance and protection markets in the UK. The acquisition of SLHC is likely to accelerate the attainment of both PruHealth and PruProtect’s UK strategies. In health insurance, where scale is important, the acquisition created a new competitor covering approximately 700 000 lives and attracting annual premiums of R4.1 billion (GBP370 million). In addition, the acquisition will provide PruHealth with opportunities to sell Vitality into SLHC’s existing client base. In the protection market, SLHC’s large, high-quality client base provides growth opportunities for PruProtect, and enhances Discovery’s ability to implement its integrated model in the UK.

Discovery funded the entire purchase consideration by using R1.16 billion from its own internal funds (dividend from Discovery Life) and through raising debt of R400 million. Discovery then contributed SLHC to PruHealth Holdings Limited (PHHL) as a capital investment. PHHL is the holding company of PruHealth and PruProtect, the joint ventures between Discovery and Prudential Assurance Company of the United Kingdom. This resulted in Discovery increasing its interest in both PruHealth and PruProtect from 50% to 75%.

Accounting for the transactions

In terms of IFRS 3 revised: Business Combinations, the increase in Discovery’s interest from 50% (a joint venture) to 75% (a subsidiary) is effectively treated as two separate transactions, that is, the disposal of the 50% interest and a subsequent acquisition of 75% interest. The purchase price for the increased shareholding must be used to calculate the deemed disposal consideration for the disposal of the 50% interest. Any resulting profit or loss (in this case profit) must be included in the earnings of the Group but is excluded from headline earnings. Using the GBP137.8 million that Discovery invested into PHHL to increase its shareholding by 25%, the deemed disposal consideration for the 50% interest is GBP69 million. Discovery has reflected a profit of R667 million in its earnings for the year ended 30 June 2011, which has been excluded from headline earnings.

For the 75% deemed subsequent acquisition, IFRS 3 revised states that this should be treated as if it was an independent acquisition at that time and requires the purchase price be allocated to the tangible assets and liabilities and to the intangible assets acquired. The balance is allocated to goodwill. The purchase price for the acquisition of SLHC and the deemed purchase price for the 75% of PHHL must be allocated in this manner and the appropriate portions allocated to non-controlling interest. In addition, for this purpose, assets must be valued on an arms-length basis to third parties, and should not take into account Discovery’s intentions post the acquisition.

Discovery has allocated the purchase price as follows:

* Translated at closing rate at 30 June 2011, which is the rate they are included in the Statement of Financial Position.

The intangible assets identified in the tables above have been included in the Statement of Financial Position of the Group. These intangible assets will be amortised over their remaining useful lives and tested for impairment at each reporting date. Discovery has recorded an amortisation charge of R97 million in profit or loss for the period 1 August 2010 to 30 June 2011 for these intangible assets.

The value of in-force business, being the value for the existing customer contracts at the date of acquisition, was calculated using a discounted cash flow model which is similar to an embedded value model and is being amortised on the basis of unwinding of the modelled cash flows.

At acquisition, a decision was taken that the computer software acquired as part of the SLHC acquisition will not be used by Discovery and accordingly the value of GBP8.6 million (R95 million) was written-off. Discovery is however reconsidering its decision and is in the process of determining whether the software can be integrated into the business.

The goodwill, which represents the value of future business expected to be written by the PHHL Group, is not amortised, but is assessed for possible impairment at each reporting date and the impairment is recorded in profit or loss, if necessary. At 30 June 2011, Discovery calculated the value in use of PruHealth and PruProtect and there was no indication that goodwill is impaired at this date.

In terms of IFRS 3 revised, paragraph 45, the initial accounting for an acquisition can be undertaken on a provisional basis. Adjustments to provisional values can be made within one year of the effective date, relating to facts or circumstances at the acquisition date. As such, the amounts disclosed at 31 December 2010 have been adjusted for information received after the initial calculations that related to the net asset value of the companies at the acquisition date.

Gains and losses resulting from business combinations

The following gains and losses resulting from the business combinations described above have been included in the Group’s income statement at 30 June 2011:

In the process of completing the acquisition, Discovery incurred once-off costs such as investment banking fees, legal costs and other consulting fees. No value was placed on the DAC balance at acquisition. This resulted in the accounting profit being R137 million higher than it would have been had the DAC been valued at that date and amortised in the current accounting period.

Recapture of reinsurance

The business combinations discussed above resulted in a need for Discovery to restructure the capital of PHHL and PruHealth. SLHC had surplus capital and PruHealth had reinsurance obligations, some of which was not required for the combined businesses.

PruHealth therefore undertook the recapture of approximately GBP28 million of reinsurance obligations which resulted in a R313 million charge to Discovery’s income statement.

Post-acquisition revenue and profit or loss of acquired entities

The table below discloses the post-acquisition revenue and profit or loss that has been included in the Group’s income statement at 30 June 2011:

Revenue and profit or loss of acquired entities from 1 July 2010

The table below discloses the revenue and profit or loss that would have been included in the Group’s income statement at 30 June 2011, if the acquisition date was 1 July 2010:

Other investments in subsidiaries and associates

Ping An Health Insurance Company of China, Ltd (PAH)

Discovery paid R225 million for the acquisition of 20% of the share capital of PAH. PAH has been treated as an associate in the results of Discovery and as such, 20% of the losses incurred for the six months to 30 June 2011 has been included in the Income Statement and Discovery’s share of PAH’s net asset value at 30 June 2011 has been included in the Statement of Financial Position in Investment in associates.

The amount included in Investment in associates is analysed as follows:

Humana Vitality joint venture

In February 2011, Discovery announced a joint venture between The Vitality Group Inc. in the US (TVG Inc.) and Humana, the fourth-largest health insurer in the United States. Through this partnership arrangement two new entities were formed, namely The Vitality Group LLC (TVG LLC) and Humana Vitality LLC (HV). The effective date of this agreement was 16 May 2011.

TVG Inc. has a 75% holding in TVG LLC with the balance being held by Humana. TVG Inc. contributed its existing business as at 1 May 2011 as its capital contribution, the net asset value at that date being US$15 million. Humana contributed US$15 million in cash for its 25% shareholding. At 30 June 2011, the fair value of Humana’s contribution has been calculated as US$7.5 million, being 25% of the total capital contributions. This fair value adjustment of US$7.5 million (R51 million) has been disclosed in the Statement of Changes in Equity as an adjustment against non- controlling interest and retained earnings. TVG LLC has been accounted for as a subsidiary in the results of Discovery.

Humana has a 75% shareholding in HV, with the balance being held by TVG Inc. Humana contributed US$50 million for its 75% shareholding. TVG Inc. contributed a perpetual royalty-free license to the Vitality IT systems, the Vitality name and associated marks, and a perpetual, royalty-free license to the Vitality intellectual property, exclusively for use in the US. This contribution has been valued at US$12.5 million and has been disclosed as a realised gain from the disposal of intellectual property in the Income Statement and as an Investment in associate in the Statement of Financial Position.

Discovery Insure Limited

Discovery Insure, a provider of short-term risk insurance products, was launched in May 2011. Discovery has a 75% shareholding in Discovery Insure with the balance being held by subsidiaries within the Hollard Group (the preference shareholders). Discovery Insure has be accounted for as a subsidiary in the results of Discovery.

Put options in subsidiaries

During the financial year, put options were granted to the non-controlling interests of three of Discovery’s subsidiaries. The put options entitle the non-controlling interest to sell its interest in the subsidiary to Discovery at contracted dates.

The following put options were issued:

• Prudential has the option to sell its 25% shareholding in PHHL to Discovery, five years from 1 August 2010 or after each succeeding one year period, at the fair market value.
• Humana has the option to sell its 25% shareholding in TVG LLC to Discovery, seven years after acquisition or after each succeeding two year period, at the fair market value less a 15% discount.
• The Discovery Insure preference shareholders have the option to sell its 25% shareholding in Discovery Insure to Discovery, between five and seven years after acquisition, at the fair market value.

In accordance with IAS32, Discovery 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). In raising this liability, the non-controlling interest is derecognised and the excess of the liability is debited to retained earnings in the Statement of Changes in Equity. Discovery has consolidated 100% of the subsidiaries results.

Interest is recorded in respect of this liability within finance charges using the effective interest rate method. The estimated purchase price is reconsidered at each reporting date, and any changes in the value of the liability as a result of changes in the assumptions used to estimate the future purchase price will be recorded in profit or loss.

The aggregate effects on Discovery’s results at 30 June 2011 were as follows:

Other significant transactions affecting the current resultsShare-based payments

Included in marketing and administration expenses is R177 million (2010: R232 million) in respect of options granted under employee share incentive schemes expensed in accordance with the requirements of IFRS 2.

The Group entered into transactions to hedge its exposure in the phantom share scheme related to changes in the Discovery share price. As at 30 June 2011, approximately 82.7% (2010: 50.8%) of this exposure was hedged.

Taxation

Taxation has been raised for all South African entities, with the exception of Discovery Insure. South African income tax has been provided at 28% (2010: 28%) and secondary tax on companies at 10% in the financial statements and embedded value statements.

Discovery obtained no tax relief for the PruHealth losses in respect of the calendar year ending 31 December 2010.

Discovery obtained tax relief for half of the PruHealth losses in respect of the calendar year ending 31 December 2009, as this tax asset was ceded to Prudential Assurance Company in the UK ("Prudential"). R10 million in respect of this tax relief has been included in income tax at 30 June 2010.

Tax relief is obtained for 100% of the PruProtect losses through Prudential.

Significant movements in the Statement of financial position

The increase in the assets arising from insurance contracts of R1 968 million is primarily as a result of profitable new business written by Discovery Life.

In May 2011, Discovery disposed of its Investment Property and a gain of R122 million has been disclosed in the Income Statement but is excluded from headline earnings.

Financial assets have increased due to the sale of Discovery Invest products and the inclusion of Standard Life Healthcare money market investments of R821 million at 30 June 2011. Borrowings at amortised cost, includes a long-term loan of R400 million raised as part of the funding to purchase Standard Life Healthcare. Interest on the loan is payable quarterly, for which a fixed interest rate swap has been entered into. The loan is repayable on 11 September 2017.

The deferred tax liability is primarily attributable to the application of the Financial Services Board directive 145. This directive allows for the zeroing on a statutory basis of the assets arising from insurance contracts. The statutory basis is used when calculating tax payable for Discovery Life, resulting in a timing difference between the tax base and the accounting base.

Shareholder informationDirectorate

There have been no changes to the directorate for the year ended 30 June 2011. A Ntsaluba (executive director) and J Durand (non-executive director) were appointed subsequent to the year-end, on 1 July 2011 and 25 August 2011 respectively.

Repurchase of shares

As advised in SENS announcement on 10 December 2010, Discovery has acquired and cancelled 80 790 ordinary shares from one of Discovery’s directors, Sindiswa Zilwa, through her investment vehicle, Newshelf 801 (Proprietary) Limited as one of Discovery’s BEE partners.

Dividend policy and capital

An interim dividend of 42 cents per share was paid on 22 March 2011.

The directors are of the view that the Discovery Group is adequately capitalised at this time. On the statutory basis the capital adequacy requirements of Discovery Life was R305 million (2010: R275 million) and was covered 3.6 times (2010: 8.0 times).

Cash dividend declaration:

The board has declared a final dividend of 48 cents per share. The salient dates are as follows:

Last date to trade "cum" dividend - Friday, 7 October 2010
Date trading commences "ex" dividend - Monday, 10 October 2011 Friday
Record date - 14 October 2011 Monday
Date of payment - 17 October 2011

Share certificates may not be dematerialised or rematerialised between Monday, 10 October 2011 and Friday, 14 October 2011, both days inclusive.

Subsequent events

At a special general meeting of shareholders held on 2 August 2011, the shareholders approved the creation of 40 000 000 A Preference Shares, 20 000 000 B Preference Shares and 20 000 000 C Preference Shares. On 15 August 2011, Discovery issued 8 000 000 B Preference Shares at an issue price of R100 per share by way of private placement. The B Preference Shares were listed on the JSE Securities Exchange South Africa under the abbreviated short name "DSY B PREF" with alpha code "DSBP" in the "Specialist Securities" – Preference Share sector of the market, and commenced trading on Monday, 15 August 2011.

Accounting policies

The annual financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS) including IAS 34, as well as the South African Companies Act 71 of 2008, and are consistent with the accounting policies applied in the annual report and the corresponding prior year except as follows: Discovery entered into a business combination for the first time, in the current reporting period. As such, IFRS 3 revised has been adopted.

Comparative figures

There have been no changes to comparative figures.

Audit

The financial results have been audited in accordance with section 29(1)(e) of the Companies Act (Act 71 of 2008). The auditors, PricewaterhouseCoopers Inc., have issued their audit opinion on the Group financial statements for the year ended 30 June 2011. A copy of the auditors’ unqualified report is available for inspection at the company’s registered office.