Embedded value statement
for the year ended 31 December 2010
The embedded value of Discovery at 31 December 2010 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 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 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 Standard Life Healthcare in the United Kingdom. For The Vitality Group (USA) and PruProtect, no published value has been placed on the current in-force business.
On 1 August 2010, Discovery acquired Standard Life Healthcare and increased its shareholding in the Prudential joint venture from 50% to 75%. For embedded value purposes, the value of the Standard Life Healthcare in-force business has been calculated based on the acquisition price of £138 million less the net asset value of the business at 31 December 2010. The performance of the Standard Life Healthcare book since acquisition has exceeded expectations and indications are that the present value of the projected future after-tax shareholder cash flows of the business in-force at the valuation date will exceed the current valuation. The values for PruHealth and Standard Life Healthcare at 31 December 2010 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 six months ended 31 December 2010. A copy of the auditors' unqualified report is available for inspection at the company's registered office.
Table 1: Group embedded value |
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| 31 December | 31 December | 30 June | ||
| R million | 2010 | 2009 | % change | 2010 |
| Shareholders’ funds | 9 168 | 7 808 | 17 | 8 382 |
| Adjustment to shareholders’ funds from | ||||
| published basis(1) | (6 839) | (4 398) | (4 883) | |
| Adjusted net worth | 2 329 | 3 410 | (32) | 3 499 |
 |
|
|
|
|
| – Free Surplus | 1 153 | 2 418 | 2 440 | |
| – Required Capital(2) | 1 176 | 992 | 1 059 | |
|
|
|
|
|
| Run-down costs for Destiny Health | – | (30) | – | |
| Value of Standard Life Healthcare in-force | ||||
| business acquired(3) | 522 | – | – | |
| Value of in-force covered business before | ||||
| cost of capital | 22 231 | 18 371 | 19 996 | |
| Cost of required capital | (375) | (324) | (351) | |
| Cost of STC(4) | (633) | (540) | (586) | |
| Discovery Holdings embedded value | 24 074 | 20 887 | 15 | 22 558 |
| Number of shares (millions) | 555.0 | 554.3 | 553.9 | |
| Embedded value per share | R43.37 | R37.68 | 15 | R40.72 |
| Diluted number of shares (millions) | 591.2 | 591.3 | 591.3 | |
| Diluted embedded value per share(5) | R42.99 | R37.37 | 15 | R40.31 |
| (1) | The published Shareholders' funds has been adjusted to eliminate net assets under insurance contracts, deferred tax and deferred acquisition costs at December 2010 of R5 466 million (June 2010: R4 858 million; December 2009: R4 374 million) in respect of Life and R39 million (June 2010: R25 million; December 2009: R24 million) in respect of PruHealth. The December 2010 adjustment also includes R1 334 million of 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. |
| (2) | The required capital at December 2010 for Life is R606 million (June 2010: R550 million; December 2009: R516 million), for Health and Vitality is R407 million (June 2010: R395 million; December 2009: R367 million) and for PruHealth is R163 million (June 2009: R114 million; December 2009: R109 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 over the next 24 months. |
| (3) | Discovery's share of the value of the Standard Life Healthcare in-force business has been calculated based on the acquisition price of £138 million less the net asset value of the business at 31 December 2010. |
| (4) | In line with Discovery's current dividend policy, the cost of STC is calculated assuming a 4.5 times dividend cover on the after-tax profits as they emerge over the projection term. An STC rate of 10% is assumed. The total STC charge has been allocated between the different business entities based on their contribution to the total value of in-force covered business. |
| (5) | The diluted embedded value per share allows for Discovery's BEE transaction where the impact is dilutive ie where the current embedded value per share exceeds the current transaction value. |
Table 2: Value of in-force covered business
| Value before | Cost of | Value after | ||
| cost of capital | required | Cost of | cost of capital | |
| R million | and STC | capital | STC | and STC |
| at 31 December 2010 | ||||
| Health and Vitality | 10 840 | (144) | (307) | 10 389 |
| Life and Invest(1) | 11 006 | (168) | (315) | 10 523 |
| PruHealth(2) | 385 | (63) | (11) | 311 |
| Total | 22 231 | (375) | (633) | 21 223 |
| at 31 December 2009 | ||||
| Health and Vitality | 8 697 | (129) | (255) | 8 313 |
| Life and Invest(1) | 9 409 | (163) | (277) | 8 969 |
| PruHealth(2) | 265 | (32) | (8) | 225 |
| Total | 18 371 | (324) | (540) | 17 507 |
| at 30 June 2010 | ||||
| Health and Vitality | 9 896 | (145) | (289) | 9 462 |
| Life and Invest(1) | 9 902 | (174) | (291) | 9 437 |
| PruHealth(2) | 198 | (32) | (6) | 160 |
| Total | 19 996 | (351) | (586) | 19 059 |
| (1) | Included in the Life and Invest value of in-force covered business is R278 million (June 2010: R226 million; December 2009: R153 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 PruHealth value of in-force has been converted using the closing exchange rate of R10.30/GBP (June 2010: R11.48/GBP; December 2009: R11.90/GBP). The values for PruHealth at 31 December 2010 reflect Discovery's 75% shareholding at that date (values in prior periods reflect Discovery's 50% shareholding). |
Table 3: Group embedded value earnings
| Six months | Six months | Year | |
| ended | ended | ended | |
| 31 December | 31 December | 30 June | |
| R million | 2010 | 2009 | 2010 |
| Embedded value at end of period | 24 074 | 20 887 | 22 558 |
| Less: Embedded value at beginning of period | (22 558) | (20 040) | (20 040) |
| Increase in embedded value | 1 516 | 847 | 2 518 |
| Net increase in capital | (17) | (5) | 7 |
| Dividends paid | 214 | 194 | 375 |
| Shares issued to non-controlling interests | – | (2) | (2) |
| Transfer to hedging reserve | 10 | 18 | (12) |
| Embedded value earnings | 1 723 | 1 052 | 2 886 |
| Annualised return on opening embedded value | 15.9% | 10.8% | 14.4% |
Table 4: Components of Group embedded value earnings
| Value of | ||||
| in-force | ||||
| Cost of | covered | |||
| required | business less | Embedded | ||
| R million | Net worth | capital | cost of STC | value |
| Total profit from new business (at point of sale) | (991) | (29) | 1 701 | 681 |
| Profit from existing business | ||||
| • Expected return | 915 | (1) | 129 | 1 043 |
| • Change in methodology and assumptions(1) | 323 | 13 | (103) | 233 |
| • Experience variances | (17) | 4 | 383 | 370 |
| Acquisition of Standard Life Healthcare and | ||||
| Prudential joint venture(2) | (751) | (19) | 616 | (154) |
| Other initiative costs(3) | (104) | – | 8 | (96) |
| Non-recurring expenses(4) | (63) | – | 1 | (62) |
| Acquisition costs(5) | (28) | – | (0) | (28) |
| Foreign exchange rate movements | (355) | 7 | (37) | (385) |
| Cost of STC | (21) | – | 13 | (8) |
| Return on shareholders’ funds(6) | 129 | – | – | 129 |
| Embedded value earnings | (963) | (25) | 2 711 | 1 723 |
| (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) | Whilst the acquisition of Standard Life Healthcare is embedded value neutral, an embedded value loss arises on the increase in Discovery's shareholding in the Prudential joint venture as the embedded value places no value on the right to use the Prudential brand, the right to use the Prudential balance sheet or on Discovery's increased share of the value of in-force PruProtect business. |
| (3) | This item reflects the 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 and Discovery Invest. These costs have not been projected on a recurring basis in the embedded value due to the fact that income from business sold under these initiatives has not been projected or the costs are not expected to recur. |
| (4) | Non-recurring expenses include Group costs related to one-off marketing events and one-off remuneration costs payable on the relocation of senior executives. |
| (5) | Acquisition costs relate to commission paid on Life business and expenses incurred in writing Health and Vitality 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. |
| (6) | Return on shareholders' funds is shown net of tax and management charges. |
Table 5: Methodology and assumption changes
| Health and Vitality | Life and Invest | PruHealth | |||||||
| Net | Value of | Net | Value of | Net | Value of | ||||
| R million | worth | in-force | worth | in-force | worth | in-force | Total | ||
| Modelling changes(1) | – | – | 204 | (283) | – | (8) | (87) | ||
| Expenses | – | 487 | 1 | 10 | – | – | 498 | ||
| Lapses and surrenders | – | – | 5 | (32) | – | (64) | (91) | ||
| Mortality and morbidity | – | – | (9) | 7 | – | – | (2) | ||
| Benefit enhancements | – | – | (41) | 11 | – | – | (30) | ||
| Commission | – | – | – | – | – | (20) | (20) | ||
| Vitality | – | (84) | – | – | – | – | (84) | ||
| Economic assumptions | – | (11) | (7) | 165 | – | (6) | 141 | ||
| Premium and benefit increases | – | – | 2 | (1) | – | – | 1 | ||
| Increased capital requirement | – | – | – | – | – | (11) | (11) | ||
| Reinsurance(2) | – | – | 337 | (352) | (169) | 102 | (82) | ||
| Total | – | 392 | 492 | (475) | (169) | (7) | 233 | ||
| (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) | The reinsurance item relates to the impact of the financing reinsurance arrangements |
Table 6: Experience variances
| Health and Vitality | Life and Invest | PruHealth | |||||||
| Net | Value of | Net | Value of | Net | Value of | ||||
| R million | worth | in-force | worth | in-force | worth | in-force | Total | ||
| Renewal expenses | 21 | – | (1) | 0 | 16 | (7) | 29 | ||
| Lapses and surrenders(1) | 6 | 183 | 15 | 106 | – | – | 310 | ||
| Mortality and morbidity | – | – | 41 | (2) | 33 | (8) | 64 | ||
| Policy alterations(2) | – | (11) | (97) | 56 | – | – | (52) | ||
| Backdated cancellations | – | – | (27) | 7 | – | – | (20) | ||
| Premium income | – | – | 2 | (10) | – | – | (8) | ||
| Economic assumptions(3) | 0 | 28 | (17) | (13) | – | – | (2) | ||
| Tax(4) | (12) | – | 94 | (90) | (30) | 2 | (36) | ||
| Reinsurance | – | – | 28 | (10) | (13) | – | 5 | ||
| Extended modelling term | – | 97 | – | 4 | – | 14 | 115 | ||
| Other | (2) | (6) | (35) | 40 | (39) | 7 | (35) | ||
| Total | 13 | 291 | 3 | 88 | (33) | 8 | 370 | ||
| (1) | The total Health and Vitality lapse experience variance of R189 million consists of a positive variance of R92 million due to lower than expected lapses and a positive variance of R97 million due to the net growth in existing employer groups (ie R420 million in respect of members joining existing employer groups during the period offset by an amount of R323 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) | 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. |
| (4) | The tax variance for Life and Invest arises due to a movement in the deferred tax asset which delays the payment of tax. |
Table 7: Embedded value of new business
| Six months | Six months | Year | ||
| ended | ended | ended | ||
| 31 December | 31 December | 30 June | ||
| R million | 2010 | 2009 | % change | 2010 |
| Health and Vitality | ||||
| Present value of future profits from new business | ||||
| at point of sale | 223 | 164 | 541 | |
| Cost of required capital | (7) | (6) | (18) | |
| Cost of STC | (6) | (10) | (16) | |
| Present value of future profits from new business at | ||||
| point of sale after cost of required capital and STC | 210 | 148 | 42 | 507 |
| New business annualised premium income(1) | 713 | 576 | 24 | 2 254 |
| Life and Invest | ||||
| Present value of future profits from new business | ||||
| at point of sale(2) | 498 | 478 | 879 | |
| Cost of required capital | (17) | (17) | (33) | |
| Cost of STC | (14) | (14) | (26) | |
| Present value of future profits from new business at | ||||
| point of sale after cost of required capital and STC | 467 | 447 | 4 | 820 |
| New business annualised premium income(3) | 883 | 804 | 10 | 1 621 |
| Annualised profit margin(4) | 6.4% | 6.5% | 5.9% | |
| Annualised profit margin excluding Invest Business | 9.0% | 9.0% | 8.4% | |
| PruHealth | ||||
| Present value of future profits from new business | ||||
| at point of sale | 9 | 22 | 16 | |
| Cost of required capital | (5) | (3) | (6) | |
| Cost of STC | (0) | (1) | (0) | |
| Present value of future profits from new business at | ||||
| point of sale after cost of required capital and STC | 4 | 18 | (78) | 10 |
| New business annualised premium income(5) | 109 | 60 | 82 | 147 |
| Annualised profit margin(4) | 0.6% | 3.3% | 0.7% |
| (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 31 December 2010. The total Health and Vitality new business annualised premium income written over the period was R2 061 million (June 2010: R4 679 million; December 2009: R1 862 million). |
| (2) | Included in the Life and Invest value of new business is R1 million (June 2010: R22 million; December 2009: R5 million) in respect of investment management services provided on off balance sheet investment 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 R883 million (June 2010: R1 621 million; December 2009: R804 million) (single premium APE: R224 million (June 2010: R480 million; December 2009: R210 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 R195 million (June 2010: R392 million; December 2009: R196 million) and servicing increases of R151 million (June 2010: R290 million; December 2009: R116 million) was R1 229 million (June 2010: R2 303 million; December 2009: R1 116 million) (single premium APE: R224 million (June 2010: R480 million; December 2009: R210 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. 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. 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 31 December 2010. There have been no changes to the definition of new business since the previous valuation. |
Table 8: Embedded value economic assumptions
| 31 December | 31 December | 30 June | ||
| 2010 | 2009 | 2010 | ||
| Beta coefficient | ||||
| South Africa | 0.56 | 0.51 | 0.54 | |
| United Kingdom | 0.56 | 0.51 | 0.54 | |
| Equity risk premium | ||||
| South Africa | 3.50 | 3.50 | 3.50 | |
| United Kingdom | 4.00 | 4.00 | 4.00 | |
| Risk discount rate (%) | ||||
| – Health and Vitality | 10.46 | 10.79 | 10.89 | |
| – Life and Invest | 10.46 | 10.79 | 10.89 | |
| – PruHealth | 6.73 | 6.99 | 6.62 | |
| Rand/GB Pound Exchange Rate | ||||
| Closing | 10.30 | 11.90 | 11.48 | |
| Average | 11.04 | 12.43 | 11.96 | |
| Medical inflation (%) | ||||
| South Africa | 7.50 | 8.00 | 8.00 | |
| United Kingdom | 7.00 | Current levels | 7.00 | |
| reducing to | ||||
| 7.00% over | ||||
| the projection | ||||
| period | ||||
| Expense inflation and CPI (%) | ||||
| South Africa | 4.50 | 5.00 | 5.00 | |
| United Kingdom | 3.75 | 3.75 | 3.75 | |
| Pre-tax investment return (%) | ||||
| South Africa | – Cash | 7.00 | 7.50 | 7.50 |
| – Bonds | 8.50 | 9.00 | 9.00 | |
| – Equity | 12.00 | 12.50 | 12.50 | |
| United Kingdom | – Risk free | 3.99 | 4.45 | 3.96 |
| Dividend cover ratio | 4.5 times | 4.5 times | 4.5 times | |
| Income tax rate (%) | ||||
| South Africa | 28.00 | 28.00 | 28.00 | |
| United Kingdom | 28.00% | 28.00 | 28.00% | |
| reducing to | reducing to | |||
| 24.00% in | 24.00% in | |||
| April 2014 | April 2014 | |||
| Projection term | ||||
| – Health and Vitality | 20 years | 20 years | 20 years | |
| – Group Life | 10 years | 10 years | 10 years | |
| – PruHealth | 20 years | 20 years | 20 years | |
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 12 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 assumptions were derived from internal experience augmented by industry information. Best estimate morbidity assumptions and forecast Vitality costs 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.
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, except for Invest business where the initial expenses are based on medium-term expectations which are lower than the current total costs. This reflects a realistic position for Invest.
The 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.
It is assumed that, for the purposes of calculating the cost of required capital, the Life required capital amount will be backed by surplus assets consisting of 100% equities and the Health, Vitality and PruHealth required capital amounts will be fully backed by cash. 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 five years. The Life 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 and PruHealth cost of capital is calculated using the difference between the risk discount rate and the net of tax cash return.
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 updated guidance note was applied for the first time in December 2008. The risk discount rate, calculated in accordance with the updated 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. Previously, the potential cost of these risks to shareholders was allowed for through a higher margin in the risk discount rate. 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 31 December 2010 to changes in the risk discount rate is shown below. In determining the values at different risk discount rates, all other assumptions have been left unchanged.
Table 9: Embedded value sensitivity to risk discount rate
Risk discount |
Published risk |
Risk discount |
|
| R million | rate -1% |
discount rate |
rate +1% |
| Adjusted net worth plus value of Standard Life Healthcare | 2 851 |
2 851 |
2 851 |
| Value of in-force covered business before cost of capital | 24 436 |
22 231 |
20 369 |
| Cost of required capital | 379) |
(375) |
(370) |
| Cost of STC | (736) |
(633) |
(556) |
| Discovery Holdings embedded value | 26 172 |
24 074 |
22 294 |
Table 10: Value of new business sensitivity to risk discount rate |
|||
Risk discount |
Published risk |
Risk discount |
|
| R million | rate -1% |
discount rate |
rate +1% |
| Present value of future profits from new business at point of sale | 886 |
730 |
597 |
| Cost of required capital | (29) |
(29) |
(27) |
| Cost of STC | (27) |
(20) |
(16) |
| Present value of future profits from new business | |||
| at point of sale after cost of required capital and STC | 830 |
681 |
554 |