Embedded value statement

for the six months ended 31 December 2011

The embedded value of Discovery at 31 December 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 in South Africa through Discovery Life, Discovery Invest, Discovery Health and Discovery Vitality, and in the United Kingdom through PruProtect, PruHealth and PruHealth Insurance Limited (previously Standard Life Healthcare). PruProtect and PruHealth Insurance Limited are included in the Group value of new business and value of in-force business with effect from 30 June 2011. For The Vitality Group (USA) and Discovery Insure, no published value has been placed on the current in-force business.

In August 2010, Discovery acquired Standard Life Healthcare and increased its shareholding in the Prudential joint venture from 50% to 75%. During 2011, Discovery 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 parties in these subsidiaries. The put option entitles the non-controlling party 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 recognized 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, the financial liability in excess of the non-controlling interest in the net asset value and the non- controlling share of the profits/losses included in retained earnings were added back to the adjusted net worth.

In August 2011, Discovery raised R800 million through the issue of non-cumulative, non-participating, non- convertible preference shares. For embedded value purposes, the capital raised, net of share issue expenses, has been excluded from the adjusted net worth.

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 2011. A copy of the auditors’ unqualified review report is available for inspection at the company’s registered office.

Table 1: Group embedded value

(1) The published shareholders’ funds was reduced to eliminate net assets under insurance contracts, deferred tax and deferred acquisition costs at December 2011 of R6 926 million (June 2011: R6 126 million; December 2010: R5 466 million) in respect of Life, R98 million (June 2011: R93 million; December 2010: R39 million) in respect of PruHealth and R53 million (June 2011: R45 million) in respect of PruProtect. The December 2011 shareholders’ funds was reduced by R1 704 million (June 2011: 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 December 2011 shareholders’ funds was increased by R1 706 million (June 2011: 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 R98 million (June 2011: R92 million) reflecting the non-controlling share of the losses included in retained earnings. The December 2011 shareholders’ funds was reduced by an amount of R779 million being the net preference share capital raised during August 2011.

(2) The required capital at December 2011 for Life is R685 million (June 2011: R610 million; December 2010: R606 million), for Health and Vitality is R462 million (June 2011: R437 million; December 2010: R407 million), for PruHealth is R699 million (June 2011: R730 million; December 2010: R163 million) and for PruProtect is R164 million (June 2011: 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 required capital amount was set equal to the capital prescribed by the FSA under the Individual Capital Adequacy Standards (“ICAS”) framework. Allowance has also been made for additional capital required by PruHealth over the next 12 months. For PruProtect, the required capital was set equal to the UK Pillar 1 capital requirement.

(3) The value of the Standard Life Healthcare (now PruHealth Insurance Limited) business in-force at 31 December 2010 was calculated based on the acquisition price less the net asset value of the business. With effect from 30 June 2011 the value of in-force business, calculated as the present value of expected future after-tax shareholder cash flows, has been included with the PruHealth value of in-force covered business.

(4) STC will be replaced by a dividend withholding tax with effect from 1 April 2012. The cost of STC at 31 December 2011 has been calculated based on the dividends expected to be declared prior to 1 April 2012.

(5) 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 R406 million (June 2011: R345 million; December 2010: R278 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 R12.51/GBP (June 2011: R10.84/GBP; December 2010: R10.30/GBP). The values for PruHealth and PruProtect reflect Discovery’s 75% shareholding in the joint venture.

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 investment in Ping An Health, the establishment of The Vitality Group in the United States, PruProtect and Discovery Insure.

(3) 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.

(4) The return on shareholders’ funds is shown net of tax and management charges.

Table 5: Methodology and assumption changes

(1) The Life and Invest modelling changes relate mainly to changes following a conversion process on the administration system. The PruHealth modelling changes relate to the modelling of commission on the PruHealth Insurance Limited book.

(2) For Life and Invest and PruHealth, long-term lapse assumptions have been strengthened at certain points.

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

(4) The PruHealth morbidity assumption has been adjusted as confidence in its experience has improved.

Table 6: Experience variances

(1) This variance relates to the reduction in the administration fee payable by the Discovery Health Medical Scheme during 2011.

(2) The total Health and Vitality lapse experience variance of R85 million consists of a positive variance of R102 million due to lower than expected lapses and a negative variance of R17 million due to the net growth in existing employer groups (i.e. R379 million in respect of members joining existing employer groups during the period offset by an amount of R396 million in respect of members leaving existing employer groups).

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

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

(5) 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 31 December 2011. The total Health and Vitality new business annualised premium income written over the period was R2 183 million (June 2011: R4 086 million; December 2010: R2 061 million).

(2) Included in the Life and Invest value of new business is R1 million (June 2011: R11 million; December 2010: R1 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 recognized 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 R926 million (June 2011: R1 724 million; December 2010: R883 million) (single premium APE: R255 million (June 2011: R478 million; December 2010: R224 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 R265 million (June 2011: R403 million; December 2010: R195 million) and servicing increases of R188 million (June 2011: R347 million; December 2010: R151 million) was R1 379 million (June 2011: R2 474 million; December 2010: R1 229 million) (single premium APE: R266 million (June 2011: R502 million; December 2010: 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.
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) The new business for PruHealth is seasonal, with more business written in the first half of the calendar year than the second half. The PruHealth value of new business at 30 June 2011 includes new business written through PruHealth Insurance Limited between August 2010 and March 2011. No new business has been written through PruHealth Insurance Limited since March 2011. No value was placed on the PruHealth Insurance Limited new business at 31 December 2010.

(6) 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 2011. There have been no changes to the definition of new business since the previous valuation.

(7) The PruProtect new business is defined as policies which incepted during the reporting period and which are on risk at the valuation date.

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.

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. 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 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 and PruHealth 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 and Vitality and PruHealth 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 31 December 2011 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

Table 10: Value of new business sensitivity to risk discount rate