Notes to the MCEV basis supplementary information

For the year ended 31 December 2009

A: MCEV policies

A1: Basis of preparation

The Market Consistent Embedded Value methodology (referred to herein and in the supplementary statements on pages 84 to 132 as 'MCEV') adopts Market Consistent Embedded Value Principles issued in June 2008 and updated in October 2009 by the CFO Forum ('the Principles') as the basis for the methodology used in preparing the supplementary information.

The CFO Forum announced changes to the MCEV Principles in October 2009 to reflect inter alia the inclusion of a liquidity premium. These changes affirm that the risk free reference rate to be applied under MCEV should include both the swap yield curve appropriate to the currency of the cash flows and a liquidity premium where appropriate. The CFO Forum is undertaking further work to develop more detailed application guidance.

The Principles have been fully complied with for all businesses as at 31 December 2009. The detailed methodology and assumptions made in presenting this supplementary information are set out in notes A2 and A3.

Where reference is made to 'Europe' only, this generally captures the Nordic, Retail Europe and Wealth Management businesses.

Throughout the supplementary information the following terminology is used to distinguish between the terms 'MCEV', 'Group MCEV' and 'adjusted Group MCEV':

• MCEV is a measure of the consolidated value of shareholders' interests in the covered business and consists of the sum of the shareholders' adjusted net worth in respect of the covered business and the value of the in-force covered business.
• Group MCEV is a measure of the consolidated value of shareholders' interests in covered and non-covered business. Non-covered business is valued at the IFRS net asset value detailed in the primary financial statements adjusted to eliminate inter-company loans.
• The adjusted Group MCEV, a measure used by management to assess the shareholders' interest in the value of the Group, includes the impact of marking all debt to market value, the market value of the Group's listed banking and general insurance subsidiaries, marking the value of deferred consideration due in respect of Black Economic Empowerment arrangements in South Africa ('the BEE schemes') to market, as well as including the market value of excess own shares held in ESOP schemes.

A2: Methodology

Introduction

MCEV represents the present value of shareholders' interests in the earnings distributable from assets allocated to the in-force covered business after sufficient allowance for the aggregate risks in the covered business and is measured in a way that is consistent with the value that would normally be placed on the cash flows generated by these assets and liabilities in a deep and liquid market. MCEV is therefore a risk-adjusted measure to the extent that financial risk is reflected through the use of market consistent techniques in the valuation of both assets and distributable earnings and a transparent explicit allowance is made for non-financial risks.

The MCEV consists of the sum of the following components:

• Adjusted net worth, which excludes acquired intangibles and goodwill, consisting of:
  • free surplus allocated to the covered business; and
  • required capital to support the covered business.
• Value of in-force covered business (VIF)

The adjusted net worth of the covered business is the market value of shareholders' assets held in respect of the covered business after allowance for the liabilities of the in-force covered business which are dictated by local regulatory reserving requirements.

MCEV is calculated net of non-controlling shareholder interests and excludes the value of future new business.

Coverage

Covered business includes, where material, any contracts that are regarded by local insurance supervisors as long-term life assurance business, and other business, where material, directly related to such long-term life assurance business where the profits are included in the IFRS long-term business profits in the primary financial statements. For the OMSA business, following the sale of the remaining stake in Nedlife to Nedbank, Nedlife is excluded from covered business from 2009 onwards although it is still included in comparative results for prior periods.

Some types of business are legally written by a life company, but under IFRS are classified as asset management because 'long-term business' only serves as a wrapper. This business continues to be excluded from covered business, for example:

• New institutional investment platform pensions business written in the United Kingdom as it is more appropriately classified as unit trust business; and
• Individual unit trusts and some group market-linked business written by the asset management companies in South Africa through the life Company as profits from this business arise in the asset management companies.

The treatment within this supplementary information of all business other than the covered business is the same as in the primary financial statements, except for the adjusted Group MCEV which includes the impact of marking all debt to market value, the market value of the Group's listed banking and general insurance subsidiaries, marking the value of deferred consideration due in respect of Black Economic Empowerment arrangements in South Africa ('the BEE schemes') to market, as well as including the market value of excess own shares held in ESOP schemes.

Free surplus

Free surplus is the market value of any assets allocated to, but not required to support, the in-force covered business. It is determined as the market value of any excess assets attributed to the covered business but not backing the regulatory liabilities, less the required capital to support the covered business.

Required capital

Required capital is the market value of assets that are attributed to support the covered business, over and above that required to back statutory liabilities for covered business, whose distribution to shareholders is restricted. The following capital measures are considered in determining the required capital held for covered business so that it reflects the level of capital considered by the directors to be appropriate to manage the business:

• Economic capital;
• Regulatory capital (ie the level of solvency capital which the local regulators require);
• Capital required by rating agencies in respect of the North American business in order to maintain the desired credit rating; and
• Any other required capital definition to meet internal management objectives.

Economic capital for the covered business is based upon Old Mutual's own internal assessment of risks inherent in the underlying business. It measures capital requirements on an economic statement of financial position, with MCEV as the available capital, consistent with a 99.93% confidence level over a one-year time horizon.

For Emerging Markets and Europe capital determined with reference to internal management objectives is the most onerous and is the capital measure used. For US Life the required capital is based on the amount that management deems necessary to maintain the desired credit rating for the Company, whilst for Bermuda the required capital is set with reference to internal management objectives.

The required capital in respect of OMSA's covered business is partially covered by the market value of the Group's investments in banking and general insurance in South Africa. On consolidation these investments are shown separately.

The table below shows the level of required capital expressed as a percentage of the minimum local regulatory capital requirements.

* There has been a large increase in the regulatory capital within the Nordic region due to the strong correlation with funds under management which have increased significantly.

** Local regulators within many of the Retail Europe countries allow intangible assets to be included as admissible regulatory capital. In such cases the required capital reported for MCEV is net of these items, although each of the countries continues to be sufficiently capitalised on the local solvency basis. Skandia Leben in Germany is permitted under local regulations to include the unallocated policyholder profit sharing liability as admissible capital, leading to a large decrease in the required capital from 31 December 2008 to 31 December 2009.

*** The Bermudan regulator allows intangible assets to be included as admissible regulatory capital. The total regulatory capital for US Life and Bermuda at 31 December 2008 has been restated from £245 million to £211 million due to refinement of the calculation.

Value of in-force covered business

Under the MCEV methodology, VIF consists of the following components:

• Present value of future profits (PVFP) from in-force covered business; less
• Time value of financial options and guarantees; less
• Frictional costs of required capital; less
• Cost of residual non-hedgeable risks (CNHR).

Projected liabilities and cash flows are calculated net of outward risk reinsurance with allowance for default risk of reinsurance counterparties where material.

Present value of future profits

The PVFP is calculated as the discounted value of future distributable earnings (taking account of local statutory reserving requirements) that are expected to emerge from the in-force covered business, including the value of contractual renewal of in-force business, on a best estimate basis where assumed earned rates of return and discount rates are equal to the risk free reference rates. It therefore represents a deterministic certainty equivalent valuation of future distributable earnings. The certainty equivalent valuation approach is described in more detail in note A3. Any limitations on distribution of such earnings due to statutory or internal capital requirements are taken into account separately in the calculation of frictional costs of required capital.

PVFP captures the intrinsic and time value of financial options and guarantees on in-force covered business which are included in the local statutory reserves according to local requirements, but excludes any additional allowance for the time value of financial options and guarantees.

Financial options and guarantees

Allowance is made in the MCEV for the potential impact of variability of investment returns (ie asymmetric impact) on future shareholder cash flows of policyholder financial options and guarantees within the in-force covered business.

The time value of financial options and guarantees describes that part of the value of financial options and guarantees that arises from the variability of future investment returns on assets to the extent that it is not already included in the statutory reserves. The calculations are based on market consistent stochastic modelling techniques where the actual assets held at the valuation date are used as the starting point for the valuation of such financial options and guarantees. Projected cash flows are valued using economic assumptions such that they are valued in line with the price of similar cash flows that are traded in the capital markets. The time value represents the difference between the average value of shareholder cash flows under many generated economic scenarios and the deterministic shareholder value under the best estimate assumptions for the equivalent business. Closed form solutions are also applied in Europe provided the nature of any guarantees is not complex.

The time value of financial options and guarantees also includes allowance for potential burn-through costs on participating business, ie the extent to which shareholders are unable to recover a loan made to participating funds to meet either regulatory or internal capital management requirements or the extent to which reserves are inadequate to cover severely adverse experience.

In the generated economic scenarios allowance is made, where appropriate, for the effect of dynamic management and/or policyholder actions in different circumstances:

• Management has some discretion in managing exposure to financial options and guarantees, particularly within participating business. Such dynamic management actions are reflected in the valuation of financial options and guarantees provided that such discretion is consistent with established and justifiable practice taking into account policyholders' reasonable expectations (eg with due consideration of the Principles and Practices of Financial Management, or PPFM, for South African business), subject to any contractual guarantees and regulatory or legal constraints and has been passed through an appropriate approval process by the local Executive team and, where applicable, the Board. Assumptions that depend on the market performance (such as crediting rates or bonus rates) are set relative to the risk free reference rates (subject to contractual guarantees) and assuming that all market participants are subjected to the same market conditions.
• Where credible evidence exists that persistency rates are linked to economic scenarios, allowance is made for dynamic policyholder behaviour in response to changes in economic conditions.
• Modelled dynamic management and policyholders' actions include the following:
  • changes in future bonus and crediting rates subject to contractual guarantees, including removing all or part of previously declared non-vested balances where circumstances warrant such action;
  • dynamic persistency rates for the US Life and Bermuda businesses, and dynamic guaranteed annuity option take-up rates for the South African business driven by changes in economic conditions and management actions; and
  • changes in surrender values.

In determining the time value of financial options and guarantees at least 1,000 simulations are run to ensure that a reasonable degree of convergence of results has been obtained. Where deemed appropriate, the number of simulations is increased to reduce sampling error.

Europe

Whilst certain products within the European businesses provide financial options and guarantees, these are immaterial due to the predominantly unit-linked nature of the business.

Emerging Markets

The financial options and guarantees mainly relate to maturity guarantees and guaranteed annuity options.

As required by the applicable Actuarial Society of South Africa guidance note, the time value of the financial options and guarantees included in the statutory reserves in the Emerging Markets businesses as at 31 December 2009 has been valued using a risk-neutral market consistent asset model, and is referred to as the 'Investment Guarantee Reserve' (IGR). This reserve includes a discretionary margin as defined by local guidelines to allow for the sensitivity of the reserve to future interest rate movements. This discretionary margin is valued in the VIF.

US Life

The financial options and guarantees mainly relate to minimum crediting (bonus) rates.

Bermuda

The financial options and guarantees mainly relate to the guaranteed minimum accumulation benefits on Variable Annuity contracts.

Frictional costs of required capital

From the shareholders' viewpoint there is a cost due to restrictions on the distribution of required capital that is locked in the Company. Where material, an allowance has been made for the frictional costs in respect of the taxation on investment return (income and capital gains) and investment costs on the assets backing the required capital for covered business. The allowance for taxation is based on the taxation rates applicable to investment earnings on assets backing the required capital, although such tax rates are reduced, where applicable, to allow for interest paid on debt which is used partly to finance the required capital.

The run-off pattern of the required capital is projected on an approximate basis over the lifetime of the underlying risks in line with drivers of the capital requirement. The same drivers are used to split the total required capital between existing business and new business.

The allowance for frictional costs is independent of the allowance for the cost of residual non-hedgeable risks as described below.

Cost of residual non-hedgeable risks

Sufficient allowance for most financial risks has been made in the PVFP and the time value of financial options and guarantees by using techniques that are similar to the type of approaches used by capital markets. In addition the modelling of some non-hedgeable non-financial risks is incorporated as part of the calculation of the PVFP (eg to the extent that expected operational losses are incorporated in the maintenance expense assumptions) or the time value of financial options and guarantees (eg dynamic policyholder behaviour such as the interaction of the investment scenario and the persistency rates).

Residual non-financial risks include, for example, liability risks such as mortality, longevity and morbidity risks; business risks such as persistency, expense and reinsurance credit risks; and operational risk. All such risks for which no or insufficient allowance is made in the PVFP or time value of financial options and guarantees, together with some allowance for hedge risk and credit spread risk in the US Life and Bermudan businesses, are considered within the allowance for the CNHR.

An allowance is made in the CNHR to reflect uncertainty in the best estimate of shareholder cash flows as a result of both symmetric and asymmetric non-hedgeable risks since these risks can not be hedged in deep and liquid capital markets and are managed, inter alia, by holding risk capital. Considering the Group as a whole, most residual non-hedgeable risks have a symmetric impact on shareholder value with the exception of operational risk.

The CNHR is calculated using a cost of capital approach, ie it is determined as the present value of capital charges for all future non-hedgeable risk capital requirements until the liabilities have run off. The capital charge in each year is the product of the projected expected non-hedgeable risk capital held after allowance for some diversification benefits and the cost of capital rate. The cost of capital rate therefore represents the return above the risk free reference rates that the market is deemed to demand for providing this capital.

The residual non-hedgeable risk capital measure is determined using an internal economic capital model based on appropriate shock scenarios consistent with a 99.5% confidence level over a one-year time horizon. The internal economic capital model makes allowance for certain management actions, such as reductions in bonus and crediting rates, where deemed appropriate.

The following allowance is made for diversification benefits in determining the residual non-hedgeable risk capital at a business unit level:

• Diversification benefits within the non-hedgeable risks of the covered business are allowed for.
• No allowance is made for diversification benefits between hedgeable and non-hedgeable risks of the covered business.
• No allowance is made for diversification benefits between covered and non-covered business.

The table below shows the amounts of diversified economic capital held in respect of residual

Capital held in respect of non-hedgeable risks

* The total capital held in respect of non-hedgeable risks for US Life and Bermuda at 31 December 2008 has been restated from £826 million to £1,030 million due to refinement of the calculation.

The economic capital included in the calculation of CNHR at 31 December 2008 was calculated with reference to the old European Embedded Value (EEV) methodology, whilst the economic capital included in the calculation of CNHR at 31 December 2009 was calculated with reference to the MCEV methodology. This has led to a step change in the calculation for all business units. To the extent that this change affected operating earnings, the impact is shown under 'other operating variance'.

In addition to the change in the underlying basis used for assessing economic capital from an EEV to MCEV basis, the increase in capital held in respect of CNHR for Europe from £720 million at 31 December 2008 to £1,116 million at 31 December 2009 is largely caused by an increase in the economic capital held for persistency risk in light of the turbulent economic market conditions and due to a change in methodology for waiver of premium products in Sweden to strengthen the economic capital held for morbidity risk.

A weighted average cost of capital rate of 2.0% has been applied to residual symmetric and asymmetric non-hedgeable capital at a business unit level over the life of the contracts. This translates into an equivalent cost of capital rate of approximately 2.6% being applied to the Group diversified capital required in respect of such non-hedgeable risks.

Participating business

For participating business in Emerging Markets, US Life and Bermuda, the method of valuation makes assumptions about future bonus or crediting rates and the determination of profit allocation between policyholders and shareholders. These assumptions are made on a basis consistent with other projection assumptions, especially the projected future risk free investment returns, established Company practice (with due consideration of the PPFM for South African business), past external communication, any payout smoothing strategy, local market practice, regulatory/contractual restrictions and bonus participation rules.

Where current benefit levels are higher than can be supported by the existing fund assets together with projected investment returns, a downward 'glide path' is projected in benefit levels so that the policyholder fund would be exhausted on payment of the last benefit.

Spread-based products

A market consistent valuation of spread-based products (such as Fixed Indexed Annuities in US Life and Bermuda, where investment returns are earned at one rate and policyholders' accounts are credited at a different rate with the difference referred to as 'spread') is dependent on the extent that management discretion can target a shareholder profit margin and the decision rules that management would follow in respect of crediting or bonus rates in any particular stochastic scenario.

Where guaranteed terms are offered at outset of a contract that dictate the payments to policyholders throughout the term of the contract, these payments are valued using the certainty equivalent valuation technique. These products, for example immediate annuities in payment, may therefore show a loss at point of sale under MCEV as investment margins are not anticipated while currently pricing practice does anticipate these margins. If returns in excess of the risk free reference rates actually emerge in the future, these will be recognised in the MCEV earnings as they arise.

For business where the crediting (bonus) rate is set in advance, crediting rates are set by considering management's target shareholder margins throughout the contract lifetime (subject to any guarantees). Projected crediting rates are set equal to the risk free reference rates less the anticipated margin to cover profit and expenses (subject to any policyholder guarantees eroding the shareholder margins). However, during the period following the valuation date the existing crediting rate is applied until the next point at which it can be varied. Given the guarantees included within such products (including consideration of a 0% floor for crediting rates), stochastic modelling is used to value such contracts.

Valuation of assets and treatment of unrealised losses

The market values of assets, where quoted in deep and liquid markets, are based on the bid price on the reporting date. Unquoted assets are valued according to IFRS and marked to model.

No smoothing of market values or unrealised gains/losses is applied.

Asset mix

The time value of financial options and guarantees and PVFP (where relevant) are calculated with reference to assets that are projected using the actual asset allocation of the policyholder funds at the reporting date. However, if the current asset mix is materially different to the long-term strategic asset allocation as a result of market movements, projected assets are assumed to revert to the long-term strategic asset allocation in the short- to medium-term as appropriate.

Defined benefit pension scheme

Where a defined benefit pension scheme within the covered business is in surplus or deficit on the liability basis that is used to determine future employer contributions, the employer pension fund expense assumptions incorporated within the VIF allow appropriately for the expected release of surplus or funding of the deficit.

Look through principle

PVFP and value of new business cash flow projections look through and include the profits/losses of owned service companies, eg distribution and administration, related to the management of the covered business. Any profit margins that are included in investment management fees payable by the life assurance companies to the asset management subsidiaries have not been included in the value of in-force business or the value of new business on the grounds of materiality and because a significant proportion of these profits arise from performance-based fees.

Taxation

In valuing shareholders' cash flows, allowance is made in the cash flow projections for taxes in the relevant jurisdiction affecting the covered business. Tax assumptions are based on best estimate assumptions, applying current local corporate tax legislation and practice together with known future changes and taking credit for any deferred tax assets.

No allowance is made for any further additional tax that would be incurred on the remittance of dividends from the life subsidiaries to Old Mutual plc, apart from the South African business where full allowance has been made for Secondary Tax on Companies (STC) that may be payable in South Africa at a rate of 10% and the impact of capital gains tax. Furthermore, for the South African business it has been assumed that a reasonable proportion of the shareholder fund equity portfolio (excluding Group subsidiaries) will be traded each year.

The value of deferred tax assets is partly recognised in the MCEV. Typically those tax assets are expected to be utilised in future by being offset against expected tax liabilities that are generated on expected profits emerging from in-force business. MCEV may therefore understate the true economic value of such deferred tax assets because it does not allow for future new business sales which could affect the utilisation of such assets.

New business and renewals

The market consistent value of new business (VNB) measures the value of the future profits expected to emerge from all new business sold, and in some cases premium increases to existing contracts, during the reporting period after allowance for the time value of financial options and guarantees, frictional costs and the cost of residual non-hedgeable risks associated with writing the new business.

VNB includes contractual renewal of premiums and recurring single premiums, where the level of premium is pre-defined and is reasonably predictable, and changes to existing contracts where these are not variations allowed for in the PVFP. Non-contractual increments are treated similarly where the volume of such increments is reasonably predictable or likely (eg where premiums are expected to increase in line with salary or price inflation).

Any variations in premiums on renewal of in-force business from that previously anticipated including deviations in non-contractual increases, deviations in recurrent single premiums and re-pricing of premiums for in-force business are treated as experience variances or economic variances on in-force business and not as new business.

VNB is calculated as follows:

• Economic assumptions at the start of the reporting period are used, except for OMSA's Non-Profit Annuities and Fixed Bond products and US Life products where point of sale assumptions are used (where applicable using economic assumptions at the middle of the reporting period as a proxy).
• Demographic and operating assumptions at the end of the reporting period are used.
• At point of sale and rolled forward to the end of the reporting period.
• Generally using a standalone approach unless a marginal approach would better reflect the additional value to shareholders created through the activity of writing new business.
• Expense allowances include all acquisition expenses, including any acquisition expense overruns.
• Net of tax, reinsurance and non-controlling interests.
• No attribution of any investment and operating variances to VNB.

New business margins are disclosed as:

• The ratio of VNB to the present value of new business premiums (PVNBP); and
• The ratio of VNB to annual premium equivalent (APE), where APE is calculated as recurring premiums plus 10% of single premiums.

PVNBP is calculated at point of sale using premiums before reinsurance and applying a valuation approach that is consistent with the calculation of VNB.

Analysis of MCEV earnings

An analysis of MCEV earnings provides a reconciliation of the MCEV for covered business at the beginning of the reporting period and the MCEV for covered business at the end of the reporting period on a net of taxation basis.

Operating MCEV earnings are generated by the value of new business sold during the reporting period, the expected existing business contribution, operating experience variances, operating assumption changes and other operating variances:

• The value of new business includes the impact of new business strain on free surplus that arises, amongst other things, from the impact of initial expenses and additional required capital that is held in respect of such new business.
• The expected existing business contribution is determined by projecting both actual assets and actual liabilities (including assets backing the free surplus and required capital) from the start of the reporting period to the end of the reporting period using expected real-world earned rates of return. The expected existing business contribution is presented in two components:
  • expected earnings on free surplus and required capital and the expected change in VIF assuming that the assets earn the beginning of period risk free reference rates; and
  • additional expected earnings on free surplus and required capital and the additional expected change in VIF as a result of real-world expected earned rates of return on assets in excess of beginning of period risk free reference rates.
• Transfers from VIF and required capital to free surplus includes the release of required capital and modelled profits from VIF into free surplus in respect of business that was in-force at the beginning of the reporting period, although the movement does not contribute to a change in the MCEV.
• Operating experience variances reflect the impact of deviations of the actual operational experience during the reporting period from the expected operational experience. It is analysed before operating assumption changes, ie such variances are assessed against opening operating assumptions, and reflects the total impact of in-force and new business variances.
• Operating assumption changes incorporate the impact of changes to operating assumptions from those assumed at the beginning of the reporting period to those assumed at the end of the reporting period. As VNB is calculated using operating assumptions at the end of the reporting period, this impact only relates to the value of in-force business at the end of the reporting period that was also in-force at the beginning of the reporting period.
• Other operating variances include model improvements, changes in methodology and the impact of certain management actions, such as a change in the asset allocation backing required capital.

Total MCEV earnings also include economic variances and other non-operating variances:

• Economic variances incorporate the impact of changes in economic assumptions from the beginning of the reporting period to the end of the reporting period as well as the impact on earnings resulting from actual returns on assets being different to the expected returns on those assets as reflected in the expected existing business contribution. It therefore also includes the impact of economic variances in the reporting period on projected future earnings.
• Other non-operating variances include the impact of changes in mandatory local regulations and changes in taxation legislation.

An analysis of MCEV earnings requires non-operating closing adjustments in respect of exchange rate movements and capital transfers such as those in respect of payment of dividends and acquiring/divesting businesses.

Return on MCEV for covered business is calculated as the operating MCEV earnings after tax divided by opening MCEV in local currency, except for Wealth Management, Long Term Savings and total covered business where the calculations are performed in sterling.

The anticipated expected existing business contribution for the 12 months following the year ended 31 December 2009 (at the reference rate as well as in excess of the reference rate) is provided to assist users of the MCEV supplementary information in forecasting operating MCEV earnings. Note that the exchange rates that are used for such disclosure are the same rates that are used to translate current year earnings for comparability purposes. Therefore the ultimate expected existing business contribution for the financial year ending 31 December 2010 may differ from these results.

Analysis of Group MCEV earnings

Presentation of Group MCEV consists of the covered business under the MCEV methodology and the non-covered business valued as the unadjusted IFRS net asset value. A mark to market adjustment is therefore not performed for external borrowings and other items not on a mark to market basis under IFRS relating to non-covered business.

A3: Assumptions

Non-economic assumptions

The appropriate non-economic projection assumptions for future experience (eg mortality, persistency and expenses) are determined using best estimate assumptions of each component of future cash flows, are specific to the entity concerned and have regard to past, current and expected future experience where sufficient evidence exists (eg longevity improvements and AIDS-related claims) as derived from both entity-specific and industry data where deemed appropriate. Material assumptions are actively reviewed by means of detailed experience investigations and updated, as deemed appropriate, at least annually.

These assumptions are based on the covered business being part of a going concern, although favourable changes in maintenance expenses such as productivity improvements are generally not included beyond what has been achieved by the end of the reporting period.

The management expenses attributable to life assurance business have been analysed between expenses relating to the acquisition of new business, maintenance of in-force business (including investment management expenses) and development projects.

• All expected maintenance expense overruns affecting the covered business are allowed for in the calculations.
• Unallocated Group holding Company expenses have been included to the extent that they relate to the covered business. The future expenses attributable to long-term business include 33% of the Group holding Company expenses, with 16% allocated to Emerging Markets, 15% allocated to Europe and 2% allocated to US Life (31 December 2008: 35% of the Group holding Company expenses, with 14% allocated to Emerging Markets, 17% allocated to Europe and 4% allocated to US Life and Bermuda). The allocation of these expenses aligns to the proportion that the management expenses incurred by the business bears to the total management expenses incurred in the Group.
• The MCEV makes provision for future development costs and one-off exceptional expenses (such as those incurred on the integration of businesses following an acquisition, restructuring costs and costs related to Solvency II implementation) that relate to covered business to the extent that such project costs are known with sufficient certainty, based on three year business plans.

Legislative changes were introduced in Germany in 2008 specifying the proportion of miscellaneous profits to be shared with policyholders. According to the regulations, the revenue on in-force business can be reduced by various expense items, including those costs arising in respect of new business acquisition expenses in any year. From 31 December 2008 Skandia Leben in Germany sets the best estimate assumptions for the amount to be shared with policyholders in future years after making an allowance for the acquisition expenses in relation to the new business expected to be written over the next three years. However note that, as previously mentioned, MCEV excludes the value of future new business.

Economic assumptions

An active basis is applied to set pre-tax investment and economic assumptions to reflect the economic conditions prevailing on the reporting date. Economic assumptions are set consistently, for example future bonus or crediting rates are set at levels consistent with the investment return assumptions.

Under a market consistent valuation, economic assumptions are determined such that projected cash flows are valued in line with the prices of similar cash flows that are traded on the capital markets. Thus, risk free cash flows are discounted at a risk free reference rate and equity cash flows at an equity rate. In practice for the PVFP, where cash flows do not depend on or vary linearly with market movements, a certainty equivalent method is used which assumes that actual assets held earn, before tax and investment management expenses, risk free reference rates (including any liquidity adjustment) and all the cash flows are discounted using risk free reference rates (including any liquidity adjustment) which are gross of tax and investment management expenses. The deterministic certainty equivalent method is purely a valuation technique and over time the expectation is still that risk premiums will be earned on assets such as equities and corporate bonds.

Risk free reference rates and inflation

The risk free reference rates, reinvestment rates and discount rates are determined with reference to the swap yield curve appropriate to the currency of the cash flows. For Europe the swap yield curve is obtained from a number of sources including Bloomberg, Nordea Bank and Reuters. For the Emerging Markets and United States businesses, the swap yield curve is sourced from a third party market consistent asset model that is used to generate the economic scenarios that are required to value the time value of financial options and guarantees.

At 31 December 2009, no adjustments are made to swap yields to allow for liquidity premiums or credit risk premiums, apart from a liquidity adjustment to the US Life business and OMSA's Retail Affluent Immediate Annuity business. Any other risk premiums are recognised within the MCEV as and when they are earned.

A wide range of liquidity market data and literature was reviewed at 31 December 2009, such as the Barrie+Hibbert calibration of US corporate bond spreads using a structural Merton-style model which decomposes the yields of illiquid assets into their constituent parts and a comparison of the yields of similar durations on South African government bonds and bonds issues by state-owned enterprises. It is the directors' view that a significant proportion of corporate bond spreads at 31 December 2009 is attributable to a liquidity premium rather than credit and default risk and that returns in excess of swap rates can be achieved, rather than entire corporate bond spreads being lost to worsening default experience. For the US Life business and OMSA's Retail Affluent Immediate Annuity business the currency, credit quality and duration of the actual corporate bond portfolios were considered and adjusted risk free reference rates were derived at 31 December 2009 by adding 100bps of liquidity premium for the US Life business (31 December 2008: 300bps) and adding 50bps of liquidity premium for OMSA's Retail Affluent Immediate Annuity business (31 December 2008: zero allowance) to the swap rates used for setting investment return and discounting assumptions. These adjustments reflect the liquidity premium component in corporate bond spreads over swap rates that is expected to be earned on the portfolios. Old Mutual believes that the differences between market yields on US Life's and OMSA's Retail Affluent bond portfolios and the adjusted risk free reference rates still provide adequate implied margins for default. No liquidity adjustment is applied for other regions in light of the pending liquidity premium application guidance from the CFO Forum.

When the liquidity premium adjustment was calibrated and introduced for US Life business at 31 December 2008, similar research was not yet concluded for South Africa to estimate the quantum of the liquidity premiums inherent in South African corporate bond spreads. In addition, the impact of a liquidity premium adjustment on US Life business was far more material than for OMSA's Retail Affluent Immediate Annuity business as the concentration of US Life's investments in the corporate bond market is far greater and the widening of corporate bond spreads has been more pronounced in the US compared to other regions. Hence the application of a liquidity premium adjustment was initially focussed on the US and an adjustment was only introduced for OMSA at 30 June 2009 for consistency in methodology.

At those durations where swap yields are not available, eg due to lack of a sufficiently liquid or deep swap market, the swap curve is extended using appropriate interpolation or extrapolation techniques.

Consumer price inflation assumptions are determined as those implied by index-linked government stocks or real swap yields if a liquid market of sufficient size exists. In other markets, the consumer price inflation assumptions are modelled considering a spread compared to swap rates. However, where modelling system capabilities are restricted (eg US Life), consumer price inflation is set as a flat assumption. Other types of inflation such as expense inflation are derived on a consistent basis and, where deemed appropriate, include a percentage addition to the consumer price inflation rate, for example as life company expenses include a large element of salary related expenses.

The risk free reference spot yields (excluding any applicable liquidity adjustments) and expense inflation rates at various terms for each of the significant regions are provided in the table below. The risk free reference spot yield curve has been derived from mid swap rates at the reporting date.

Risk free reference spot yields (excluding any applicable liquidity adjustments)

Expense inflation

Volatilities and correlations

Where cash flows contain financial options and guarantees that do not move linearly with market movements, asset cash flows are projected and all cash flows discounted using risk-neutral stochastic models. These models project the assets and liabilities using a distribution of asset returns where all asset types, on average, earn the same risk free reference rates.

Apart from the risk free reference yields specified above, other key economic assumptions for the calibration of economic scenarios include the implied volatilities for each asset class and correlations of investment returns between different asset classes. The volatility assumptions for the calibration of economic scenarios that are used in the stochastic models are, where possible, based on those implied from appropriate derivative prices (such as equity options or swaptions in respect of guarantees that are dependent on changes in equity markets and interest rates respectively) as observed on the valuation date. However, historic implied and historic observed volatilities of the underlying instruments and expert opinion are considered where there are concerns over the depth or liquidity of the market, eg volatilities for property returns. Where strict adherence to the above is not possible, for example where markets only exist at short durations such as the equity option market in South Africa, interpolation or extrapolation techniques are used to derive volatility assumptions for the full term structure of the liabilities. Correlation assumptions between asset classes that are used in stochastic models are based on an assessment of historic relationships. Where historic data is used in setting volatility or correlation assumptions, a suitable time period is considered for analysing historic data including consideration of the appropriateness of historical data where economic conditions were materially different to current conditions.

For the Emerging Markets stochastic models, due to the immateriality of corporate bond and property holdings, corporate bonds are assumed to yield the same returns as equivalent long-term government bonds and property is assumed to earn a return equal to a portfolio that is invested 50% in local equities and 50% in long-term government bonds.

The at-the-money annualised asset volatility assumptions of the asset classes incorporated in the stochastic models are detailed below.

ZAR volatilities*

* Due to limited liquidity in the ZAR swaption and equity option market, the market consistent asset model has been calibrated by extrapolating swaption and equity option implied volatility data beyond terms of 2 years and 3 years respectively.

USD volatilities

* Due to limited liquidity in the USD swap market as at 31 December 2008, the market consistent asset model was calibrated by reference to volatility data as at 30 September 2008.

International equity volatilities (applicable to Old Mutual Bermuda)*

International equity volatilities (applicable to Old Mutual Bermuda)*

* These volatilities, as represented by their Bloomberg codes, refer to price indices. Due to ongoing enhancements in the fund mapping process, the indices referenced will vary from period to period

Exchange rates

All MCEV figures are calculated in local currency and translated to GBP using the appropriate exchange rates as detailed in Note C2 of the IFRS statements.

Expected asset returns in excess of the risk free reference rates

The expected asset returns in excess of the risk free reference rates have no bearing on the calculated MCEV other than the calculation of the expected existing business contribution in the analysis of MCEV earnings. Real-world economic assumptions are determined with reference to one-year forward risk free reference rates applicable to the currency of the liabilities at the start of the reporting period. All other economic assumptions, for example future bonus or crediting rates, are set at levels consistent with the real-world investment return assumptions.

Equity and property risk premiums incorporate both historical relationships and the directors' view of future projected returns in each region. Pre-tax real-world economic assumptions are determined as follows:

• The equity risk premium is 3.5% for Africa and 3% for Europe and the United States.
• The cash return equals the risk free reference rate less a deduction of 2% for Africa and 1% for Europe and the United States.
• The corporate bond return is based on actual corporate bond spreads on the reporting date less an allowance for defaults.
• The property risk premium is 1.5% in Africa and 2% in Europe.

Tax

The weighted average effective tax rates that apply to the cash flow projections within the VIF at 31 December 2009 are set out below:

• OMSA - 33% (31 December 2008: 33%)
• Namibia - 0% (31 December 2008: 0%)
• Nordic - 4% (31 December 2008: 3%)
• Retail Europe - 28% (31 December 2008: 28%)
• Wealth Management - range of 4% to 21% (31 December 2008: 6% to 28%)
• US Life - 5% (31 December 2008: 0%)
• Bermuda - 10% (31 December 2008: 1%)