of this report) and Note 20 of Notes to Consolidated Financial Statements.
AllianceBernstein’s assets under management, consolidated results of operations, the value of the Insurance Group’s investment in AllianceBernstein, and the level of distributions paid by AllianceBernstein to the Company have all declined materially. In particular, the decline in value of the Insurance Group’s investment in AllianceBernstein has had a material negative impact on the Insurance Group’s regulatory capital levels.
the demand for the Insurance Group’s products has been and will likely continue to be adversely affected.
Regulatory Capital. AXA Financial used a portion of the proceeds from its $3.00 billion in financing from AXA to make a $1.00 billion capital contribution to AXA Equitable through purchases of surplus notes.
Insurance Product Offerings. The Insurance Group revised and/or eliminated the sale of certain annuity and life insurance products, taking into account customer needs and preferences, competitive market considerations, risk management and capital utilization, among other factors. The Insurance Group may offer new and/or different products, and it may also further revise, suspend or discontinue one or more of its product offerings as conditions in the marketplace and capital markets develop.
Risk Management. The Insurance Group has continued to evaluate, refine and enhance its hedging and other risk management strategies.
The consolidated and segment earnings narratives that follow discuss the results for 2008 compared to the 2007 results.
The increases in consolidated net earnings for the Company and the Insurance segment were largely due to the substantial increases in 2008 in the fair values of derivative instruments used to hedge the GMDB/GMIB riders that are reported at fair value. Reserves for the GMDB/GMIB liabilities are not reported on a fair value basis under U.S. GAAP but rather on the basis of actuarial assumptions related to projected benefits and related contract charges over the lives of the contracts. Consequently, the U.S. GAAP reserves do not fully and immediately reflect the impact of equity and interest market fluctuations. If the reserves were calculated on a basis that would fully and immediately reflect the impact of equity and interest market fluctuations, U.S. GAAP earnings would be significantly lower than that being reported. Also under U.S. GAAP, the GMIB reinsurance contracts are accounted for as derivatives and are reported at fair value. The framework for determining their fair value was modified as required by SFAS No. 157, effective January 1, 2008. The 2008 increase in the reinsurance contracts fair value included the initial increase in fair value related to SFAS No. 157 as well as the increases related to market conditions during the year. Thus, the GMIB reinsurance contracts are also reflected on a basis inconsistent with the gross reserves for the GMIB liabilities under U.S. GAAP.
Total revenues increased $7.17 billion to $18.58 billion in 2008 from $11.41 billion in 2007 due to revenue increases of $8.18 billion in the Insurance segment being offset by the Investment Management segment’s $1.02 billion decrease. The 2008 increase in the Insurance segment principally resulted from $6.82 billion higher net investment income and $1.52 billion higher commissions, fees and other income, partially offset by $320.6 million higher investment losses. The $546.7 million decrease in investment advisory and services fees, the $349.2 million of investment losses and $95.0 million decrease in distribution revenues at AllianceBernstein contributed to the $1.02 billion decrease in the Investment Management segment’s revenues.
Policy fee income increased $210.0 million to $2.95 billion in 2008 as compared to $2.74 billion in the prior year. This increase resulted from higher life insurance policy charges and GMDB/GMIB fees partially offset by lower fees earned on lower average Separate Account balances due to market depreciation. Policy fee income in the immediate future periods is expected to decline as compared to recent historic performance.
Net investment income increased $6.82 billion to $9.36 billion in 2008 from the $2.55 billion in 2007. This increase was primarily related to the $7.30 billion increase in the fair values of derivative instruments including those related to hedging programs implemented to mitigate certain risks associated with the GMDB/GMIB features of certain variable annuity contracts and interest rate swap and floor contracts as compared to the $86.6 million increase in 2007. In addition, there was an $18.2 million increase in income from the mortgage loan portfolio. These increases were partially offset by the $292.1 million, $59.9 million, $48.7 million and $22.7 million decreases in investment income related to equity limited partnerships (reflecting unfavorable market conditions), fixed maturities, Separate Accounts surplus and short-term investments, respectively.
In 2008, investment losses totaled $361.2 million as compared to $40.6 million in 2007. The $320.6 million increase primarily resulted from higher writedowns on General Account fixed maturities, $285.9 million in 2008 as compared to $79.0 million in 2007, $75.0 million of losses on sales of fixed maturity securities in 2008 as compared to $23.4 million of gains in 2007 and a $1.6 million loss in 2008 on equity real estate compared to $7.3 million of gains in 2007. The 2008 losses included $143.7 million and $54.1 million in losses on the Insurance segment’s investments in Lehman Brothers Holdings Inc. and Washington Mutual Inc. debt, respectively.
Compensation and benefits for the Insurance segment decreased to $509.6 million in 2008 as compared to $595.4 million in 2007. The $85.8 million decrease was principally related to lower salary expense, incentive compensation and stock compensation plan expenses. Pension plan expenses are expected to increase in 2009 due to the market impact on pension plan assets and the change in the target allocation of pension plan assets.
Interest expense decreased $1.6 million in 2008 as compared to 2007. Due to the issuance of surplus notes in late 2008, interest expense is expected to increase in 2009.
DAC amortization increased to $3.48 billion in 2008, up $2.38 billion from $1.10 billion in 2007. DAC amortization for the Accumulator® products increased $2.1 billion in 2008. In accordance with SFAS No. 97 as amended, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”) and SFAS No. 120 as amended, “Accounting and Reporting by Mutual Life Insurance Enterprises and by Insurance Enterprises for Certain Long-Duration Participating Contracts-an amendment of FASB Statements 60, 97, and 113 and Interpretation No. 40,” current and expected future profit margins for products covered by these standards are examined regularly in determining the amortization of DAC. Due primarily to the significant decline in Separate Accounts balances during 2008 and a change in the estimate of average gross short-term annual return on Separate Accounts balances to 9.0%, future estimated gross profits for certain issue years of the Accumulator® products are expected to be negative as the increases in the fair values of derivatives used to hedge certain risks related to these product are recognized in current earnings while the related reserves do not fully and immediately reflect the impact of equity and interest market fluctuations. As required under U.S. GAAP, for those issue years with future estimated negative gross profits, the DAC amortization method was changed from one based on estimated gross profits to one based on estimated assessments for the Accumulator® products, subject to loss recognition testing. For non-Accumulator® products, DAC amortization increased by $286.0 million principally due to the significant reduction in Separate Accounts balances during 2008 and the unlocking of the estimate regarding Separate Accounts growth that was reduced to 9%. The DAC unlocking impact in 2007 principally related to the recognition of updated assumptions of individual annuity persistency, lower expected future margins on pre-demutualization individual participating annuities and higher estimated future margins due to expectations of life mortality improvements, reduced DAC amortization by $62.5 million.
In addition, projections of future mortality assumptions related to variable and interest-sensitive life products are based on a long-term average of actual experience. This assumption is updated quarterly to reflect recent experience as it emerges. Improvement of life mortality in future periods from that currently projected would result in future deceleration of DAC amortization. Conversely, deterioration of life mortality in future periods from that currently projected would result in future acceleration of DAC amortization. Generally, life mortality experience has been improving in recent years.
Other significant assumptions underlying gross profit estimates relate to contract persistency and General Account investment spread.
DAC capitalization decreased $325.2 million to $1.39 billion in 2008 from $1.72 billion in 2007 principally due to $295.6 million lower first year commissions and a decrease in deferrable operating expenses related to lower sales of variable annuities and interest-sensitive life products.
Revenues. The Investment Management segment’s pre-tax earnings from continuing operations for 2008 were $932.2 million, a decrease of $468.3 million from $1.40 billion the prior year. Revenues totaled $3.54 billion in 2008, a decrease of $1.02 billion from $4.56 billion in 2007, primarily due to a $546.7 million decrease in investment advisory and services fees, $95.0 million lower distribution revenues and $420.4 million lower investment results partially offset by $48.2 million higher institutional research services. Investment advisory and services fees include base fees and performance fees. The 2008 decrease in investment advisory and services fees primarily resulted from lower average AUM in all three distribution channels (Institutional Investment, Retail and Private Client) and a $67.8 million decrease in performance fees from $81.2 million in 2007 to $13.4 million in 2008. The distribution revenue decrease was also due to lower average mutual fund AUM while the institutional research revenues increased due to higher revenues from U.S. operations offset by a decline in Europe. Net investment (losses) income consisted principally of dividend and interest income, offset by interest expense related to customer accounts and collateral received for securities loaned, and realized and unrealized (losses) gains on investments related to deferred compensation plan obligations and other investments. The $287.4 million of net investment losses in 2008 were primarily due to $325.0 million of realized and unrealized losses on trading account securities related to deferred compensation plan obligations in 2008 as compared to $4.8 million in gains in 2007 and lower dividends from the deferred compensation-related investments as well as lower interest earned on stock borrowing and loan activity. Investment gains, net includes non-cash gains resulting from the issuance of AllianceBernstein units to employees in connection with their long-term incentive plans. The 2008 decrease of $10.7 million principally resulted from a $9.9 million non-cash gain in 2008 as compared to the $15.5 million in 2007 and losses on sales of investments.
Expenses. The segment’s total expenses were $2.61 billion in 2008, compared to $3.16 billion in 2007, a decrease of $550.8 million principally due to the $378.2 million and $60.7 million decreases in compensation and benefits and distribution plan payments, respectively. The decrease in AllianceBernstein employee compensation and benefits in 2008 as compared to 2007 resulted as higher compensation costs were more than offset by lower incentive compensation and lower commission expense. The $69.9 million increase in compensation costs were due to higher base compensation, fringe benefits and other employment costs as the result of higher headcount throughout most of 2008 and the $42.7 million in severance and severance-related items due to fourth quarter 2008 workforce reductions, partially offset by lower recruitment costs and lower payroll taxes due to lower incentive compensation. Incentive compensation decreased $370.6 million in 2008 due to lower annual bonus payments and lower deferred compensation expense resulting from mark-to-market losses on related investments. Commission expense decreased $78.4 million in 2008 reflecting lower sales volumes across all distribution channels. The distribution plan payment decrease of $60.7 million to $274.4 million in 2008 resulted from lower average Retail Services assets under management. A decrease of $106.3 million in other operating costs and expenses to $549.1 million was primarily a result of the $35.3 million of insurance recoveries related to a class action claims processing error, lower client transaction errors, incremental foreign exchange gains and lower travel and entertainment expenses in 2008. Rent expense increased $22.5 million due to higher occupancy costs related to office expansion at AllianceBernstein.
Included $36.36 billion and $34.01 billion of assets managed on behalf of AXA affiliates at December 31, 2008 and 2007, respectively. Also included in 2008 and 2007 were $22.9 billion and $19.75 billion, respectively, in assets related to an Australian joint venture between AllianceBernstein and an AXA affiliate.
Third party AUM decreased $321.63 billion to $412.48 billion in 2008 from $734.11 billion in 2007 primarily due to decreases at AllianceBernstein. General Account and other AUM increased $8.88 billion from the total reported in 2007 due to the increase in cash and short-term investments from derivative gains and the proceeds from the issuance of surplus notes in fourth quarter 2008 partially offset by unrealized losses on fixed maturities resulting from the widening of credit spreads and current market conditions. The $29.20 billion decrease in Insurance Group Separate Accounts AUM in 2008 resulted from market depreciation.
AllianceBernstein’s AUM decreased $338.44 billion to $461.95 billion in 2008 from $800.39 billion at December 31, 2007, with $294.2 billion of the decrease resulting from market depreciation due to substantial equity market losses and $44.2 billion due to net asset outflows. Active equity growth and active equity value account AUM, which made up 56.4% of AllianceBernstein’s total AUM at December 31, 2008, decreased by $318.7 million or 55.0%. Net outflows in 2008 were $25.1 billion, $14.4 billion and $4.7 billion, respectively, in the retail, institutional investment and private client channels. Non-U.S. clients accounted for 38.7% of AllianceBernstein’s December 31, 2008 AUM total.
Each of the members of the Insurance Group is subject to the regulatory capital requirements of its place of domicile, which are designed to monitor capital adequacy. The level of an insurer’s required capital is impacted by many factors including, but not limited to, business mix, product design, sales volume, invested assets, liabilities, reserves and movements in the capital markets, including interest rates and equity markets. At December 31, 2008, the total adjusted capital of each of the members of the Insurance Group was in excess of its respective regulatory capital requirements and management believes that the Insurance Group has (or has the ability to meet) the necessary capital resources to support their business. For additional information, see “Item 1 - Business - Regulation” and “Item 1A - Risk Factors”.
Reinsurance. In fourth quarter 2008, as part of its capital management efforts, AXA Equitable ceded Accumulator® variable annuity GMDB and GMIB riders for policies issued from January 1, 2006 through September 30, 2008 to AXA Bermuda, a captive life insurance company established by AXA Financial in 2003. For further information, see Supplemental Information - Reinsurance, below, and Note 11 of Notes to Consolidated Financial Statements contained elsewhere herein.
2008 Borrowings and Loans. On September 23, 2008, AXA Equitable repaid its $350.0 million short-term debt, $101.7 million of which was included in Wind-up Annuities discontinued operations. At December 31, 2008, AXA Equitable had no short-term debt outstanding.
On November 24, 2008 and again on December 15, 2008, AXA Equitable issued $500.0 million of surplus notes to AXA Financial for a total of $1.00 billion. These callable notes, which mature on December 1, 2018, bear interest at the rate of 7.1% per annum. Interest expense in 2009 is expected to be $71.0 million. Payment of interest to AXA Financial on these surplus notes requires the prior approval of the NYID.
2007 Borrowings and Loans. On September 26, 2007, subsidiaries of AXA issued $650.0 million in senior unsecured notes to AXA Equitable. These notes pay interest semiannually on June 30 and December 30 and mature on September 30, 2012.
AXA Equitable’s primary source of short-term liquidity to support continuing and discontinued insurance operations is a pool of liquid, high quality short-term instruments structured to provide liquidity in excess of the expected cash requirements. At December 31, 2008, this asset pool included an aggregate of $1.60 billion in highly liquid short-term investments, as compared to $489.4 at December 31, 2007. In addition, a substantial portfolio of public bonds including U.S. Treasury and agency securities and other investment grade fixed maturities is available to meet AXA Equitable’s liquidity needs.
In recent years, AllianceBernstein completed several transactions involving its domestic and foreign services. During 2008 and 2007, respectively, AllianceBernstein received $18.7 million and $15.8 million in contingent purchase price payments related to the cash management services disposition in 2005.
The Company is involved in a number of ventures and transactions with AXA and certain of its affiliates:
AllianceBernstein provides investment management and related services to AXA, AXA Financial and AXA Equitable and certain of their subsidiaries and affiliates. In 2001, AllianceBernstein entered into joint ventures with AXA Asia Pacific Holdings, Limited, an AXA affiliate, and recognized management fees of $68.3 million, $77.6 million and $61.1 million in 2008, 2007 and 2006, respectively, of which approximately $19.6 million, $22.9 million and $21.3 million, respectively, were from AXA affiliates and $9.7 million, $11.1 million and $8.8 million, respectively, were attributed to minority interest.
Policyholders liabilities represent estimated cash flows out of the General Account related to the payment of death and disability claims, policy surrenders and withdrawals, annuity payments, minimum guarantees on Separate Account funded contracts, matured endowments, benefits under accident and health contracts, policyholder dividends and future renewal premium-based and fund-based commissions offset by contractual future premiums and deposits on in-force contracts. These estimated cash flows are based on mortality, morbidity and lapse assumptions comparable with the Company’s experience and assume market growth and interest crediting consistent with assumptions used in amortizing DAC. These amounts are undiscounted and, therefore, exceed the Policyholders’ account balances and Future policy benefits and other policyholder liabilities included in the consolidated balance sheet included elsewhere herein. They do not reflect projected recoveries from reinsurance agreements. Due to the use of assumptions, actual cash flows will differ from these estimates (see “Critical Accounting Estimates - Future Policy Benefits”). Separate Accounts liabilities have been excluded as they are legally insulated from General Account obligations and will be funded by cash flows from Separate Accounts assets.
Unrecognized tax benefits of $506.6 million including $9.7 million related to AllianceBernstein were not included in the above table because it is not possible to make reasonably reliable estimates of the occurrence or timing of cash settlements with the respective taxing authorities.
Certain of AllianceBernstein’s deferred compensation plans provide for election by participants to have their deferred compensation awards invested notionally in AllianceBernstein Holding units and in company-sponsored mutual funds. Since January 1, 2009, AllianceBernstein made purchases of mutual funds and hedge funds totaling $196 million to fund its future obligations resulting from participant elections with respect to 2008 awards. AllianceBernstein also allocated AllianceBernstein Holding units with an aggregate value of approximately $27 million within its deferred compensation trust to fund its future obligations that resulted from participant elections with respect to 2008 awards. AllianceBernstein issued approximately $1.6 million of new Units. At year-end 2008, AllianceBernstein had a $321.2 million accrual for compensation and benefits, of which $211.4 million is expected to be paid in 2009, $57.3 million in 2010-2011, $25.7 million in 2012-2013 and the rest thereafter. Further, AllianceBernstein expects to make contributions to its qualified profit sharing plan of approximately $25 million in each of the next four years. AllianceBernstein currently expects to contribute an estimated $22 million to its qualified, noncontributory, defined benefit plan during 2009.
In addition, the Company has obligations under contingent commitments at December 31, 2008, including: AllianceBernstein’s revolving credit facility and commercial paper program; the Insurance Group’s $59.8 million undrawn letters of credit; AllianceBernstein’s $125.0 million guarantee on behalf of SCB LLC; and the Company’s guarantees or commitments to provide equity financing to certain limited partnerships of $711.3 million. Information on these contingent commitments can be found in Notes 10, 18 and 19 of Notes to Consolidated Financial Statements.
Reinsurance. In fourth quarter 2008, AXA Equitable ceded Accumulator® variable annuity GMDB and GMIB riders for policies issued from January 1, 2006 through September 30, 2008 to AXA Bermuda, a captive life reinsurance company established by AXA Financial in 2003. AXA Bermuda reinsures level premium term insurance and lapse protection riders under universal life insurance policies issued by AXA Equitable and USFL. For AXA Equitable, the reinsurance transaction provided capital relief and mitigated the volatility of capital requirements.
AXA Bermuda placed $6.3 billion into a Regulation 114 Trust (the “Trust”), to support the reinsurance reserve credit at AXA Equitable. AXA Bermuda intends to hold a combination of assets in the Trust and/or letters of credit equal to the statutory reserves for this business, so that AXA Equitable will be permitted to take reserve credit for the reinsurance. AXA Bermuda may make additional deposits to the Trust, and may remove assets from the Trust, subject to quarterly reserve evaluations.
AXA Bermuda has implemented a dynamic hedging program to mitigate the GMDB/GMIB market risk.
The Company’s management narrative is based upon the Company’s consolidated financial statements that have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires management to make estimates and assumptions (including normal, recurring accruals) that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, the Company evaluates its estimates, including those related to investments, recognition of insurance income and related expenses, DAC, future policy benefits, recognition of Investment Management revenues and related expenses and benefit plan cost. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. The results of such factors form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions or conditions.
Investments - The Company records an investment impairment charge when it believes an investment has experienced a decline in fair value that is other than temporary. Identifying those situations requires management's careful consideration of the facts and circumstances including, but not limited to, the duration and extent to which the fair value has been depressed, the financial condition, cash flows, and near-term earnings potential of the issuer, as well as the Company’s ability and intent to retain the investment to allow sufficient time for any anticipated recovery in fair value. If quoted market prices are not readily available, the basis for measuring fair value may require utilization of other observable inputs such as quoted market prices for similar instruments or in markets that are not active, inputs to model-derived valuations, or unobservable inputs supported by little or no market activity and often requiring significant management or estimation using investment valuation methodologies, such as discounted cash flow analysis.
Future policy benefit liabilities for traditional policies are based on actuarial assumptions as to such factors as mortality, morbidity, persistency, interest and expenses and, in the case of participating policies, expected annual and terminal dividends. Determination of the U.S. GAAP GMDB/GMIB liabilities is based on models that involve numerous estimates and subjective judgments, including those regarding expected market rates of return and volatility, contract surrender rates, mortality experience and, for GMIB, GMIB election rates. Premium deficiency reserves are based upon estimates of future gross premiums, expected policy benefits and other expenses. The allowance for future losses for the discontinued Wind-up Annuities business is based upon numerous estimates and subjective judgments regarding the expected performance of the related investment assets, future asset reinvestment rates and future benefit payments. If the Company’s analysis in any given period indicates that an allowance for future losses is not necessary, any current period Wind-Up Annuities’ operating losses or earnings are recognized as losses/earnings from discontinued operations, net of income taxes in the consolidated statements of earnings.
Recognition of Investment Management Revenues and Related Expenses - The Investment Management segment’s revenues are largely dependent on the total value and composition of assets under management. The most significant factors that could affect this segment’s results include, but are not limited to, the performance of the financial markets and the investment performance and composition of sponsored investment products and separately managed accounts.
Income Taxes - Income taxes represent the net amount of income taxes that the Company expects to pay to or receive from various taxing jurisdictions in connection with its operations. The Company provides for Federal and state income taxes currently payable, as well as those deferred due to temporary differences between the financial reporting and tax bases of assets and liabilities. The Company’s accounting for income taxes represents management’s best estimate of the tax consequences of various events and transactions.
Consolidation - The Company includes in its consolidated financial statements the accounts and activities of AXA Equitable; those of its subsidiaries engaged in insurance related businesses; other subsidiaries, principally AllianceBernstein; and those investment companies, partnerships and joint ventures in which the Company has control and a majority economic interest as well as those VIEs that meet the requirements for consolidation. All significant intercompany transactions and balances have been eliminated in consolidation.