form10q.htm

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q
 
þ   Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the quarterly period ended March 31, 2012
 
OR
 
o  Transition Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the transition period from ________________to ________________
 
Commission file number 001-33364 
Flagstone Reinsurance Holdings, S.A.
(Exact name of registrant as specified in its charter)
 
Luxembourg
 
98-0481623
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)

65 Avenue de la Gare
 L-1611 Luxembourg, Grand Duchy of Luxembourg
(Address of principal executive offices)

+352 273 515 30
(Registrants telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
Common Shares, par value 1 cent per share
Name of exchange on which registered:
New York Stock Exchange
Bermuda Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act: None
 
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  
Yes    þ     No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes    þ    No  
 
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  o    
Accelerated filer þ     
Non-accelerated filer o (Do not check if a smaller reporting company)
Smaller reporting company  o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o       No  þ
 
As of May 4, 2012, the Registrant had 71,058,922 common voting shares outstanding, net of treasury shares with a par value of  $0.01 per share.

 
 

 

FLAGSTONE REINSURANCE HOLDINGS, S.A.
INDEX TO FORM 10-Q

     
Page
 
PART I.    FINANCIAL INFORMATION
   
       
   
       
   
1
       
   
 
2
       
   
 
3
       
   
 
5
       
   
6
       
 
23
       
 
40
       
 
44
       
 
PART II.    OTHER INFORMATION
   
       
 
45
       
 
45
       
 
45
       
 
45
       
 
45
       
 
45
       
 
45
       
 
45

 
 

PART I − FINANCIAL INFORMATION

Item 1. Financial Statements

FLAGSTONE REINSURANCE HOLDINGS, S.A.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(Expressed in thousands of U.S. dollars, except share data)


 
As at March 31,
 
As at December 31,
   
2012
   
2011
ASSETS
         
Investments:
         
Fixed maturity investments, at fair value (Amortized cost: 2012 - $1,113,457; 2011 - $1,135,755)
$
 1,132,101
 
$
 1,138,435
Short term investments, at fair value (Amortized cost: 2012 - $7,475; 2011 - $10,620)
 
 7,473
   
 10,616
Equity investments, at fair value (Amortized cost: 2012 - $249; 2011 - $245)
 
 81
   
 82
Other investments
 
 131,509
   
 125,452
Total investments
 
 1,271,164
   
 1,274,585
Cash and cash equivalents
 
 217,050
   
 249,424
Restricted cash
 
 22,144
   
 17,538
Premium balances receivable
 
 254,948
   
 236,375
Unearned premiums ceded
 
 82,904
   
 30,550
Reinsurance recoverable
 
 251,207
   
 271,183
Accrued interest receivable
 
 9,914
   
 12,950
Receivable for investments sold
 
 4,060
   
 18
Deferred acquisition costs
 
 39,735
   
 38,155
Funds withheld
 
 20,680
   
 25,116
Other assets
 
 120,569
   
 160,950
Assets held for sale including discontinued operations
 
 540,123
   
 461,652
Total assets
$
 2,834,498
 
$
 2,778,496
           
LIABILITIES
         
Loss and loss adjustment expense reserves
$
 849,975
 
$
 897,368
Unearned premiums
 
 242,341
   
 215,316
Insurance and reinsurance balances payable
 
 104,266
   
 75,433
Payable for investments purchased
 
 44,781
   
 6,255
Long term debt
 
 251,088
   
 250,575
Other liabilities
 
 52,702
   
 54,059
Liabilities of discontinued operations held for sale
 
 441,409
   
 472,957
Total liabilities
 
 1,986,562
   
 1,971,963
           
EQUITY
         
Common voting shares, 300,000,000 authorized, $0.01 par value, issued (2012 - 84,464,259; 2011 - 84,464,259) and outstanding (2012 - 71,058,922; 2011 - 70,167,142)
 
 845
   
 845
Common shares held in treasury, at cost (2012 - 13,405,337; 2011 - 14,297,117)
 
 (150,202)
   
 (160,448)
Additional paid-in capital
 
 859,327
   
 872,819
Accumulated other comprehensive loss
 
 (8,255)
   
 (12,584)
Retained earnings
 
 127,601
   
 88,416
Total Flagstone shareholders’ equity
 
 829,316
   
 789,048
Noncontrolling interest in subsidiaries
 
 18,620
   
 17,485
Total equity
 
 847,936
   
 806,533
Total liabilities and equity
$
 2,834,498
 
$
 2,778,496

The accompanying notes to the unaudited condensed consolidated financial statements are an integral part of the unaudited condensed consolidated financial statements.

 

 
1

FLAGSTONE REINSURANCE HOLDINGS, S.A.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
(Expressed in thousands of U.S. dollars, except share and per share data)

 

 
For the three months ended March 31,
 
 
2012
   
2011
 
         
 REVENUES
         
 Gross premiums written  
$
 170,228
 
$
 352,675
 Premiums ceded  
 
 (84,899)
   
 (118,750)
 Net premiums written
 
 85,329
   
 233,925
 Change in net unearned premiums  
 
 28,416
   
 (32,872)
 Net premiums earned
 
 113,745
   
 201,053
 Net investment income
 
 5,067
   
 9,198
 Net realized and unrealized gains - investments
 
 18,103
   
 10,771
 Net realized and unrealized gains (losses) - other
 
 6,383
   
 (690)
 Other income  
 
 2,811
   
 1,132
 Total revenues
 
 146,109
   
 221,464
 
         
 EXPENSES
         
 Loss and loss adjustment expenses  
 
 66,449
   
 302,999
 Acquisition costs
 
 22,653
   
 38,071
 General and administrative expenses
 
 21,860
   
 16,075
 Interest expense
 
 2,958
   
 2,850
 Net foreign exchange losses
 
 4,231
   
 9,603
 Total expenses
 
 118,151
   
 369,598
 Income (loss) from continuing operations before income taxes and interest in earnings of equity investments
 
 27,958
   
 (148,134)
 (Provision) recovery for income tax
 
 (128)
   
 246
 Interest in earnings of equity investments  
 
 18
   
 (285)
 Income (loss) from continuing operations
 
 27,848
   
 (148,173)
 Income (loss) from discontinued operations, net of taxes
 
 12,472
   
 (12,223)
 Net income (loss)
 
 40,320
   
 (160,396)
 Less: Income attributable to noncontrolling interest
 
 (1,135)
   
 (824)
 NET INCOME (LOSS) ATTRIBUTABLE TO FLAGSTONE
$
 39,185
 
$
 (161,220)
 
         
 Net income (loss)
$
 40,320
 
$
 (160,396)
 Change in currency translation adjustment  
 
 4,537
   
 2,877
 Change in defined benefit pension plan obligation
 
 (208)
   
 - 
 Comprehensive income (loss)
 
 44,649
   
 (157,519)
 Less: Comprehensive income attributable to noncontrolling interest
 
 (1,135)
   
 (824)
 COMPREHENSIVE INCOME (LOSS) ATTRIBUTABLE TO FLAGSTONE
$
 43,514
 
$
 (158,343)
 
         
 Weighted average common shares outstanding—Basic
 
 70,678,937
   
 69,351,852
 Weighted average common shares outstanding—Diluted
 
 71,156,700
   
 69,351,852
 Income (loss) from continuing operations per common share—Basic
$
 0.38
 
$
 (2.15)
 Income (loss) from discontinued operations per common share—Basic
$
 0.17
 
$
 (0.17)
 Net income (loss) attributable to Flagstone per common share—Basic
$
 0.55
 
$
 (2.32)
 Income (loss) from continuing operations per common share—Diluted
$
 0.38
 
$
 (2.15)
 Income (loss) from discontinued operations per common share—Diluted
$
 0.17
 
$
 (0.17)
 Net income (loss) attributable to Flagstone per common share—Diluted
$
 0.55
 
$
 (2.32)
 Distributions declared per common share
$
 0.04
 
$
 0.04
 
         

The accompanying notes to the unaudited condensed consolidated financial statements are an integral part of the unaudited condensed consolidated financial statements.

 

 
2


FLAGSTONE REINSURANCE HOLDINGS, S.A.
(Expressed in thousands of U.S. dollars)
                                         
       
 Flagstone Shareholders' Equity
     
For the three months ended March 31, 2012
 Total equity
 
 Retained earnings
 
 Accumulated other comprehensive loss
 
 Common voting shares
   
Treasury shares
 
 Additional paid-in capital
 
 Noncontrolling interest in subsidiaries
                                         
Beginning balance
$
 806,533
 
$
 88,416
 
$
 (12,584)
 
$
 845
 
$
 (160,448)
 
$
 872,819
 
$
 17,485
Net income
 
 40,320
   
 39,185
                           
 1,135
Change in currency translation adjustment
 
 4,537
         
 4,537
                       
Defined benefit pension plan obligation
 
 (208)
         
 (208)
                       
Stock based compensation
 
 950
                           
 950
     
Stock compensation exercised from treasury
 
 - 
                     
 10,246
   
 (10,246)
     
Distributions declared per common share
 
 (2,842)
                           
 (2,842)
     
Other
 
 (1,354)
                           
 (1,354)
     
Ending balance
$
 847,936
 
$
 127,601
 
$
 (8,255)
 
$
 845
 
$
 (150,202)
 
$
 859,327
 
$
 18,620
                                         

The accompanying notes to the unaudited condensed consolidated financial statements are an integral part of the unaudited condensed consolidated financial statements.

 

 
3



FLAGSTONE REINSURANCE HOLDINGS, S.A.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
(Expressed in thousands of U.S. dollars)
                                         
       
 Flagstone Shareholders' Equity
     
For the three months ended March 31, 2011
 Total equity
 
 Retained earnings
 
 Accumulated other comprehensive loss
 
 Common voting shares
   
Treasury shares
 
 Additional paid-in capital
 
 Noncontrolling interest in subsidiaries
                                         
Beginning balance
$
 1,196,595
 
$
 414,549
 
$
 (6,178)
 
$
 845
 
$
 (178,718)
 
$
 904,235
 
$
 61,862
Redemption of preferred shares
 
 (46,488)
                                 
 (46,488)
Net loss
 
 (160,396)
   
 (161,220)
                           
 824
Change in currency translation adjustment
 
 2,877
         
 2,877
                       
Stock based compensation
 
 (3,005)
                           
 (3,005)
     
Stock compensation exercised from treasury
 
 - 
                     
 16,572
   
 (16,572)
     
Distributions declared per common share
 
 (2,801)
                           
 (2,801)
     
Other
 
 (1,791)
                           
 (1,791)
     
Ending balance
$
 984,991
 
$
 253,329
 
$
 (3,301)
 
$
 845
 
$
 (162,146)
 
$
 880,066
 
$
 16,198
                                         

The accompanying notes to the unaudited condensed consolidated financial statements are an integral part of the unaudited condensed consolidated financial statements.

 

 
4


FLAGSTONE REINSURANCE HOLDINGS, S.A.
 (Expressed in thousands of U.S. dollars)
           
 
For the three months ended March 31,
   
2012
   
2011
           
Cash flows provided by (used in) operating activities:
         
Net income (loss)
$
 40,320
 
$
 (160,396)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
       
Net realized and unrealized gains
 
 (25,902)
   
 (10,214)
Net unrealized foreign exchange losses
 
 6,158
   
 1,683
Depreciation and amortization expense
 
 980
   
 1,637
Share based compensation expense (recovery)
 
 950
   
 (3,005)
Interest in earnings of equity investments
 
 (18)
   
 285
Accretion/amortization on fixed maturity investments
 
 2,863
   
 1,110
Changes in assets and liabilities, excluding net assets acquired:
         
Premium balances receivable
 
 (29,042)
   
 (120,238)
Unearned premiums ceded
 
 (63,752)
   
 (78,795)
Reinsurance recoverable
 
 16,132
   
 (61,430)
Deferred acquisition costs
 
 (3,698)
   
 (8,061)
Funds withheld
 
 4,440
   
 684
Loss and loss adjustment expense reserves
 
 (42,843)
   
 324,560
Unearned premiums
 
 38,272
   
 114,200
Insurance and reinsurance balances payable
 
 31,117
   
 58,692
Other changes in assets and liabilities, net
 
 (13,293)
   
 (18,744)
Net cash (used in) provided by operating activities
 
 (37,316)
   
 41,968
           
Cash flows (used in) provided by investing activities:
         
Purchases of fixed maturity investments
 
 (345,343)
   
 (308,812)
Sales and maturities of fixed maturity investments
 
 420,981
   
 394,147
Purchases of other investments
 
 (1,418)
   
 (3,486)
Sales and maturities of other investments
 
 (2,115)
   
 (9,068)
Purchases of fixed assets
 
 (1,621)
   
 (2,246)
Sales of fixed asset
 
 39
   
 - 
Change in restricted cash
 
 (70,011)
   
 (12,458)
Net cash provided by investing activities
 
 512
   
 58,077
           
Cash flows (used in) provided by financing activities:
         
Repurchase of noncontrolling interest
 
 - 
   
 (46,488)
Distributions paid per common share
 
 (2,842)
   
 (2,801)
Other
 
 (1,292)
   
 (361)
Net cash used in financing activities
 
 (4,134)
   
 (49,650)
           
Effect of foreign exchange rate on cash
 
 (892)
   
 990
           
(Decrease) increase in cash and cash equivalents
 
 (41,830)
   
 51,385
Decrease (increase) in cash and cash equivalents from discontinued operations
 
 9,456
   
 (17,117)
Cash and cash equivalents - beginning of year
 
 249,424
   
 223,033
Cash and cash equivalents - end of period
$
 217,050
 
$
 257,301
           
Supplemental cash flow information:
         
Receivable for investments sold
$
 4,060
 
$
 75,574
Payable for investments purchased
$
 44,781
 
$
 18,919
Interest paid
$
 2,450
 
$
 2,318
           

The accompanying notes to the unaudited condensed consolidated financial statements are an integral part of the unaudited condensed consolidated financial statements.

 

 
5

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)



1.    ORGANIZATION

Flagstone Reinsurance Holdings, S.A. (“Flagstone” or the “Company”) is a holding company incorporated as a société anonyme under the laws of Luxembourg. On May 14, 2010, the Company’s shareholders approved the redomestication to change the Company’s jurisdiction of incorporation from Bermuda to Luxembourg and the Company thereby discontinued its existence as a Bermuda company as provided in Section 132G of The Companies Act 1981 of Bermuda and continued its existence as a société anonyme under the laws of Luxembourg effective May 17, 2010 (the “Redomestication”).  As a result of the Redomestication, the Company changed its name from Flagstone Reinsurance Holdings Limited to Flagstone Reinsurance Holdings, S.A. The Company was originally incorporated on October 4, 2005 under the laws of Bermuda.

On October 24, 2011, the Company announced its plans to undertake a number of strategic initiatives, including its decision to divest its ownership positions in its former Lloyd’s and Island Heritage reportable segments in order to address changing business conditions, refocus the Company’s underwriting strategy on its property catastrophe reinsurance business and reduce its focus on reportable segments that absorb capital and produce lower returns. As part of this strategy, the Company is adjusting its geographic diversification in order to decrease the threat of frequency risk

The Company has classified the assets and liabilities associated with its former Lloyd’s and Island Heritage reportable segments as held for sale and the associated financial results have been presented in the Company’s consolidated financial statements as “discontinued operations” for all periods presented. See Note 4 “Assets Held for Sale and Discontinued Operations” for more information.

2.    BASIS OF PRESENTATION AND CONSOLIDATION
 
These unaudited condensed consolidated financial statements include the accounts of Flagstone and its wholly owned subsidiaries, including Flagstone Réassurance Suisse S.A. (“Flagstone Suisse”), and have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements.  References in this Quarterly Report on Form 10-Q (this “Quarterly Report”) to “dollars” or “$” are to the lawful currency of the United States of America (the “U.S.”), unless the context otherwise requires.  All amounts in the following tables are expressed in thousands of U.S. dollars, except share amounts, per share amounts, percentages or unless otherwise stated. References in this Quarterly Report to (i) “foreign currency” are to currencies other than U.S. dollars and (ii) “foreign exchange” transactions or “foreign investments” are to transactions or investments, respectively, involving currencies other than U.S. dollars, in each case unless the context otherwise requires.  References in this Quarterly Report to “foreign subsidiaries” are to subsidiaries of Flagstone that are not domiciled in the U.S. or whose primary transactions are in foreign currency.  These unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiaries, including those that meet the consolidation requirements of variable interest entities (“VIEs”).  The Company assesses the consolidation of VIEs based on whether the Company is the primary beneficiary of the entity in accordance with the Consolidation Topic of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”).  Entities in which the Company has an ownership of more than 20% and less than 50% of the voting shares are accounted for using the equity method.  All inter-company accounts and transactions have been eliminated on consolidation, except as otherwise required under discontinued operations treatment.

Except as discussed in Note 4 “Assets Held for Sale and Discontinued Operations” and unless otherwise noted, the notes to the unaudited condensed consolidated financial statements reflect the Company’s continuing operations.  These financial statements contain certain reclassifications of prior period amounts to be consistent with the current period presentation with no effect on net income or loss.

The preparation of these unaudited condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the disclosed amounts of assets and liabilities and 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.  Actual results could differ from those estimates.  The Company's principal estimates are for loss and loss adjustment expenses (“LAE”), estimates of premiums written, premiums earned, acquisition costs, fair value of investments and share based compensation.  The Company reviews and revises these estimates as appropriate based on current information. Any adjustments made to these estimates are reflected in the period the estimates are revised.

 
6

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)



In the opinion of management, these unaudited condensed consolidated financial statements reflect all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the Company’s financial position and results of operations as at the end of and for the periods presented.  The results of operations and cash flows for any interim period will not necessarily be indicative of the results of operations and cash flows for the full fiscal year or subsequent quarters. This Quarterly Report should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011 (the “2011 Annual Report”), filed with the Securities and Exchange Commission (“SEC”) on March 13, 2012.

3.    NEW ACCOUNTING PRONOUNCEMENTS
 

The Company describes its significant accounting policies in the 2011 Annual Report. There has been no change to our significant accounting policies since December 31, 2011.
 
 
4.    ASSETS HELD FOR SALE AND DISCONTINUED OPERATIONS
 

On October 24, 2011, the Company announced its plan to undertake a number of strategic initiatives designed to realign the Company’s strategy and core capabilities.  As a result of this realignment, the Company has commenced a formal process to divest its ownership positions in its former Lloyd’s and Island Heritage reportable segments.  The sale of our ownership position in Island Heritage was completed on April 5, 2012, for total proceeds of approximately $68.0 million, of which the Company received approximately $40.8 million for its approximate 60% interest, which is subject to a purchase price adjustment based on a final March 31, 2012 balance sheet. The divestiture will be recorded in the second quarter results. On April 3, 2012, the Company announced that it had entered into a definitive agreement to divest its former Lloyd’s reportable segment for total proceeds of approximately $48.0 million. The Lloyd’s divestiture is expected to be complete by the end of the second quarter of 2012, subject to the satisfaction of regulatory approvals and certain other customary closing conditions and subject to a purchase price adjustment based on a final March 31, 2012 balance sheet.
 
The Company has classified the assets and liabilities associated with its former Lloyd’s and island Heritage reportable segments as held for sale and the assets and liabilities have been recorded at the lower of the carrying value or fair value less costs to sell. The financial results for these operations have been presented as discontinued operations in the Company’s consolidated statements of operations for all periods presented.
 
The Company does not anticipate losses on these divestitures.
 
 

 
7

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)



Details of the assets and liabilities of discontinued operations held for sale as at March 31, 2012 and December 31, 2011 are as follows:

   
As at March 31,
 
As at December 31,
   
2012
 
2011
Assets of discontinued operations held for sale
           
Fixed maturity investments, at fair value
 
$
 91,804
 
$
 94,422
Short term investments, at fair value
   
 1,400
   
 4,444
Total investments
   
 93,204
   
 98,866
Cash and cash equivalents
   
 82,338
   
 91,794
Restricted cash
   
 95,712
   
 30,307
Premium balances receivable
   
 110,079
   
 99,075
Unearned premiums ceded
   
 38,440
   
 27,042
Reinsurance recoverable
   
 21,831
   
 17,934
Deferred acquisition costs
   
 29,160
   
 26,949
Goodwill and intangible assets
   
 45,159
   
 44,161
Other assets
   
 14,518
   
 15,836
Total assets of discontinued operations held for sale
 
$
 530,441
 
$
 451,964
             
Liabilities of discontinued operations held for sale
           
Loss and loss adjustment expense reserves
 
$
 240,335
 
$
 233,290
Unearned premiums
   
 154,466
   
 142,713
Insurance and reinsurance balances payable
   
 29,827
   
 27,400
Amounts due to affiliates
   
 - 
   
 46,682
Other liabilities
   
 16,781
   
 22,872
Total liabilities of discontinued operations held for sale
 
$
 441,409
 
$
 472,957
             
Net assets (liabilities) of discontinued operations held for sale
 
$
 89,032
 
$
 (20,993)

The increase in net assets of discontinued operations during the quarter ended March 31, 2012, is primarily the result of amounts due to affiliates being capitalized and letters of credit being extinguished by placing funds directly with Lloyd’s of London.
 

The Company has reclassified the results of operations of the discontinued operations to income (loss) from discontinued operations in its consolidated statements of operations.  Details of the income from discontinued operations for the three months ended March 31, 2012 and 2011 are as follows:
   
For the three months ended March 31,
   
2012
 
2011
Revenues
           
Gross premiums written
 
$
 86,925
 
$
 69,476
Premiums ceded
   
 (27,866)
   
 (21,241)
Net premiums written
   
 59,059
   
 48,235
Net premiums earned
 
$
 59,163
 
$
 49,437
Other reinsurance income
   
 122
   
 3,943
Loss and loss adjustment expenses
   
 (24,430)
   
 (46,750)
Acquisition costs
   
 (13,867)
   
 (13,684)
General and administrative expenses
   
 (9,372)
   
 (9,018)
Underwriting income (loss)
   
 11,616
   
 (16,072)
Other income (expenses)
   
 722
   
 (537)
Recovery for income tax
   
 134
   
 4,386
Income (loss) from discontinued operations
 
$
 12,472
 
$
 (12,223)


 
8

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




Assets held for sale

During the year ended December 31, 2011, the Company decided to dispose of its one remaining aircraft as well as corporate apartments, which will no longer be required due to the divestiture plans discussed above. These assets are reflected in assets held for sale including discontinued operations on the consolidated balance sheet as at March 31, 2012, at a carrying value of $9.7 million. The sale of the corporate apartments was completed on April 13, 2012, for total proceeds of approximately $1.3 million and will be recorded in the second quarter results. The Company does not anticipate a significant gain or loss on disposal of these assets.


5.       INVESTMENTS

Fixed maturity, short term, equity and other investments

The amortized cost or cost, gross unrealized gains and losses, and fair values as at March 31, 2012 and December 31, 2011 are as follows:

   
As at March 31, 2012
 
 Amortized cost or cost
 
 Gross unrealized gains
 
 Gross unrealized losses
 
 Fair value
Fixed maturity investments
                     
U.S. government and agency securities
$
 313,078
 
$
 5,249
 
$
 (97)
 
$
 318,230
Other foreign governments
 
 75,685
   
 2,196
   
 (396)
   
 77,485
Corporates
 
 390,884
   
 13,565
   
 (1,729)
   
 402,720
Mortgage-backed securities
 
 181,218
   
 1,837
   
 (2,844)
   
 180,211
Asset-backed securities
 
 152,592
   
 1,172
   
 (309)
   
 153,455
   
 1,113,457
   
 24,019
   
 (5,375)
   
 1,132,101
                       
Short term investments
                     
Corporates
 
 7,475
   
 - 
   
 (2)
   
 7,473
   
 7,475
   
 - 
   
 (2)
   
 7,473
                       
Equity investments
 
 249
   
 - 
   
 (168)
   
 81
   
 249
   
 - 
   
 (168)
   
 81
                       
Other investments
                     
Investment funds
 
 68,964
   
 4,033
   
 (6,490)
   
 66,507
Catastrophe bonds
 
 63,000
   
 148
   
 (321)
   
 62,827
   
 131,964
   
 4,181
   
 (6,811)
   
 129,334
                       
 Totals
$
 1,253,145
 
$
 28,200
 
$
 (12,356)
 
$
 1,268,989


 
9

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




   
As at December 31, 2011
 
 Amortized cost or cost
 
 Gross unrealized gains
 
 Gross unrealized losses
 
 Fair value
Fixed maturity investments
                     
U.S. government and agency securities
$
 320,666
 
$
 3,352
 
$
 (237)
 
$
 323,781
Other foreign governments
 
 102,116
   
 7,874
   
 (475)
   
 109,515
Corporates
 
 471,025
   
 11,362
   
 (10,041)
   
 472,346
Mortgage-backed securities
 
 182,610
   
 384
   
 (7,904)
   
 175,090
Asset-backed securities
 
 59,338
   
 7
   
 (1,642)
   
 57,703
   
 1,135,755
   
 22,979
   
 (20,299)
   
 1,138,435
                       
Short term investments
                     
U.S. government and agency securities
 
 3,023
   
 1
   
 (1)
   
 3,023
Other foreign governments
 
 496
   
 - 
   
 - 
   
 496
Corporates
 
 7,101
   
 - 
   
 (4)
   
 7,097
   
 10,620
   
 1
   
 (5)
   
 10,616
                       
Equity investments
 
 245
   
 - 
   
 (163)
   
 82
   
 245
   
 - 
   
 (163)
   
 82
                       
Other investments
                     
Investment funds
 
 67,661
   
 - 
   
 (8,383)
   
 59,278
Catastrophe bonds
 
 63,000
   
 1,016
   
 - 
   
 64,016
   
 130,661
   
 1,016
   
 (8,383)
   
 123,294
                       
Totals
$
 1,277,281
 
$
 23,996
 
$
 (28,850)
 
$
 1,272,427

Other investments do not include an investment accounted for under the equity method in which the Company has significant influence and accordingly, is not accounted for at fair value under the FASB ASC guidance for financial instruments.  This investment was recorded at $2.2 million at both March 31, 2012 and December 31, 2011.

 
10

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




The country composition of the other foreign government classifications including the amortized cost or cost, gross unrealized gains and losses, and fair values as at March 31, 2012 and December 31, 2011 are as follows:
                             
       
As at March 31, 2012
         
Amortized
   
Gross unrealized
   
Gross unrealized
   
Fair
         
cost or cost
   
gains
   
losses
   
value
Other foreign governments
                       
Sovereign Debt
                       
 
Eurozone
                       
   
Portugal, Ireland, Italy, Greece & Spain
 
$
 - 
 
$
 - 
 
$
 - 
 
$
 - 
 
Other (excluding Eurozone)
   
 47,442
   
 1,297
   
 (357)
   
 48,382
         
 47,442
   
 1,297
   
 (357)
   
 48,382
                             
Financial institutions
                       
 
Eurozone
                       
   
Portugal, Ireland, Italy, Greece & Spain
   
 - 
   
 - 
   
 - 
   
 - 
   
Other
   
 3,013
   
 - 
   
 (20)
   
 2,993
 
Total
   
 3,013
   
 - 
   
 (20)
   
 2,993
 
Other (excluding Eurozone)
   
 25,230
   
 899
   
 (19)
   
 26,110
         
 28,243
   
 899
   
 (39)
   
 29,103
                             
Totals
 
$
 75,685
 
$
 2,196
 
$
 (396)
 
$
 77,485

       
As at December 31, 2011
         
Amortized
   
Gross unrealized
   
Gross unrealized
   
Fair
         
cost or cost
   
gains
   
losses
   
value
Other foreign governments
                       
Sovereign debt
                       
 
Eurozone
                       
   
Portugal, Ireland, Italy, Greece & Spain
 
$
 - 
 
$
 - 
 
$
 - 
 
$
 - 
 
Other (excluding Eurozone)
   
 49,667
   
 4,527
   
 (46)
   
 54,148
         
 49,667
   
 4,527
   
 (46)
   
 54,148
                             
Financial institutions
                       
 
Eurozone
                       
   
Portugal, Ireland, Italy, Greece & Spain
   
 - 
   
 - 
   
 - 
   
 - 
   
Other
   
 7,740
   
 149
   
 (403)
   
 7,486
 
Total
   
 7,740
   
 149
   
 (403)
   
 7,486
 
Other (excluding Eurozone)
   
 45,205
   
 3,198
   
 (26)
   
 48,377
         
 52,945
   
 3,347
   
 (429)
   
 55,863
                             
Totals
 
$
 102,612
 
$
 7,874
 
$
 (475)
 
$
 110,011


 
11

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




The following table presents the contractual maturity dates of fixed maturity and short term investments and their respective amortized cost and fair values as at March 31, 2012 and December 31, 2011.
                       
 
As at March 31, 2012
 
As at December 31, 2011
 
 Amortized cost
 
 Fair value
 
 Amortized cost
 
 Fair value
                       
 Due within one year
$
 11,352
 
$
 11,638
 
$
 29,294
 
$
 29,663
 Due after 1 through 5 years
 
 740,782
   
 759,018
   
 746,610
   
 754,709
 Due after 5 through 10 years
 
 26,400
   
 26,477
   
 106,287
   
 107,461
 Due after 10 years
 
 8,588
   
 8,775
   
 22,236
   
 24,425
 Mortgage and asset-backed securities
 
 333,810
   
 333,666
   
 241,948
   
 232,793
 Total
$
 1,120,932
 
$
 1,139,574
 
$
 1,146,375
 
$
 1,149,051

Actual maturities may differ from contractual maturities because certain borrowers have the right to prepay certain obligations with or without prepayment penalties.

The following table presents a breakdown of the credit quality of the Company's fixed maturity and short term investments as at March 31, 2012 and December 31, 2011:
                       
 
As at March 31, 2012
 
As at December 31, 2011
 
Fair value
 
Percentage of total
 
Fair value
 
Percentage of total
Rating Category
                     
AAA
$
 732,603
 
64.3
%
 
$
 695,931
 
60.6
%
AA
 
 115,641
 
10.1
%
   
 92,299
 
8.0
%
A
 
 194,924
 
17.1
%
   
 231,143
 
20.1
%
BBB
 
 96,406
 
8.5
%
   
 129,678
 
11.3
%
Total
$
 1,139,574
 
100.0
%
 
$
 1,149,051
 
100.0
%

The Company has included credit rating information with respect to the Company’s investment portfolio to supplement the reader’s understanding of its composition and the consistency of the Company’s investment portfolio with the Company’s investment philosophy.

Fair value disclosure

The valuation technique used to determine the fair value of the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets.  

In accordance with the Fair Value Measurements and Disclosures Topic of the FASB ASC, the Company has classified its investments in U.S. government treasury securities and listed equity securities as Level 1 in the fair value hierarchy.  The fair value of these securities is the quoted market price of these securities, as provided either by independent pricing services or exchange market prices.

Investments in U.S. government agency securities, corporate bonds, mortgage-backed securities, foreign government bonds and asset-backed securities are classified as Level 2 in the fair value hierarchy.  The fair value of these securities is derived from broker quotes based on inputs that are observable for the asset, either directly or indirectly, such as yield curves and transactional history. Catastrophe bonds are classified as Level 2 in the fair value hierarchy as determined by reference to independent pricing services.  Those indications are based on current market conditions, including liquidity and transactional history, recent issue price of similar catastrophe bonds and seasonality of the underlying risks.

Investments in investment funds are classified as Level 3 in the fair value hierarchy.  The fair value of the private equity funds is determined by the investment fund managers using the net asset value provided by the administrator or manager of the funds and adjusted based on analysis and discussions with the fund managers.  The fair value of the mortgage-backed and distressed debt investment funds is determined by the net asset valuation provided by the independent administrator of the fund.  These valuations are then adjusted for cash flows since the most recent valuation, which is a methodology generally employed in the investment industry. 

 
12

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




As at March 31, 2012 and December 31, 2011, the Company’s investments are allocated among fair value levels as follows:
 
 
Fair Value Measurement at March 31, 2012 using:
       
Quoted prices in
 
Significant other
 
Significant other
 
Fair value
 
active markets
 
observable inputs
 
unobservable inputs
 
measurements
 
(Level 1)
 
(Level 2)
 
(Level 3)
Fixed maturity investments
                     
U.S. government and agency securities
$
 318,230
 
$
 265,652
 
$
 52,578
 
$
 - 
Other foreign governments
 
 77,485
   
 - 
   
 77,485
   
 - 
Corporates
 
 402,720
   
 - 
   
 402,720
   
 - 
Residential mortgage-backed securities
 
 180,211
   
 - 
   
 180,211
   
 - 
Asset-backed securities
 
 153,455
   
 - 
   
 153,455
   
 - 
   
 1,132,101
   
 265,652
   
 866,449
   
 - 
                       
Short term investments
                     
Corporates
 
 7,473
   
 - 
   
 7,473
   
 - 
   
 7,473
   
 - 
   
 7,473
   
 - 
                       
Equity investments
                     
Financial services
 
 81
   
 81
   
 - 
   
 - 
   
 81
   
 81
   
 - 
   
 - 
                       
Other investments
                     
Investment funds
 
 66,507
   
 - 
   
 - 
   
 66,507
Catastrophe bonds
 
 62,827
   
 - 
   
 62,827
   
 - 
   
 129,334
   
 - 
   
 62,827
   
 66,507
                       
Totals
$
 1,268,989
 
$
 265,733
 
$
 936,749
 
$
 66,507


 
13

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




 
Fair Value Measurement at December 31, 2011 using:
       
Quoted prices in
 
Significant other
 
Significant other
 
Fair value
 
active markets
 
observable inputs
 
unobservable inputs
 
measurements
 
(Level 1)
 
(Level 2)
 
(Level 3)
Fixed maturity investments
                     
U.S. government and agency securities
$
 323,781
 
$
 264,096
 
$
 59,685
 
$
 - 
Other foreign government
 
 109,515
   
 - 
   
 109,515
   
 - 
Corporates
 
 472,346
   
 - 
   
 472,346
   
 - 
Residential mortgage-backed securities
 
 175,090
   
 - 
   
 175,090
   
 - 
Asset-backed securities
 
 57,703
   
 - 
   
 57,703
   
 - 
   
 1,138,435
   
 264,096
   
 874,339
   
 - 
                       
Short term investments
                     
U.S. government and agency securities
 
 3,023
   
 - 
   
 3,023
   
 - 
Other foreign government
 
 496
   
 - 
   
 496
   
 - 
Corporates
 
 7,097
   
 - 
   
 7,097
   
 - 
   
 10,616
   
 - 
   
 10,616
   
 - 
                       
Equity investments
                     
Financial services
 
 82
   
 82
   
 - 
   
 - 
   
 82
   
 82
   
 - 
   
 - 
                       
Other investments
                     
Investment funds
 
 59,278
   
 - 
   
 - 
   
 59,278
Catastrophe bonds
 
 64,016
   
 - 
   
 64,016
   
 - 
   
 123,294
   
 - 
   
 64,016
   
 59,278
                       
Totals
$
 1,272,427
 
$
 264,178
 
$
 948,971
 
$
 59,278

Other investments do not include an investment accounted for under the equity method in which the Company has significant influence and accordingly, is not accounted for at fair value under the FASB ASC guidance for financial instruments.  This investment was recorded at $2.2 million at both March 31, 2012 and December 31, 2011.

The reconciliation of the fair value for the Level 3 investments for the period ended March 31, 2012, including purchases and sales and change in realized and unrealized gains (losses) in earnings, is set out below:
       
     
For the three months ended
     
March 31, 2012
       
Fair value, December 31, 2011
 
$
 59,278
Total realized losses included in earnings
   
 - 
Total unrealized gains included in earnings
   
 5,926
Purchases
   
 1,420
Sales
   
 (117)
Fair value, March 31, 2012
 
$
 66,507

For the Level 3 items still held as of March 31, 2012, the total change in fair value for the three months ended March 31, 2012 was $5.9 million.  Transfers between levels, if necessary, are done as of the actual date of the event or change in circumstance that caused the transfer.  There were no transfers between levels during the three months ended March 31, 2012.

Other investments

The Catastrophe bonds pay a variable and fixed interest coupon and generate investment return, and their performance is contingent upon climatological and geological events. 

 
14

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




The Company’s investment funds consist of investments in private equity, distressed debt and mortgage-backed investment funds.  As at March 31, 2012 and December 31, 2011, the Company had total outstanding investment commitments of $9.3 million and $10.7 million, respectively. Redemptions from these investments occur at the discretion of the general partner, board of directors or, in other cases, subject to a majority vote by the investors. The Company is not able to redeem a significant portion of these investments prior to 2017.
 
The following table presents the fair value of the Company’s investment funds as at March 31, 2012 and December 31, 2011:

   
As at
   
March 31, 2012
 
December 31, 2011
             
Distressed debt funds
 
$
 17,606
 
$
 14,876
Mortgage-backed funds
   
 38,553
   
 33,789
Private equity funds
   
 10,348
   
 10,613
Total
 
$
 66,507
 
$
 59,278

Pledged assets

The Company holds cash and cash equivalents and fixed maturity investments that were deposited or pledged in favor of ceding companies and other counterparties or government authorities to comply with reinsurance contract provisions, Lloyd’s of London requirements and insurance laws.

The total amount of such deposited or pledged cash and cash equivalents and fixed maturity investments as at March 31, 2012 and December 31, 2011 are as follows:

   
As at
   
March 31, 2012
 
December 31, 2011
             
Cash and cash equivalents
 
$
 22,144
 
$
 17,538
Fixed maturity investments
   
 648,236
   
 659,243
Total
 
$
 670,380
 
$
 676,781

6.       DERIVATIVES

The Company accounts for its derivative instruments using the Derivatives and Hedging Topic of the FASB ASC, which requires an entity to recognize all derivative instruments as either assets or liabilities on the balance sheet and measure those instruments at fair value, with the fair value recorded in other assets or liabilities.  The accounting for realized and unrealized gains and losses associated with changes in the fair value of derivatives depends on the hedge designation and, if designated as a hedging instrument, whether the hedge is effective in achieving offsetting changes in the fair value of the asset or liability being hedged.  The realized and unrealized gains and losses on derivatives not designated as hedging instruments are included in net realized and unrealized gains and losses in the consolidated financial statements.  Gains and losses associated with changes in fair value of the designated hedge instruments are recorded with the gains and losses on the hedged items, to the extent that the hedge is effective.  

The Company enters into derivative instruments such as interest rate futures contracts, foreign currency forward contracts and currency swaps in order to manage portfolio duration and interest rate risk, borrowing costs and foreign currency exposure.  The Company enters into index futures contracts to gain exposure to the underlying asset or index and enters into foreign currency forward contracts and foreign currency futures contracts to gain exposure to currency movements against the U.S. dollar. The Company also purchases “to be announced” mortgage-backed securities (“TBAs”) as part of its investing activities.  The Company manages the exposure to these instruments in accordance with guidelines established by management and approved by the Company’s Board of Directors (the “Board”).


 
15

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




The Company has entered into certain foreign currency forward contracts for the purpose of hedging its net investments in foreign subsidiaries, and has designated these as hedging instruments.  These foreign currency forward contracts are carried at fair value and the realized and unrealized gains and losses are recorded in other comprehensive income as part of the cumulative translation adjustment, to the extent that these are effective as hedges.  All other derivatives are not designated as hedges, and accordingly, these instruments are carried at fair value, with the fair value recorded in other assets or liabilities with the corresponding realized and unrealized gains and losses included in net realized and unrealized gains and losses.

The details of the derivatives held by the Company as at March 31, 2012 and December 31, 2011 are as follows:
                         
   
As at March 31, 2012
   
Asset derivatives
 
Liability derivatives
           
   
record in
 
recorded in
           
   
other assets
 
other liabilities
 
Total derivatives
   
Fair value
 
Fair value
 
Net notional exposure
 
Fair value
         
Derivatives designated as hedging instruments
                     
 
Foreign currency forward contracts(1)
$
 - 
 
$
 243
 
$
 55,041
 
$
 (243)
     
 - 
   
 243
         
 (243)
                         
Derivatives not designated as hedging instruments
                 
 
Purpose - risk management
                     
 
Currency swaps
$
 - 
 
$
 571
 
$
 17,335
 
$
 (571)
 
Foreign currency forward contracts
 
 14,439
   
 16,011
   
 715,288
   
 (1,572)
     
 14,439
   
 16,582
         
 (2,143)
 
Purpose - exposure
                     
 
Foreign currency forward contracts
$
 87
 
$
 49
 
$
 7
 
$
 38
     
 87
   
 49
         
 38
                         
     
 14,526
   
 16,631
         
 (2,105)
                         
Total derivatives
$
 14,526
 
$
 16,874
       
$
 (2,348)


 
16

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




   
As at December 31, 2011
   
Asset derivatives
recorded in
other assets
 
Liability derivatives
recorded in
other liabilities
 
Total derivatives
   
Fair value
 
Fair value
 
Net notional exposure
 
Fair value
         
Derivatives designated as hedging instruments
                     
 
Foreign currency forward contracts (1)
$
 - 
 
$
 498
 
$
 51,564
 
$
 (498)
     
 - 
   
 498
         
 (498)
                         
Derivatives not designated as hedging instruments
                 
 
Purpose - risk management
                     
 
Currency swaps
$
 - 
 
$
 999
 
$
 16,825
 
$
 (999)
 
Foreign currency forward contracts
 
 15,196
   
 7,685
   
 648,556
   
 7,511
 
Futures contracts
 
 - 
   
 4,820
   
 426,362
   
 (4,820)
     
 15,196
   
 13,504
         
 1,692
 
Purpose - exposure
                     
 
Futures contracts
$
 - 
 
$
 206
 
$
 7,685
 
$
 (206)
 
Foreign currency forward contracts
 
 7
   
 - 
   
 4,993
   
 7
     
 7
   
 206
         
 (199)
                         
     
 15,203
   
 13,710
         
 1,493
                         
Total derivatives
$
 15,203
 
$
 14,208
       
$
 995

 Designated
                           
  
 
Amount of Gain or (Loss) on Derivatives Recognized in
  
 
Comprehensive income (loss)
     
Net income (loss)
  
 
(Effective portion)
     
(Ineffective portion)
 Derivatives designated
as hedging instruments
 
For the three months ended March 31,
     
For the three months ended March 31,
  
   
2012
   
2011
 
Location
   
2012
   
2011
 Foreign currency forward contracts(1)
 
$
 (2,159)
 
$
 (1,209)
 
Net realized and unrealized gains (losses) - other
 
$
 34
 
$
 (225)
 
 
$
 (2,159)
 
$
 (1,209)
     
$
 34
 
$
 (225)
 
                           
(1)Recognized as a foreign currency hedge under the Derivatives and Hedging Topic of the ASC.
     

Non-Designated
               
   
Gain or (Loss) on Derivatives Recognized in Net Income
Derivatives not designated
     
For the three months ended March 31,
as hedging instruments
 
Location
 
2012
 
2011
Futures contracts
 
Net realized and unrealized gains - investments
 
$
 253
 
$
 7,568
Currency swaps
 
Net realized and unrealized gains - other
   
 428
   
 1,080
Foreign currency forward contracts
 
Net realized and unrealized losses - investments
   
 (12,558)
   
 (33,976)
Foreign currency forward contracts
 
Net realized and unrealized gains (losses) - other
   
 5,921
   
 (1,786)
Mortgage-backed securities TBA
 
Net realized and unrealized losses - investments
   
 - 
   
 (2)
Other reinsurance derivatives
 
Net realized and unrealized gains - other
   
 - 
   
 241
       
$
 (5,956)
 
$
 (26,875)


 
17

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




Foreign currency forward contracts

The Company enters into foreign currency forward contracts for the purpose of hedging its net investment in foreign subsidiaries which are recorded as designated hedges. Foreign currency forward contracts are also entered into for the purpose of hedging the Company’s foreign currency fixed maturity investments, select investment funds and the Company’s net foreign currency operational assets and liabilities. Foreign currency forward contracts are also entered into for the purpose of gaining exposure to currency movements against the U.S. dollar.

Futures contracts

The Company uses futures contracts to gain exposure to U.S. equity, global equity, emerging market equity and commodities.  The Company uses interest rate futures contracts to manage the duration of the fixed maturity investments and foreign currency futures contracts to gain exposure to currency movements against the U.S. dollar.

Currency swaps

The Company uses currency swaps to minimize the effect of fluctuating foreign currencies.  The currency swaps relate to the Company’s Euro denominated debentures.

To be announced mortgage-backed securities

The Company also purchases TBAs as part of its investing activities.  By acquiring a TBA, the Company makes a commitment to purchase a future issuance of mortgage-backed securities.

Other reinsurance derivatives

The Company writes certain reinsurance contracts that are classified as derivatives in accordance with the FASB ASC Topic for Derivatives and Hedging.  The Company has entered into industry loss warranty (“ILW”) transactions that may be structured as reinsurance or derivatives.
 
Fair value disclosure

Derivative instruments are stated at fair value in accordance with the Fair Value Measurements and Disclosures Topic of the FASB ASC as determined by the quoted market price for futures contracts and based on observable market inputs for foreign currency forward contracts, currency swaps and TBAs. The Company fair values reinsurance derivative contracts, which are under one year in duration, by approximating the present value of cash flows as the carrying value equal to the unearned premium.

In accordance with the Fair Value Measurements and Disclosures Topic of the FASB ASC, the fair value of derivative instruments held as at March 31, 2012 and December 31, 2011 is allocated between levels as follows:

 
Fair Value Measurement at March 31, 2012, using:
       
Quoted prices
 
Significant other
 
Significant other
 
Fair value
 
in active markets
 
observable inputs
 
unobservable inputs
 
measurements
 
(Level 1)
 
(Level 2)
 
(Level 3)
Description
                     
Swaps
 
 (571)
   
 - 
   
 (571)
   
 - 
Foreign currency forward contracts
 
 (1,777)
   
 - 
   
 (1,777)
   
 - 
Total derivatives
$
 (2,348)
 
$
 - 
 
$
 (2,348)
 
$
 - 

For the Level 3 items still held as of March 31, 2012, the total change in fair value for the three months ended March 31, 2012, recorded in net realized and unrealized gains (losses) – other, was $nil.

 
18

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




 
Fair Value Measurement at December 31, 2011, using:
       
Quoted prices
 
Significant other
 
Significant other
 
Fair value
 
 in active markets
 
observable inputs
 
unobservable inputs
 
measurements
 
(Level 1)
 
(Level 2)
 
(Level 3)
Description
                     
Futures contracts
$
 (5,026)
 
$
 (5,026)
 
$
 - 
 
$
 - 
Swaps
 
 (999)
   
 - 
   
 (999)
   
 - 
Foreign currency forward contracts
 
 7,020
   
 - 
   
 7,020
   
 - 
Total derivatives
$
 995
 
$
 (5,026)
 
$
 6,021
 
$
 - 
                       
At March 31, 2012 and December 31, 2011, there were no Level 3 derivative instruments held.  Transfers between levels, if necessary, are done as of the actual date of the event or change in circumstance that caused the transfer.  There were no transfers between levels during the three months ended March 31, 2012.

7.      DEBT AND FINANCING ARRANGEMENTS

Long term debt

Interest expense includes interest payable and amortization of debt offering expenses.  The debt offering expenses are amortized over the period from the issuance of the Deferrable Interest Debentures to the earliest date that they may be called by the Company.  For the three months ended March 31, 2012, the Company incurred interest expense of $2.5 million on the Deferrable Interest Debentures compared to $2.6 million for the same period in 2011.  The Company had $0.8 million of interest payable included in other liabilities at both March 31, 2012 and December 31, 2011.

The Company does not carry its long term debt at fair value on its consolidated balance sheets.  At March 31, 2012, the Company estimated the fair value of its long term debt to be approximately $216.7 million compared to $192.7 million at December 31, 2011.

Letter of credit facilities

On August 31, 2011, Flagstone Suisse and Flagstone Capital Management Luxembourg SICAF – FIS (“FCML”) entered into a $200.0 million secured committed letter of credit facility with Barclays Bank Plc (the “Barclays Facility”).  The Barclays Facility is for letters of credit with a maximum tenor of 15 months and is used to support the reinsurance obligations of the Company.  As of March 31, 2012, $52.3 million had been drawn under the Barclays Facility, and the drawn amount was secured by $61.6 million of fixed maturity investments from the Company’s investment portfolio.  The Barclays Facility replaced a $200.0 million credit facility with Barclays Bank Plc which commenced on March 5, 2009.

On April 28, 2010, Flagstone Suisse and FCML entered into a secured $450.0 million standby letter of credit facility with Citibank Europe Plc (the “Citi Facility”). The Citi Facility comprised a $225.0 million facility for letters of credit with a maximum tenor of 15 months, to be used to support reinsurance obligations of the Company, and a $225.0 million facility for letters of credit drawn in respect of Funds at Lloyd’s with a maximum tenor of 60 months. On December 21, 2010, the Citi Facility was amended to increase the amount available under the facility by $100.0 million to $550.0 million, with all the terms and conditions remaining unchanged. The Citi Facility now comprises a $240.0 million facility for letters of credit with a maximum tenor of 15 months, to be used to support reinsurance obligations of the Company, and a $310.0 million facility for letters of credit drawn in respect of Funds at Lloyd’s with a maximum tenor of 60 months. As at March 31, 2012, $497.9 million had been drawn under the Citi Facility, and the drawn amount of the facility was secured by $586.6 million of fixed maturity investments from the Company’s investment portfolio. The Citi Facility replaced a $450.0 million credit facility with Citibank Europe Plc which commenced on January 22, 2009.

These facilities are used to provide security to reinsureds and for Funds at Lloyd’s, and they are fully collateralized by the Company, to the extent of the letters of credit outstanding at any given time.

8.      SHARE BASED COMPENSATION

The Company accounts for share based compensation in accordance with the Compensation – Stock Compensation Topic of the FASB ASC which requires entities to measure the cost of services received from employees and directors in exchange for an award of equity instruments based on the grant date fair value of the award. The cost of such services will be recognized as compensation expense over the period during which an employee or director is required to provide service in exchange for the award. The Company’s share based compensation plans consist of Performance Share Units (“PSUs”) and Restricted Share Units (“RSUs”).

 
19

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




Performance Share Units
 
The Company’s Performance Share Unit Plan (“PSU Plan”) is the Company’s shareholder approved primary executive long term incentive scheme. Pursuant to the terms of the PSU Plan, at the discretion of the Compensation Committee of the Board, PSUs may be granted to executive officers and certain other key employees and vesting is contingent upon the Company meeting certain diluted return-on-equity (“DROE”) goals.

A summary of the activity under the PSU Plan as at March 31, 2012, and changes during the three months ended March 31, 2012, is as follows:
             
 
For the three months ended March 31, 2012
           
Weighted
 
Number
 
Weighted
 
average
 
expected
 
average grant
 
remaining
 
to vest
 
date fair value
 
contractual term
             
Outstanding at beginning of period
 1,676,125
 
$
 10.83
 
0.7
Granted
 300,000
   
 8.29
   
Forfeited
 (93,750)
   
 11.54
   
Performance factor changes
 23,375
   
 9.93
   
Exercised
 (889,700)
   
 9.98
   
Outstanding at end of period
 1,016,050
   
 10.73
 
 1.7

The Company reviews its assumptions in relation to the PSUs on a quarterly basis. The issuance of shares with respect to the PSUs is contingent upon the attainment of certain levels of average DROE over a three year period. Taking into account the results to date and the expected results for the remainder of the performance periods, the Company has established the most probable factor as the minimum for each series, with the exception of one series which has been established to have a probable factor of 60%. For the three months ended March 31, 2012, $0.3 million of compensation expense related to the PSU Plan has been recorded in general and administrative expenses compared to $(4.2) million for the same period in 2011. As at March 31, 2012 and December 31, 2011, there was a total of $5.9 million and $4.8 million, respectively, of unrecognized compensation cost related to non−vested PSUs; that cost is expected to be recognized over periods of approximately 1.9 years and 1.6 years, respectively.

Since the inception of the PSU Plan, 2,363,026 PSUs have vested and 2,368,658 PSUs have been cancelled.

Restricted Share Units

The purpose of the Company’s Restricted Share Unit Plan (the “RSU Plan”) is to encourage certain employees and directors of the Company to further the development of the Company and to attract and retain key employees for the Company’s long term success. The RSUs granted to employees vest over a period of approximately two years and RSUs granted to directors vest on the grant date.

A summary of the activity under the RSU Plan as at March 31, 2012, and changes during the three and three months ended March 31, 2012, is as follows:
             
 
For the three months ended March 31, 2012
 
Number
   
Weighted average
 
Weighted average
 
expected to
   
grant date
 
remaining
 
vest
   
fair value
 
contractual term
             
Outstanding at beginning of period
 524,179
 
$
11.40
 
0.3
Granted
 217,706
   
8.28
   
Forfeited
 (41,250)
   
10.79
   
Exercised
 (147,020)
   
10.68
   
Outstanding at end of period
 553,615
   
10.40
 
 1.3

 
20

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




Unrecognized compensation cost related to non-vested RSUs was $1.6 million and $1.0 million at March 31, 2012 and December 31, 2011, respectively, and is expected to be recognized over a period of approximately 1.4 years and 1.0 year, respectively.  Compensation expenses related to the RSU Plan of $0.7 million were recorded in general and administrative expenses for the three months ended March 31, 2012 compared to $1.2 million for the same period in 2011.

Since the inception of the RSU Plan in July 2006, 707,262 RSUs granted to employees have vested and no RSUs granted to employees have been cancelled. During the three months ended March 31, 2012, 59,856 RSUs were granted to the directors, compared to 63,964 RSUs granted to directors during the same period in 2011. During both the three months ended March 31, 2012 and 2011, no RSUs granted to directors were converted into common shares of the Company as elected by the directors.

The Company uses a nil forfeiture assumption for its PSUs and RSUs.  The intrinsic value of both PSUs and RSUs outstanding as at March 31, 2012 was $8.0 million and $4.4 million, respectively.

9.       EARNINGS (LOSS) PER COMMON SHARE

The computation of basic and diluted earnings (loss) per common share for the three months ended March 31, 2012 and 2011 is as follows:

   
For the three months ended March 31,
   
2012
 
2011
             
Basic earnings per common share
           
Net income (loss) attributable to Flagstone
 
$
 39,185
 
$
 (161,220)
Weighted average common shares outstanding
   
 70,422,864
   
 69,025,875
Weighted average vested restricted share units
   
 256,073
   
 325,977
Weighted average common shares outstanding—Basic
   
 70,678,937
   
 69,351,852
Basic earnings (loss) per common share
 
$
 0.55
 
$
 (2.32)
             
Diluted earnings per common share
           
Net income (loss) attributable to Flagstone
 
$
 39,185
 
$
 (161,220)
Weighted average common shares outstanding
   
 70,422,864
   
 69,025,875
Weighted average vested restricted share units outstanding
   
 256,073
   
 325,977
     
 70,678,937
   
 69,351,852
Share equivalents:
           
Weighted average unvested restricted share units
   
 120,616
   
 - 
Weighted average unvested performance share units
   
 357,147
   
 - 
Weighted average common shares outstanding—Diluted
   
 71,156,700
   
 69,351,852
Diluted earnings (loss) per common share
 
$
 0.55
 
$
 (2.32)

Dilutive share equivalents have been excluded in the weighted average common shares used for the calculation of earnings per share in periods of net loss because the effect of such securities would be anti-dilutive.  The number of anti-dilutive share equivalents that were excluded in the computation of diluted earnings per share for the three months ended March 31, 2011, was 895,610. Because the number of shares above a minimum threshold are contingently issuable under the PSU Plan depends on the average DROE over a two or three year period, those contingently issuable PSUs are excluded from the calculation of diluted earnings per common share until the end of the performance period, at which time the number of shares issuable under the PSU Plan will be known. Only the minimum number of PSUs that will vest under each grant are included in the calculation of diluted earnings in a period of net income. As at March 31, 2012 and 2011, there were 1,016,950 and 1,965,091 PSUs expected to vest, respectively.  The maximum number of common shares that could be issued under the PSU Plan at March 31, 2012 and 2011 was 2,331,950 and 4,962,078, respectively. There was a warrant outstanding which would result in the issuance of 630,194 common shares at both March 31, 2012 and 2011, that were excluded from the computation of diluted earnings per common share because the effect would be anti-dilutive. 


 
21

FLAGSTONE REINSURANCE HOLDINGS, S.A.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)




10.   SHAREHOLDERS’ EQUITY

Common shares

At March 31, 2012, the total authorized common voting shares of the Company were 300,000,000, with a par value of $0.01 per common share (December 31, 2011 – 300,000,000).

The following table is a summary of the common shares issued and outstanding for the periods ending March 31, 2012 and December 31, 2011:

 
For the periods ended
  
March 31, 2012
 
December 31, 2011
 Common voting shares: 
     
 Balance at beginning of period
 70,167,142
 
 68,585,588
 Conversion of performance share units (1)
 782,179
 
 1,359,378
 Conversion of restricted share units (1)
 109,601
 
 222,176
 Balance at end of period
 71,058,922
 
 70,167,142
  
     
(1)Conversion of performance share units and restricted share units are net of shares withheld for the payment of tax on the employee's behalf.

11.   LEGAL PROCEEDINGS

In the normal course of business, the Company may become involved in various claims litigation and legal proceedings.  Such proceedings often involve reinsurance contract disputes which are typical for the insurance and reinsurance industry. As at March 31, 2012, the Company was not a party to any material litigation or arbitration proceedings.

12.    SUBSEQUENT EVENTS

The Company has evaluated subsequent events through to the date the financial statements were available to be issued and has determined that there were no subsequent events that require disclosure, except in connection with the divestiture processes relating to the former Island Heritage and Lloyd’s reportable segments.  Refer to Note 4 “Assets Held for Sale and Discontinued Operations” for more information.
.



 
22


Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is a discussion and analysis of our financial condition as at March 31, 2012 and December 31, 2011, and our results of operations for the three months ended March 31, 2012 and 2011, including, as specified, our discontinued operations.  The historical results presented in this Quarterly Report are not necessarily indicative of the results to be expected for any future period and results for any interim period may not necessarily be indicative of the results expected for a full year.  This discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included in Part 1, Item 1 of this Quarterly Report on Form 10-Q (this “Quarterly Report”) and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and the audited consolidated financial statements and notes thereto, presented under Item 7 and Item 8, respectively, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 (our “2011 Annual Report”), filed with the SEC on March 13, 2012.  Some of the information contained in this discussion and analysis is included elsewhere in this document, including information with respect to our plans and strategy for our business, and includes forward-looking statements that involve risks and uncertainties.  Please see the “Cautionary Statement Regarding Forward-Looking Statements” for more information. You should review the information described under “Recent Developments”, the risks described in this Quarterly Report and in Item 1A, “Risk Factors” contained in the 2011 Annual Report for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements.
 
References in this Quarterly Report to the “Company”, “Flagstone”, “we”, “us”, and “our” refer to Flagstone Reinsurance Holdings, S.A. and/or its subsidiaries, including Flagstone Réassurance Suisse SA, its wholly-owned Switzerland reinsurance company, Flagstone Alliance Insurance & Reinsurance PLC, its wholly-owned Cyprus insurance and reinsurance company, Flagstone Reinsurance Africa Limited, its wholly-owned South African reinsurance company, Mont Fort Re Ltd., its wholly-owned Bermuda reinsurance company, and any other direct or indirect wholly-owned subsidiary, but not including its United Kingdom  Lloyd's managing agency Flagstone Syndicate Management Limited, or Island Heritage Holdings Ltd., each of which are discontinued operations, unless the context suggests otherwise. On October 24, 2011, we announced a strategic decision to divest our ownership positions in our former Lloyd’s and Island Heritage reportable segments. On April 5, 2012, the Company completed the sale of the business comprising its former Island Heritage reportable segment. On April 3, 2012, the Company announced that it had entered into definitive agreements to divest the business comprising its former Lloyd’s reportable segment. The Company has classified the assets and liabilities associated with its former Lloyd’s and Island Heritage reportable segments as held for sale and the assets and liabilities have been recorded at the lower of the carrying value or fair value less costs to sell.  The financial results for these operations have been presented as discontinued operations in the Company’s consolidated statements of operations for all periods presented. Unless otherwise noted, all discussions and amounts presented in this Quarterly Report relate to our business without giving effect to our discontinued operations. References to “Flagstone Suisse” refer to Flagstone Réassurance Suisse SA, its wholly-owned subsidiaries and its Bermuda branch. References to “FSML” refer to Flagstone Syndicate Management Limited, its wholly-owned subsidiaries and Syndicate 1861.  References to “Island Heritage” refer to Island Heritage Holdings Ltd. and its subsidiaries. References to “Flagstone Africa” refer to Flagstone Reinsurance Africa Limited.  References to “Mont Fort” refer to Mont Fort Re Ltd. References in this Quarterly Report to “dollars” or “$” are to the lawful currency of the United States of America (the “U.S.”), unless the context otherwise requires.  All amounts in the following tables are expressed in thousands of U.S. dollars, except share amounts, per share amounts, percentages or unless otherwise stated. References in this Quarterly Report to (i) “foreign currency” are to currencies other than U.S. dollars and (ii) “foreign exchange” transactions or “foreign investments” are to transactions or investments, respectively, involving currencies other than U.S. dollars, in each case unless the context otherwise requires.  References in this Quarterly Report to “foreign subsidiaries” are to subsidiaries of Flagstone that are not domiciled in the U.S. or whose primary transactions are in foreign currency.

Executive Overview

On October 24, 2011, we announced a strategic business decision to divest our ownership positions in our former Lloyd’s and Island Heritage reportable segments. Our goal was to free up underwriting capital for our core business, substantially reducing risk while retaining acceptable return on equity levels, to continue to lower costs and to return to profitability. We have achieved these goals in the first quarter, and have started 2012 with a return to profitability, despite the ongoing challenging environment in the industry. Our improved performance this quarter reflects the benefits of improving rates in our core business, which partially offset the reduction in income as we pare back our risk levels. It also begins to demonstrate the benefits of our expense saving initiatives, as well as the avoidance of significant exposure to first quarter 2012 loss events.

 
 
23

 
As previously announced on April 2, 2012, and April 3, 2012, the Company entered into definitive agreements to divest its former Island Heritage and Lloyd’s reportable segments, respectively. The Island Heritage transaction was completed on April 5, 2012, as previously announced.  The Lloyd’s segment transaction is expected to be completed before the end of the second quarter of 2012.  These divestitures are part of a strategic business realignment to address changing business conditions, refocus the Company’s underwriting strategy on its property catastrophe reinsurance business and reduce its focus on operating segments that absorb capital and produce lower returns. Except as explicitly described as held for sale or as discontinued operations, and unless otherwise noted, all discussions and amounts presented herein relate to our continuing operations.  See Note 4, “Assets Held for Sale and Discontinued Operations” in our unaudited condensed consolidated financial statements (Item 1 above) for additional information related to discontinued operations.  All prior years presented have been reclassified to conform to this new presentation.

We continue to make significant progress on our business realignment as we establish a more nimble, cost-effective and opportunistic business. We remain focused on leveraging the existing strengths in our core businesses in order to deliver enhanced value for our shareholders.

We are a global reinsurance company. Our management views the operations and management of our continuing operations as one reportable segment and does not differentiate our lines of business into separate reportable segments. Our continuing operations provide reinsurance primarily through our property and property catastrophe business as well as short-tail specialty and casualty reinsurance lines of business. We diversify our risks across business lines by risk zones, each of which combines a geographic zone with one or more types of peril (for example, Texas Windstorm, Florida Hurricane or California Earthquake). The majority of our reinsurance contracts contain loss limitation provisions such as fixed monetary limits to our exposure and per event caps. We specialize in underwriting where we believe sufficient data exists to analyze effectively the risk/return profile, and where we are subject to legal systems we believe are reasonably fair and reliable. Previously, the underwriting results associated with our discontinued operations were included in our former Lloyd’s and Island Heritage reportable segments.

Our financial statements are prepared in accordance with accounting principles generally accepted in the U.S (“U.S. GAAP”) and our fiscal year ends on December 31.  Because a substantial portion of the insurance and reinsurance we write in our discontinued operations and reinsurance we write in our continuing operations provides protection from damages relating to natural and man-made catastrophes, our results depend to a large extent on the frequency and severity of such catastrophic events, and the specific coverages we offer to clients affected by these events.  This has resulted and may continue to result in volatility in our results of operations, cash flows and financial condition.  In addition, the amount of premiums written with respect to any particular line of business may vary from quarter to quarter and year to year as a result of available capital and retrocessional support and market and other conditions.

We measure our financial success through long term growth in diluted book value per share plus accumulated distributions measured over intervals of three years. We believe this is the most appropriate measure of our performance, a measure that focuses on the return provided to our common shareholders. Diluted book value per share is obtained by dividing Flagstone shareholders’ equity by the number of common shares and common share equivalents outstanding including all potentially dilutive securities such as a warrant, Performance Share Units (“PSUs”) and Restricted Share Units (“RSUs”).

Our continuing operations derive revenues primarily from net premiums earned on the reinsurance policies we write, net of any retrocessional or reinsurance coverage purchased, income from our investment portfolio, and fees for services provided.  Premiums are generally a function of the number and type of contracts we write, as well as prevailing market prices. Premiums are normally due in installments and earned over the contract term, which ordinarily is 12 or 24 months.

Income from our investment portfolio primarily comprises interest on fixed maturity, short term investments and cash and cash equivalents and net realized and unrealized gains (losses) on our investment portfolio including our derivative positions, net of investment expenses.

Our expenses consist primarily of the following: loss and loss adjustment expenses (“LAE”) incurred on the policies of reinsurance that we sell; acquisition costs which typically represent a percentage of the premiums that we write; general and administrative expenses which primarily consist of salaries, benefits and related costs, including costs associated with awards under our Performance Share Unit Plan (“PSU Plan”) and Restricted Share Unit Plan (“RSU Plan”), and other general operating expenses; interest expense related to our debt obligations; and noncontrolling interest, which represents the interest of external parties with respect to the net income of Mont Fort (on March 25, 2011 there were no longer third party investors in Mont Fort) and our Island Heritage discontinued operations.  We are also subject to taxes in certain jurisdictions in which we operate; however, since the majority of our income to date has been earned in Bermuda, a non-taxable jurisdiction, the tax impact on our operations has historically been minimal. The Company is a Luxembourg tax resident entity due to its change of jurisdiction of incorporation from Bermuda to Luxembourg effective May 17, 2010 (the “Redomestication”); therefore, it is subject to Luxembourg corporate income tax, municipal business tax, withholding tax, and net wealth tax. The Company minimizes the income tax impact on the Company through effective tax planning. 

 
 
24

 
Recent Developments

On April 2, 2012, the Company announced that it had entered into a definitive share purchase agreement with BF&M Limited (“BF&M”), and certain other parties, under which BF&M acquired Island Heritage for approximately $68 million in cash.  The divesture process for Island Heritage was completed on April 5, 2012, for total proceeds of approximately $68.0 million, of which, the Company received approximately $40.8 million for its approximate 60% interest, which is subject to a purchase price adjustment based on a final March 31, 2012 balance sheet. The divestiture will be recorded in the second quarter result and is not expected to result in a significant gain or loss on disposal.
 
On April 3, 2012, the Company announced that it had entered into a definitive agreement with a wholly-owned subsidiary of ANV Holdings BV (“ANV”), under which ANV, with capital support from Ontario Teachers’ Pension Plan Board, will acquire the Company’s Lloyd’s operations for approximately $48 million in cash, subject to a purchase price adjustment based on a final March 31, 2012 balance sheet. As a result of the transaction, the Company will release approximately $162 million of underwriting capital currently supporting its Lloyd’s operation. This transaction is expected to be completed before the end of the second quarter of 2012, subject to the satisfaction of customary regulatory approvals and certain other customary closing conditions, and is not expected to result in a significant gain or loss on disposal.

You should review all the information in this Quarterly Report in conjunction with the information under this “Recent Developments.”

Critical Accounting Policies

Our critical accounting policies are discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of the 2011 Annual Report.  Our critical accounting policies at March 31, 2012 have not changed compared to December 31, 2011.
 
 
It is important to understand our accounting policies in order to understand our financial position and results of operations.  Our unaudited condensed consolidated financial statements contain certain amounts that are inherently subjective in nature and have required our management to make assumptions and best estimates to determine the reported values.  If events or other factors, including those described herein and in Item 1A, “Risk Factors,” of the 2011 Annual Report, cause actual events or results to differ materially from management’s underlying assumptions or estimates, there could be a material adverse effect on our results of operations, financial condition and liquidity.

Results of Operations - For the Three Months Ended March 31, 2012 and 2011

Our reporting currency is the U.S. dollar.  Our subsidiaries have one of the following functional currencies: U.S. dollar, Swiss franc, Euro, British pound sterling, Canadian dollar, Indian rupee, and South African rand.  As a significant portion of our operations are transacted in foreign currencies, fluctuations in foreign exchange rates may affect period-to-period comparisons.  To the extent that fluctuations in foreign currency exchange rates affect comparisons, their impact has been quantified, when possible, and discussed in each of the relevant sections.  See Note 2 “Significant Accounting Policies” to the consolidated financial statements in Item 8, “Financial Statements and Supplementary Data”, in the 2011 Annual Report for a discussion on translation of foreign currencies.

   
For the three months ended
U.S. dollar (weakened) strengthened against:
 
March 31, 2012
       
Canadian dollar
 
 (2.1)
%
Swiss franc
 
 (4.1)
%
Euro
 
 (3.0)
%
British pound sterling
 
 (3.0)
%
Indian rupee
 
 (4.2)
%
South African rand
 
 (5.2)
%

 
 
25

 
Summary Overview

 The following table sets forth selected key financial information for the three months ended March 31, 2012 and 2011:
 
                         
 
For the three months ended March 31,
  
2012
 
2011
 
 $ Change
 
 % Change
  
                         
 Underwriting income (loss)
$
 4,618
   
$
 (155,819)
   
$
 160,437
 
 103.0
%
 Net investment income
$
 5,067
   
$
 9,198
   
$
 (4,131)
 
 (44.9)
%
 Net realized and unrealized gains - investments
$
 18,103
   
$
 10,771
   
$
 7,332
 
 68.1
%
 Net realized and unrealized gains (losses) - other
$
 6,383
   
$
 (690)
   
$
 7,073
 
 1,025.1
%
 Income (loss) from continuing operations
$
 27,848
   
$
 (148,173)
   
$
 176,021
 
 118.8
%
 
                         
 Income (loss) from continuing operations per common share - Basic
$
 0.38
   
$
 (2.15)
   
$
 2.53
     
 Income (loss) from continuing operations per common share - Diluted(1)
$
 0.38
   
$
 (2.15)
   
$
 2.53
     
 Loss ratio
 
58.4
%
   
150.7
%
           
 Expense ratio
 
39.1
%
   
26.9
%
           
 Combined ratio
 
97.5
%
   
177.6
%
           
 
                         
 The following table sets forth selected key non-GAAP financial measures as at March 31, 2012 and December 31, 2011:
 
 
                         
 
As at
 
March 31,
   
December 31,
             
 
2012
   
2011
     
 $ Change
 
 % Change
 Basic book value per common share
$
 11.62
   
$
 11.21
   
$
 0.41
 
 3.7
%
 Diluted book value per common share
$
 11.42
   
$
 10.90
   
$
 0.52
 
 4.8
%
 Diluted book value per common share plus accumulated distributions
$
 12.18
   
$
 11.62
   
$
 0.56
 
 4.8
%
 
                         
(1)Income (loss) from continuing operations per common share - Diluted for the three months ended March 31, 2012 and 2011 does not contain the effect of:
  a. a warrant conversion as this would be anti-dilutive for U.S. GAAP purposes
  b. the PSU conversion until the end of the performance period, when the number of shares issuable under the PSU Plan will be known. There were 1,016,050  and 1,965,091 PSU's expected to vest under the PSU plan as at March 31, 2012 and 2011, respectively . Only the minimum number of PSUs that will vest under each grant are included in the calculation of diluted earnings in a period of net income.

The increase in underwriting income in the three months ended March 31, 2012, is primarily due to the lack of significant catastrophe losses (net of reinsurance and reinstatements) in the period compared to the same period last year, which included Australian floods ($34.4 million), cyclone Yasi ($31.0 million), New Zealand earthquake of February 2011 ($81.5 million) and the Japan earthquake and tsunami ($109.7 million).
 
The increase in the net realized and unrealized gains and losses – investments, for the three months ended March 31, 2012, is primarily associated with the foreign currency forward contracts and is related to the currency hedges on non-U.S. dollar bonds, offset by net realized and unrealized gains on the fixed maturity investments.
 
The increase in the net realized and unrealized gains and losses – other, for the three months ended March 31, 2012, is primarily associated with currency swaps and foreign currency forward contracts are due to currency fluctuations which is partially offset by losses recorded through balance sheet currency revaluations and are attributable to operational hedges on reinsurance balances.

These items are discussed in more detail in the following sections. 

Non-GAAP Reconciliation

In addition to the U.S. GAAP financial measures set forth in this Quarterly Report, we have presented “basic book value per common share” and “diluted book value per common share”, which are non-GAAP financial measures.  Our management uses growth in diluted book value per common share as a prime measure of the value we are generating for our common shareholders, as we believe that growth in our diluted book value per common share ultimately translates into growth in our stock price.
 
 
26

 
Basic book value per common share is defined as total Flagstone shareholders’ equity divided by the number of common shares outstanding at the end of the period plus vested RSUs, giving no effect to dilutive securities.  Diluted book value per common share is defined as total Flagstone shareholders’ equity divided by the number of common shares and common share equivalents outstanding at the end of the period including all potentially dilutive securities such as a warrant, PSUs and RSUs. When the effect of securities would be anti-dilutive, these securities are excluded from the calculation of diluted book value per common share.  The warrant was anti-dilutive and was excluded from the calculation of diluted book value per common share as at March 31, 2012 and December 31, 2011.

While we believe that these non-GAAP financial measures provide useful supplemental information to investors, there are limitations associated with the use of these non-GAAP financial measures. Basic book value per common share does not reflect the number of common shares that may be issued upon vesting or exercise of dilutive securities. On the other hand, by giving effect to dilutive securities, diluted book value per common share takes into account common share equivalents and not just the number of common shares actually outstanding. These non-GAAP financial measures are not prepared in accordance with GAAP, are not based on any comprehensive set of accounting rules or principles, are not reported by all of our competitors and may not be directly comparable to similarly titled measures of our competitors due to potential differences in the exact method of calculation. In light of these limitations, we use these non-GAAP financial measures only as supplements to GAAP financial measures and provide a reconciliation of the non-GAAP financial measures to their most comparable GAAP financial measures.
 

 
 
As at
 
 
March 31, 2012
 
December 31, 2011
 
           
 
   
 
           
 Flagstone shareholders' equity
 
$
 829,316
 
$
 789,048
 Potential net proceeds from assumed:
           
   Exercise of PSU (1)
   
 - 
   
 - 
   Exercise of RSU (1)
   
 - 
   
 - 
   Conversion of warrant (2)
   
 - 
   
 - 
 Diluted Flagstone shareholders' equity
 
$
 829,316
 
$
 789,048
 
           
 
           
 Cumulative distributions paid per outstanding common share
 
$
0.76
 
$
0.72
 
           
 Common shares outstanding - end of period
   
 71,058,922
   
 70,167,142
 Vested RSUs
   
 293,565
   
 233,709
 Total common shares outstanding - end of period
   
 71,352,487
   
 70,400,851
 
           
 Potential shares to be issued:
           
   PSUs expected to vest
   
 1,016,050
   
 1,676,125
   RSUs outstanding
   
 260,050
   
 290,470
   Conversion of warrant (2)
   
 - 
   
 - 
 Common shares outstanding - diluted
   
 72,628,587
   
 72,367,446
 
           
 
           
 Basic book value per common share
 
$
11.62
 
$
11.21
 
           
 Diluted book value per common share
 
$
11.42
 
$
10.90
 
           
 Basic book value per common share plus accumulated distributions
 
$
12.38
 
$
11.93
 
           
 Diluted book value per common share plus accumulated distributions
 
$
12.18
 
$
11.62
 
           
 
           
 Distributions per common share paid during the period
 
$
0.04
 
$
0.16
 
           
(1)No proceeds due when exercised
           
(2)Below strike price - not dilutive
           

 
27

 
Outlook and Trends

Market Outlook

At the important January 1, 2012 renewal period, North American rates increased approximately 10-15% from rates a year ago, averaging high single digit increases in loss-free regions and ranging from 15-40% increases in loss-affected regions.  Looking forward toward the next major North American renewal period at mid-year, we expect a similar level of increases and a strong renewal. Many clients are now out with their submissions early, with several looking for modest increases in programs and recognizing the potential of price increases.  On average, clients are buying more and therefore more capacity is needed, however we anticipate that reinsurers will also be willing to extend more capacity to meet this need in a measured approach.  Furthermore, the Florida market looks to be more orderly at the upcoming renewal, due in part to the successful cat bond placement by Citizens Property Insurance Corporation of Florida, which lessens the amount of capacity required of the private market.  As such, we do not expect any significant dislocation in the Florida market at the upcoming renewal.  However, we believe there will be more financial flexibility in the system with Florida companies finally seeing the rate increases from last year earn through, and most have filed for, and expect to receive, another round of double digit price increases.  As such, we are expecting less resistance to rate increases from cedents who in the past have been squeezed by the rate environment in Florida. 

The International market saw January 1, 2012 rates up 5% on average for European business, and loss-affected areas such as Australia showing more significant rate increases of 50-100%, which were expected given the recent catastrophic events in the region.  At April 1, 2012, renewals were primarily focused on Japan and saw strong pricing increases in these Japanese programs. Overall price increases averaged over 20%. Comparing 2012 prices with pre-Tohoku pricing, loss affected Japanese earthquake programs paid 80-140% increases. Non-loss affected programs saw 40-75% increases and Japanese wind programs were up 15-25%.  The few European accounts that renewed in April were flat on a risk-adjusted basis. Caribbean accounts had to increase pricing by 10-20% to receive the required capacity.  With the Caribbean competing for capacity with the U.S. wind accounts overall capacity was tight. In summary, outside of the Caribbean, capacity was generally abundant, and looking forward to the next major International renewal period at January 1, 2013, we expect the level of International loss activity to dictate the direction of rates.
 
Regarding the specialty lines, rates in the marine business, aviation, and aerospace and satellite have been flat since the January 1 renewal period and as these lines renew throughout the year we expect a similar pattern to continue.  Rates have generally failed to increase materially and the modest profitability has been primarily due to a lack of loss activity.  

This information should be read in conjunction with the other information in the 2011 Annual Report, including “Risk Factors— Risks Related to our Business”.

Underwriting Results
 
Our management views our operations and management of our continuing operations as one reportable segment and does not differentiate its lines of business into separate reportable segments.  We provide reinsurance through our property and property catastrophe business as well as high-margin short-tail specialty and casualty reinsurance lines of business.  We regularly review our financial results and assess our performance on the basis of our single reportable segment in accordance with the Segment Reporting Topic of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”).

Those lines of business are more fully described as follows:

(1)  
Property Catastrophe Reinsurance.  Property catastrophe reinsurance contracts are typically “all risk” in nature, meaning that they protect against losses from earthquakes and hurricanes, as well as other natural and man-made catastrophes such as tornados, wind, fires, winter storms, and floods (where the contract specifically provides for coverage).  Losses on these contracts typically stem from direct property damage and business interruption.  To date, property catastrophe reinsurance has been our most important product.  We write property catastrophe reinsurance primarily on an excess of loss basis.  In the event of a loss, most contracts of this type require us to cover a subsequent event and generally provide for a premium to reinstate the coverage under the contract, which is referred to as a “reinstatement premium”. These contracts typically cover only specific regions or geographical areas, but may be on a worldwide basis.

(2)  
Property Reinsurance.  We also provide reinsurance on a pro rata share basis and per risk excess of loss basis.  Per risk reinsurance protects insurance companies on their primary insurance risks on a single risk basis, for example, covering a single large building.  Generally, our property per risk and pro rata business is written with loss limitation provisions, such as per occurrence or per event caps, which serve to limit exposure to catastrophic events.

(3)  
Short-tail Specialty and Casualty Reinsurance.  We also provide short-tail specialty and casualty reinsurance for risks such as aviation, energy, accident and health, satellite, marine and workers’ compensation catastrophe.  Generally, our short-tail specialty and casualty reinsurance is written with loss limitation provisions.

 
 
28

.
Gross Premiums Written

Details of the consolidated gross premiums written by line of business and geographic area of risk insured for our continuing operations are provided below:

                         
   
For the three months ended March 31,
   
2012
 
2011
   
Gross premiums written
 
Percentage of total
 
Gross premiums written
 
Percentage of total
Line of business
                       
Property catastrophe
 
$
 106,341
 
 62.5
%
 
$
 201,862
 
 57.2
%
Property
   
 37,885
 
 22.3
%
   
 65,799
 
 18.7
%
Short-tail specialty and casualty
   
 26,002
 
 15.2
%
   
 85,014
 
 24.1
%
Total
 
$
 170,228
 
 100.0
%
 
$
 352,675
 
 100.0
%

 
 
For the three months ended March 31,
 
 
2012
 
2011
 
 
Gross premiums written
 
Percentage of total
 
Gross premiums written
 
Percentage of total
 Geographic area of risk insured (1)
                       
 Caribbean
 
$
 1,500
 
 0.9
%
 
$
 1,793
 
 0.5
%
 Europe
   
 49,259
 
 28.9
%
   
 76,514
 
 21.7
%
 Japan and Australasia
   
 11,097
 
 6.5
%
   
 42,500
 
 12.0
%
 North America
   
 71,419
 
 42.0
%
   
 124,020
 
 35.2
%
 Worldwide risks (2)
   
 29,610
 
 17.4
%
   
 92,627
 
 26.3
%
 Other
   
 7,343
 
 4.3
%
   
 15,221
 
 4.3
%
 Total
 
$
 170,228
 
 100.0
%
 
$
 352,675
 
 100.0
%
 
                       
(1)Except as otherwise noted, each of these categories includes contracts that cover risks located primarily in the designated geographic area.
(2)Includes contracts that cover risks in two or more geographic zones.

Premiums Ceded

In the normal course of our business, we purchase reinsurance in order to manage our exposures. The amount and type of reinsurance that we enter into is dependent on a variety of factors, including the cost of a particular reinsurance cover, our appetite and capacity to write certain risks and the nature of our gross premiums written during a particular period.

The majority of these contracts are excess-of-loss contracts covering one or more lines of business or quota share reinsurance with respect to specific lines of business. We also purchase protection through catastrophe bond structures, Montana Re, and industry loss warranty (“ILW”) policies which provide coverage for certain losses provided they are triggered by events exceeding a specified industry loss size. Reinsurance purchases to date have represented prospective cover; that is, ceded reinsurance purchased to protect against the risk of future losses as opposed to covering losses that have already been incurred but have not been paid.

Various factors will continue to affect our appetite and capacity to write and retain risk.  These include the impact of changes in frequency and severity assumptions used in our models and the corresponding pricing required to meet our return targets, capital levels, evolving industry-wide capital requirements, increased competition, and other considerations.

 
29


 Below is a summary of the underwriting results and ratios for the three months ended March 31, 2012 and 2011:
                           
 
For the three months ended March 31,
 
2012
 
2011
 
$ Change
 
% Change
                           
 Property catastrophe reinsurance
$
106,341
   
$
201,862
   
$
(95,521)
 
(47.3)
%
 Property reinsurance
 
37,885
     
65,799
     
(27,914)
 
(42.4)
%
 Short tail specialty and casualty reinsurance
 
26,002
     
85,014
     
(59,012)
 
(69.4)
%
 Gross premiums written
 
170,228
     
352,675
     
(182,447)
 
(51.7)
%
 Premiums ceded
 
(84,899)
     
(118,750)
     
33,851
 
(28.5)
%
 Net premiums written
 
85,329
     
233,925
     
(148,596)
 
(63.5)
%
 Net premiums earned
 
113,745
     
201,053
     
(87,308)
 
(43.4)
%
 Other related income