Edgar Filing: Flagstone Reinsurance Holdings, S.A.

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 June 30, 2012

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

(Registrant’s 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 August 7, 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

Item 1.	Financial Statements

	Unaudited Condensed Consolidated Balance Sheets as at June 30, 2012 and December 31, 2011	1

	Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income for the Three and Six Months Ended June 30, 2012 and 2011	2

	Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity for the Three and Six Months Ended June 30, 2012 and 2011	3

	Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011	5

	Notes to the Unaudited Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	43

Item 4.	Controls and Procedures	47

	PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	48

Item 1A.	Risk Factors	48

Item 1B.	Unresolved Staff Comments	48

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds and Issuer Repurchase of Equity Securities	48

Item 3.	Defaults Upon Senior Securities	48

Item 4.	Mine Safety Disclosure	48

Item 5.	Other Information	48

Item 6.	Exhibits	48

Index

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 June 30, 2012		As at December 31, 2011
ASSETS
Investments:
Fixed maturity investments, at fair value (Amortized cost: 2012 - $342,491; 2011 - $1,135,755)	$	333,674	$	1,138,435
Short term investments, at fair value (Amortized cost: 2012 - $696,837; 2011 - $10,620)		696,838		10,616
Equity investments, at fair value (Amortized cost: 2012 - $236; 2011 - $245)		61		82
Other investments		142,443		125,452
Total investments		1,173,016		1,274,585
Cash and cash equivalents		186,251		249,424
Restricted cash		17,823		17,538
Premium balances receivable		273,744		236,375
Unearned premiums ceded		58,679		30,550
Reinsurance recoverable		232,784		271,183
Accrued interest receivable		2,607		12,950
Receivable for investments sold		2,435		18
Deferred acquisition costs		50,144		38,155
Funds withheld		25,983		25,116
Other assets		110,919		160,950
Assets held for sale including discontinued operations		439,641		461,652
Total assets	$	2,574,026	$	2,778,496

LIABILITIES
Loss and loss adjustment expense reserves	$	682,329	$	897,368
Unearned premiums		292,109		215,316
Insurance and reinsurance balances payable		45,454		75,433
Payable for investments purchased		2,494		6,255
Long term debt		250,202		250,575
Other liabilities		70,964		54,059
Liabilities of discontinued operations held for sale		393,814		472,957
Total liabilities		1,737,366		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		857,714		872,819
Accumulated other comprehensive loss		(12,788)		(12,584)
Retained earnings		141,091		88,416
Total Flagstone shareholders’ equity		836,660		789,048
Noncontrolling interest in subsidiaries		-		17,485
Total equity		836,660		806,533
Total liabilities and equity	$	2,574,026	$	2,778,496

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

Index

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 June 30,				For the six months ended June 30,
		2012		2011		2012		2011

REVENUES
Gross premiums written	$	171,150	$	264,128	$	341,378	$	616,803
Premiums ceded		(6,285)		(44,409)		(91,184)		(163,159)
Net premiums written		164,865		219,719		250,194		453,644
Change in net unearned premiums		(62,366)		(101,099)		(33,950)		(133,971)
Net premiums earned		102,499		118,620		216,244		319,673
Net investment income		3,866		12,300		8,933		21,498
Net realized and unrealized gains (losses) - investments		5,365		(7,905)		23,468		2,866
Net realized and unrealized (losses) gains - other		(4,990)		13,986		1,393		13,296
Other income		1,546		1,554		4,357		2,686
Total revenues		108,286		138,555		254,395		360,019

EXPENSES
Loss and loss adjustment expenses		55,483		96,490		121,932		399,489
Acquisition costs		22,113		25,613		44,766		63,684
General and administrative expenses		18,822		19,744		40,682		35,819
Interest expense		2,965		2,892		5,923		5,742
Net foreign exchange (gains) losses		(3,354)		27,445		877		37,048
Total expenses		96,029		172,184		214,180		541,782
Income (loss) from continuing operations before income taxes and interest in earnings of equity investments		12,257		(33,629)		40,215		(181,763)
(Provision) recovery for income tax		(185)		827		(313)		1,073
Interest in earnings of equity investments		270		(171)		288		(456)
Income (loss) from continuing operations		12,342		(32,973)		40,190		(181,146)
Income from discontinued operations, net of taxes		1,148		13,960		13,620		1,737
Net income (loss)		13,490		(19,013)		53,810		(179,409)
Less: Income attributable to noncontrolling interest		-		(1,197)		(1,135)		(2,021)
NET INCOME (LOSS) ATTRIBUTABLE TO FLAGSTONE	$	13,490	$	(20,210)	$	52,675	$	(181,430)

Net income (loss)	$	13,490	$	(19,013)	$	53,810	$	(179,409)
Change in currency translation adjustment		(4,669)		873		(132)		3,750
Change in defined benefit pension plan obligation		136		(158)		(72)		(158)
Comprehensive income (loss)		8,957		(18,298)		53,606		(175,817)
Less: Comprehensive income attributable to noncontrolling interest		-		(1,197)		(1,135)		(2,021)
COMPREHENSIVE INCOME (LOSS) ATTRIBUTABLE TO FLAGSTONE	$	8,957	$	(19,495)	$	52,471	$	(177,838)

Weighted average common shares outstanding—Basic		71,352,487		70,380,852		71,015,712		69,869,195
Weighted average common shares outstanding—Diluted		71,763,904		70,380,852		71,572,129		69,869,195
Income (loss) from continuing operations per common share—Basic	$	0.17	$	(0.49)	$	0.55	$	(2.62)
Income from discontinued operations per common share—Basic	$	0.02	$	0.20	$	0.19	$	0.02
Net income (loss) attributable to Flagstone per common share—Basic	$	0.19	$	(0.29)	$	0.74	$	(2.60)
Income (loss) from continuing operations per common share—Diluted	$	0.17	$	(0.49)	$	0.55	$	(2.62)
Income from discontinued operations per common share—Diluted	$	0.02	$	0.20	$	0.19	$	0.02
Net income (loss) attributable to Flagstone per common share—Diluted	$	0.19	$	(0.29)	$	0.74	$	(2.60)
Distributions declared per common share	$	0.04	$	0.04	$	0.08	$	0.08

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

Index

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 six months ended June 30, 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
Disposal of discontinued operations		(18,620)												(18,620)
Net income		53,810		52,675										1,135
Change in currency translation adjustment		(132)				(132)
Defined benefit pension plan obligation		(72)				(72)
Stock based compensation		2,239										2,239
Stock compensation exercised from treasury		-								10,246		(10,246)
Distributions declared per common share		(5,684)										(5,684)
Other		(1,414)										(1,414)
Ending balance	$	836,660	$	141,091	$	(12,788)	$	845	$	(150,202)	$	857,714	$	-

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

Index

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 six months ended June 30, 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		(179,409)		(181,430)										2,021
Change in currency translation adjustment		3,750				3,750
Defined benefit pension plan obligation		(158)				(158)
Stock based compensation		(2,573)										(2,573)
Stock compensation exercised from treasury		-								17,017		(17,017)
Distributions declared per common share		(5,604)										(5,604)
Other		(1,814)										(1,814)
Ending balance	$	964,299	$	233,119	$	(2,586)	$	845	$	(161,701)	$	877,227	$	17,395

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

Index

FLAGSTONE REINSURANCE HOLDINGS, S.A.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Expressed in thousands of U.S. dollars)

	For the six months ended June 30,
		2012		2011

Cash flows provided by (used in) operating activities:
Net income (loss)	$	53,810	$	(179,409)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Net realized and unrealized gains		(26,552)		(16,439)
Net unrealized foreign exchange (gains) losses		(9,228)		2,947
Depreciation and amortization expense		1,839		3,142
Share based compensation expense (recovery)		2,239		(2,573)
Interest in earnings of equity investments		(288)		456
Accretion/amortization on fixed maturity investments		2,522		(1,808)
Changes in assets and liabilities, excluding net assets acquired:
Gain on sale of discontinued operations		(4,522)		-
Premium balances receivable		(60,932)		(212,208)
Unearned premiums ceded		(35,492)		(67,180)
Reinsurance recoverable		28,599		(152,094)
Deferred acquisition costs		(16,054)		(22,514)
Funds withheld		(870)		(4,780)
Loss and loss adjustment expense reserves		(200,673)		344,102
Unearned premiums		104,022		199,173
Insurance and reinsurance balances payable		(27,912)		44,411
Other changes in assets and liabilities, net		8,527		(30,467)
Net cash (used in) provided by operating activities		(180,965)		(95,241)

Cash flows (used in) provided by investing activities:
Net cash received in disposal of subsidiaries		8,628		1,948
Purchases of fixed maturity investments		(1,209,342)		(520,808)
Sales and maturities of fixed maturity investments		1,338,513		661,901
Purchases of other investments		(10,650)		(17,907)
Sales and maturities of other investments		15,734		(28,767)
Purchases of fixed assets		(2,725)		(5,617)
Sales of fixed asset		1,194		-
Change in restricted cash		(61,208)		(11,323)
Net cash provided by investing activities		80,144		79,427

Cash flows (used in) provided by financing activities:
Repurchase of noncontrolling interest		-		(46,488)
Distributions paid per common share		(5,684)		(5,602)
Other		(1,290)		(179)
Net cash used in financing activities		(6,974)		(52,269)

Effect of foreign exchange rate on cash		712		(1,638)

Decrease in cash and cash equivalents		(107,083)		(69,721)
Decrease in cash and cash equivalents from discontinued operations		43,910		44,724
Cash and cash equivalents - beginning of year		249,424		223,033
Cash and cash equivalents - end of period	$	186,251	$	198,036

Supplemental cash flow information:
Receivable for investments sold	$	2,435	$	203,257
Payable for investments purchased	$	2,494	$	176,750
Interest paid	$	4,901	$	2,358

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

Index

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.

The Company has classified the assets and liabilities associated with its former Lloyd’s reportable segment 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. The financial results of the Company’s former Island Heritage reportable segment have been presented in the Company’s consolidated financial statements as “discontinued operations” for all periods up to and including March 31, 2012. The sale of the former Island Heritage reportable segment was completed on April 5, 2012. 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.

Index

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 commenced a formal process to divest its ownership positions in its former Lloyd’s and Island Heritage reportable segments. The sale of the Company’s ownership position in Island Heritage was completed on April 5, 2012, for total proceeds of $70.1 million, of which the Company received $42.1 million for its approximate 60% interest. The divestiture has been recorded in the second quarter results and resulted in a gain on disposal of $4.5 million. On April 3, 2012, the Company announced that it had entered into a definitive agreement to divest its former Lloyd’s reportable segment. The UK Financial Services Authority has approved the change in control and the Company now expects other regulatory approvals to be obtained, and the transaction completed, by August 31, 2012, for total proceeds of approximately $49.7 million. Our letter of credit for Funds at Lloyd’s in the amount of approximately $158.7 million will also be released on the same day. The divestiture will be recorded in the third quarter results and the Company anticipates a small gain on disposal, net of any deal-related expenses.

The Company has classified the assets and liabilities associated with its former Lloyd’s reportable segment 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 financial results of the Company’s former Island Heritage reportable segment have been presented as discontinued operations for all periods presented up to and including March 31, 2012.

Details of the assets and liabilities of discontinued operations held for sale as at June 30, 2012 and December 31, 2011 are as follows:

Index

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 June 30,		As at December 31,
	2012		2011
Assets of discontinued operations held for sale
Fixed maturity investments, at fair value	$	71,573	$	94,422
Short term investments, at fair value		-		4,444
Total investments		71,573		98,866
Cash and cash equivalents		47,884		91,794
Restricted cash		91,230		30,307
Premium balances receivable		103,503		99,075
Unearned premiums ceded		24,165		27,042
Reinsurance recoverable		25,023		17,934
Deferred acquisition costs		23,928		26,949
Goodwill and intangible assets		33,619		44,161
Other assets		10,204		15,836
Total assets of discontinued operations held for sale	$	431,129	$	451,964

Liabilities of discontinued operations held for sale
Loss and loss adjustment expense reserves	$	240,688	$	233,290
Unearned premiums		126,997		142,713
Insurance and reinsurance balances payable		17,892		27,400
Amounts due to affiliates		-		46,682
Other liabilities		8,237		22,872
Total liabilities of discontinued operations held for sale	$	393,814	$	472,957

Net assets (liabilities) of discontinued operations held for sale	$	37,315	$	(20,993)

The increase in net assets of discontinued operations during the six months ended June 30, 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 and six months ended June 30, 2012 and 2011 are as follows:
	For the three months ended June 30,				For the six months ended June 30,
	2012			2011	2012		2011
Revenues
Gross premiums written	$	65,419	$	82,364	$	152,344	$	151,841
Premiums ceded		(6,683)		(37,946)		(34,549)		(59,187)
Net premiums written		58,736		44,418		117,795		92,654
Net premiums earned	$	38,737	$	52,657	$	97,900	$	102,094
Other reinsurance income		528		1,442		650		5,385
Loss and loss adjustment expenses		(26,099)		(18,705)		(50,529)		(65,455)
Acquisition costs		(10,103)		(13,444)		(23,970)		(27,129)
General and administrative expenses		(6,078)		(9,441)		(15,450)		(18,459)
Underwriting income (loss)		(3,015)		12,509		8,601		(3,564)
Gain on disposal of discontinued operations		4,522		-		4,522		-
Other income (expenses)		(139)		745		583		209
(Provision) recovery for income tax		(220)		706		(86)		5,092
Income from discontinued operations	$	1,148	$	13,960	$	13,620	$	1,737

Index

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. The sale of the corporate apartments was completed on April 13, 2012, and has been recorded in second quarter results for total proceeds of approximately $1.3 million, which resulted in a gain on disposal of $0.1 million. The aircraft asset is reflected in assets held for sale including discontinued operations on the consolidated balance sheet as at June 30, 2012, at a carrying value of $8.5 million. The Company does not anticipate a significant gain or loss on disposal of the aircraft.

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 June 30, 2012 and December 31, 2011 are as follows:

		As at June 30, 2012
	Amortized cost or cost		Gross unrealized gains		Gross unrealized losses		Fair value
Fixed maturity investments
Other foreign governments	$	20,359	$	997	$	-	$	21,356
Mortgage-backed securities		137,655		405		(6,416)		131,644
Asset-backed securities		184,477		92		(3,895)		180,674
		342,491		1,494		(10,311)		333,674

Short term investments
U.S. government and agency securities		690,486		6		-		690,492
Corporates		6,351		-		(5)		6,346
		696,837		6		(5)		696,838

Equity investments		236		-		(175)		61
		236		-		(175)		61

Other investments
Investment funds		69,155		4,451		(5,371)		68,235
Catastrophe bonds		71,880		320		(438)		71,762
		141,035		4,771		(5,809)		139,997

Totals	$	1,180,599	$	6,271	$	(16,300)	$	1,170,570

Index

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 $2.4 million and $2.2 million at June 30, 2012 and December 31, 2011, respectively.

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 June 30, 2012 and December 31, 2011 are as follows:

		As at June 30, 2012
			Amortized		Gross unrealized		Gross unrealized		Fair
			cost or cost		gains		losses		value
Other foreign governments
Sovereign Debt
	Other (excluding Eurozone)	$	20,359	$	997	$	-	$	21,356

Totals		$	20,359	$	997	$	-	$	21,356

Index

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		Gross unrealized		Gross unrealized		Fair
				cost or cost		gains		losses		value
Other foreign governments
Sovereign debt
	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

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 June 30, 2012 and December 31, 2011.

	As at June 30, 2012				As at December 31, 2011
	Amortized cost		Fair value		Amortized cost		Fair value

Due within one year	$	696,837	$	696,838	$	29,294	$	29,663
Due after 1 through 5 years		4,100		4,269		746,610		754,709
Due after 5 through 10 years		8,517		9,062		106,287		107,461
Due after 10 years		7,742		8,025		22,236		24,425
Mortgage and asset-backed securities		322,132		312,318		241,948		232,793
Total	$	1,039,328	$	1,030,512	$	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 June 30, 2012 and December 31, 2011:

	As at June 30, 2012				As at December 31, 2011
	Fair value		Percentage of total		Fair value		Percentage of total
Rating Category
AAA	$	1,002,469	97.3	%	$	695,931	60.6	%
AA		2,678	0.3	%		92,299	8.0	%
A		24,998	2.4	%		231,143	20.1	%
BBB		367	0.0	%		129,678	11.3	%
Total	$	1,030,512	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.

Index

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 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.

As at June 30, 2012 and December 31, 2011, the Company’s investments are allocated among fair value levels as follows:

	Fair Value Measurement at June 30, 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
Other foreign governments	$	21,356	$	-	$	21,356	$	-
Residential mortgage-backed securities		131,644		-		131,644		-
Asset-backed securities		180,674		-		180,674		-
		333,674		-		333,674		-

Short term investments
U.S. government and agency securities		690,492		690,492		-		-
Corporates		6,346		-		6,346		-
		696,838		690,492		6,346		-

Equity investments
Financial services		61		61		-		-
		61		61		-		-

Other investments
Investment funds		68,235		-		-		68,235
Catastrophe bonds		71,762		-		71,762		-
		139,997		-		71,762		68,235

Totals	$	1,170,570	$	690,553	$	411,782	$	68,235

Index

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

The reconciliation of the fair value for the Level 3 investments for the period ended June 30, 2012, including purchases and sales and change in realized and unrealized gains (losses) in earnings, is set out below:

		For the six months ended
		June 30, 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
Total realized losses included in earnings		-
Total unrealized gains included in earnings		1,537
Purchases		355
Sales		(164)
Fair value, June 30, 2012	$	68,235

Index

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)

For the Level 3 items still held as of June 30, 2012, the total change in fair value for the three and six months ended June 30, 2012 was $1.6 million and $7.5 million, respectively. 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 and six months ended June 30, 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.

The Company’s investment funds consist of investments in private equity, distressed debt and mortgage-backed investment funds. As at June 30, 2012 and December 31, 2011, the Company had total outstanding investment commitments of $8.9 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 June 30, 2012 and December 31, 2011:

	As at
	June 30, 2012		December 31, 2011

Distressed debt funds	$	18,052	$	14,876
Mortgage-backed investment funds		38,441		33,789
Private equity funds		11,742		10,613
Total	$	68,235	$	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 June 30, 2012 and December 31, 2011 are as follows:

	As at
	June 30, 2012		December 31, 2011

Cash and cash equivalents	$	17,823	$	17,538
Fixed maturity investments		603,103		659,243
Total	$	620,926	$	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.

Index

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 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”).

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 June 30, 2012 and December 31, 2011 are as follows:

		As at June 30, 2012
		Asset derivatives		Liability derivatives
		recorded 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)	$	-	$	1,065	$	51,947	$	(1,065)
			-		1,065				(1,065)

Derivatives not designated as hedging instruments
	Purpose - risk management
	Currency swaps	$	-	$	1,481	$	16,446	$	(1,481)
	Foreign currency forward contracts		9,508		12,492		416,428		(2,984)
			9,508		13,973				(4,465)

Total derivatives		$	9,508	$	15,038			$	(5,530)

Index

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		Liability derivatives
		recorded 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)	$	-	$	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 June 30,					For the three months ended June 30,
		2012		2011	Location		2012		2011
Foreign currency forward contracts(1)	$	3,120	$	(831)	Net realized and unrealized losses - other	$	(56)	$	(124)
	$	3,120	$	(831)		$	(56)	$	(124)

	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 six months ended June 30,					For the six months ended June 30,
		2012		2011	Location		2012		2011
Foreign currency forward contracts(1)	$	961	$	(2,040)	Net realized and unrealized losses - other	$	(401)	$	(349)
	$	961	$	(2,040)		$	(401)	$	(349)

(1)Recognized as a foreign currency hedge under the Derivatives and Hedging Topic of the ASC.

Index

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)

Non-Designated
	Gain or (Loss) on Derivatives Recognized in Net Income
Derivatives not designated		For the three months ended June 30,
as hedging instruments	Location	2012		2011
Futures contracts	Net realized and unrealized losses - investments	$	(74)	$	(16,554)
Currency swaps	Net realized and unrealized (losses) gains - other		(937)		467
Foreign currency forward contracts	Net realized and unrealized gains (losses) - investments		15,584		(17,542)
Foreign currency forward contracts	Net realized and unrealized (losses) gains - other		(3,997)		13,643
		$	10,576	$	(19,986)

	Gain or (Loss) on Derivatives Recognized in Net Income
Derivatives not designated		For the six months ended June 30,
as hedging instruments	Location	2012		2011
Futures contracts	Net realized and unrealized gains (losses) - investments	$	179	$	(8,986)
Currency swaps	Net realized and unrealized (losses) gains - other		(509)		1,547
Foreign currency forward contracts	Net realized and unrealized gains (losses) - investments		3,026		(51,518)
Foreign currency forward contracts	Net realized and unrealized gains - other		2,303		11,857
Mortgage-backed securities TBA	Net realized and unrealized losses - investments		-		(2)
Other reinsurance derivatives	Net realized and unrealized gains - other		-		241
		$	4,999	$	(46,861)

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.

Index

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 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 June 30, 2012 and December 31, 2011 is allocated between levels as follows:

	Fair Value Measurement at June 30, 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	$	(1,481)	$	-	$	(1,481)	$	-
Foreign currency forward contracts		(4,049)		-		(4,049)		-
Total derivatives	$	(5,530)	$	-	$	(5,530)	$	-

For the Level 3 items still held as of June 30, 2012, the total change in fair value for the three and six months ended June 30, 2012, recorded in net realized and unrealized gains (losses) – other, was $nil.

	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 June 30, 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 and six months ended June 30, 2012.

7. DEBT AND FINANCING ARRANGEMENTS

Long term debt