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, 2008
 
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 Limited
(Exact Name of Registrant as Specified in Its Charter)
 
Bermuda
  
98-0481623
     
(State or Other Jurisdiction of
Incorporation or Organization)
  
(I.R.S. Employer
Identification No.)
 
Crawford House
23 Church Street
Hamilton HM 11
Bermuda
(Address of Principal Executive Offices)
 
Registrant's telephone number, including area code:
(441) 278-4300
(Former Address)
 
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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  o    Accelerated filer o     Non-accelerated filer þ
 
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 7, 2008 the Registrant had 85,316,924 common voting shares outstanding, with a par value of $0.01 per share.
 



 
 
 
FLAGSTONE REINSURANCE HOLDINGS LIMITED
INDEX TO FORM 10-Q
 
     
Page
     
       
   
       
   
 
1
       
  Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income for the Three Months Ended March 31, 2008 and 2007  
 
2
       
   
 
3
       
   
 
4
       
   
 5
       
 
 
14
       
 
 25
       
 
 29
       
     
       
 
  30
       
 
  30
       
 
  30
       
 
 30
       
 
30
       
 
30
       
 
30
 

 
 

 
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements

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

 
   
As at March 31, 2008
    
As at December 31, 2007
   
(Unaudited)
      
ASSETS
          
Investments:
          
Fixed maturities, at fair value (Amortized cost: 2008 - $701,279; 2007 - $1,099,149)
   $ 709,393     $ 1,109,105
Short term investments, at fair value (Amortized cost: 2008 - $71,098; 2007 - $23,660)
     70,956       23,616
Equity investments, at fair value (Cost: 2008 - $93,734; 2007 - $73,603)
     86,854       74,357
Other investments
     322,907       293,166
Total Investments
     1,190,110       1,500,244
Cash and cash equivalents
     710,663       362,680
Insurance and reinsurance premium balances receivable
     205,683       136,555
Unearned premiums ceded
     18,348       14,608
Accrued interest receivable
     6,225       9,915
Receivable for investments sold
     5,660       -
Deferred acquisition costs
     37,290       30,607
Funds withheld
     10,361       6,666
Goodwill
     10,781       10,781
Other assets
     46,764       31,717
Total Assets
   $ 2,241,885     $ 2,103,773
               
LIABILITIES
              
Loss and loss adjustment expense reserves
   $ 200,602     $ 180,978
Unearned premiums
     276,823       175,607
Insurance and reinsurance balances payable
     13,207       12,088
Payable for investments purchased
     23,843       41,750
Long term debt
     266,375       264,889
Other liabilities
     33,375       33,198
Total Liabilities
     814,225       708,510
               
Minority Interest
     186,098       184,778
               
SHAREHOLDERS' EQUITY
              
Common voting shares, 150,000,000 authorized, $0.01 par value, issued and outstanding (2008 - 85,316,924; 2007 - 85,309,107)
     853       853
Additional paid-in capital
     909,026       905,316
Accumulated other comprehensive income
     5,457       7,426
Retained earnings
     326,226       296,890
Total Shareholders' Equity
     1,241,562       1,210,485
               
Total Liabilities, Minority Interest and Shareholders' Equity
   $ 2,241,885     $ 2,103,773

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

 
 
   
For the Three Months Ended
  
   
March 31, 2008
    
March 31, 2007
  
             
REVENUES
            
Gross premiums written
   $ 242,246     $ 207,013  
Premiums ceded
     (16,014 )     (8,245 )
Net premiums written
     226,232       198,768  
Change in net unearned premiums
     (90,975 )     (97,542 )
Net premiums earned
     135,257       101,226  
Net investment income
     18,696       13,631  
Net realized and unrealized (losses) gains - investments
     (12,412 )     4,508  
Net realized and unrealized (losses) gains - other
     (12,237 )     6  
Other income
     1,724       673  
Total revenues
     131,028       120,044  
                 
EXPENSES
                
Loss and loss adjustment expenses
     39,767       47,748  
Acquisition costs
     24,165       12,718  
General and administrative expenses
     26,549       14,669  
Interest expense
     5,340       3,264  
Net foreign exchange gains
     (6,699 )     (1,282 )
Total expenses
     89,122       77,117  
Income before income taxes, minority interest and interest in earnings of equity investments
     41,906       42,927  
Provision for income tax
     (865 )     (45 )
Minority interest
     (8,181 )     (7,733 )
Interest in earnings of equity investments
     -       461  
NET INCOME
   $ 32,860     $ 35,610  
                 
Change in currency translation adjustment
     (1,420 )     (276 )
COMPREHENSIVE INCOME
   $ 31,440     $ 35,334  
                 
Weighted average common shares outstanding—Basic
     85,469,270       71,746,162  
Weighted average common shares outstanding—Diluted
     85,690,742       71,839,562  
Net income per common share outstanding—Basic
   $ 0.38     $ 0.50  
Net income per common share outstanding—Diluted
   $ 0.38     $ 0.50  
Dividends declared per common share
   $ 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 LIMITED
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
 (Expressed in thousands of U.S. dollars, except share data)


   
For the Three Months Ended
  
   
March 31, 2008
    
March 31, 2007
  
             
             
Common voting shares:
            
Balance at beginning of period
     85,309,107       71,547,891  
Issued during the period
     7,817       13,000,000  
Balance at end of period
     85,316,924       84,547,891  
                 
Share capital:
                
Common voting shares
                
Balance at beginning of period
   $ 853     $ 715  
Issued during period
     -       130  
Balance at end of period
     853       845  
                 
Additional paid-in capital
                
Balance at beginning of period
     905,316       728,378  
Issue of shares
     111       175,370  
Issuance costs (related party: 2008 - $nil  ; 2007 - $400)
     -       (15,755 )
Share based compensation expense
     3,599       1,638  
Balance at end of period
     909,026       889,631  
                 
Accumulated other comprehensive income (loss)
                
Balance at beginning of period
     7,426       (4,528 )
Change in currency translation adjustment
     (1,420 )     (276 )
Defined benefit plan - transitional obligation
     (549 )     -  
Cumulative effect adjustment from adoption of new accounting principle SFAS 159
     -       4,009  
Balance at end of period
     5,457       (795 )
                 
Retained earnings
                
Balance at beginning of period
     296,890       139,954  
Cumulative effect adjustment from adoption of accounting principle
     -       (4,009 )
Dividend declared
     (3,524 )     -  
Net income for the period
     32,860       35,610  
Balance at end of period
     326,226       171,555  
Total Shareholders' Equity
   $ 1,241,562     $ 1,061,236  
 
 
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 LIMITED
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (Expressed in thousands of U.S. dollars)

   
For the Three Months Ended
  
   
March 31, 2008
    
March 31, 2007
  
             
Cash flows provided by (used in) operating activities:
            
Net income
   $ 32,860     $ 35,610  
Adjustments to reconcile net income to net cash provided by operating activities:
  
Net realized and unrealized gains
     24,649       (4,514 )
Minority interest
     8,181       7,733  
Depreciation expense
     1,154       384  
Share based compensation expense
     3,599       1,638  
Interest in earnings of equity investments
     -       (461 )
Accretion/amortization on fixed maturities
     (4,754 )     (449 )
Changes in assets and liabilities, excluding net assets acquired:
          
Reinsurance premium receivable
     (66,304 )     (76,894 )
Unearned premiums ceded
     (3,475 )     (6,596 )
Deferred acquisition costs
     (6,237 )     (10,658 )
Funds withheld
     (3,696 )     (5,069 )
Loss and loss adjustment expense reserves
     18,257       44,023  
Unearned premiums
     98,123       104,144  
Insurance and reinsurance balances payable
     (287 )     6,235  
Other changes in assets and liabilities, net
     3,628       1,273  
Net cash provided by operating activities
     105,698       96,399  
                 
Cash flows provided by (used in) investing activities:
                
Net cash received in acquisitions of subsidiaries
     -       4,581  
Purchases of fixed income securities
     (399,242 )     (400,673 )
Sales and maturities of fixed income securities
     732,348       248,350  
Purchases of equity securities
     (20,131 )     (22,682 )
Purchases of other investments
     (2,002 )     (76,520 )
Sales of other investments
     (51,885 )     -  
Purchases of fixed assets
     (4,830 )     (542 )
Net cash provided by (used in) investing activities
     254,258       (247,486 )
                 
Cash flows (used in) provided by financing activities:
                
Issue of common shares, net of issuance costs paid
     -       (1,385 )
Contribution of minority interest
     (222 )     83,100  
Repurchase of minority interest
     (6,639 )     -  
Dividend paid on common shares
     (3,413 )     -  
Other
     205       (424 )
Net cash (used in) provided by financing activities
     (10,069 )     81,291  
                 
Effect of foreign exchange rate on cash and cash equivalents
     (1,904 )     (365 )
                 
Increase (decrease) in cash and cash equivalents
     347,983       (70,161 )
Cash and cash equivalents - beginning of period
     362,680       261,352  
Cash and cash equivalents - end of period
   $ 710,663     $ 191,191  
                 
Supplemental cash flow information:
                
Payable for investments purchased
   $ 23,843     $ 7,246  
Receivable for investments sold
   $ 5,660     $ -  
Interest paid
   $ 5,588     $ 3,359  
Proceeds receivable from initial public offering
   $ -     $ 164,854  
                 
 
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 LIMITED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for ratios, share and per share amounts)

 
1.      Basis of Presentation and Consolidation

These unaudited condensed consolidated financial statements include the accounts of Flagstone Reinsurance Holdings Limited (the “Company”) and its wholly owned subsidiaries, including Flagstone Reinsurance Limited (“Flagstone”) and Flagstone Réassurance Suisse SA (“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.  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 Financial Accounting Standards Board (“FASB”) Interpretation No. 46, as revised, “Consolidation of Variable Interest Entities - an interpretation of ARB No. 51” (“FIN 46(R)”).  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.

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 reported 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 and estimates of premiums written, premiums earned, acquisition costs and share based compensation.  The Company reviews and revises these estimates as appropriate. Any adjustments made to these estimates are reflected in the period the estimates are revised.

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 on Form 10-Q should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2007 filed with the Securities and Exchange Commission (the “SEC”) on March 19, 2008.

Certain prior year balances were reclassified to conform with the current year classifications.

2.      New Accounting Pronouncements

The Company maintains a contributory defined benefit plan that covers certain employees at Flagstone Suisse.  The Company accounts for this pension plan using the accrual method, consistent with the requirements of FASB Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Post-retirement Plans, an amendment of FASB Statement No. 87, 88, 106 and 132” (“SFAS 158”), which was adopted by the Company on January 1, 2008.  SFAS 158 requires an employer to recognize the over-funded or under-funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in funded status through comprehensive income in the year in which the changes occur.  An unfunded transitional liability of $0.6 million was recorded in accumulated other comprehensive income at January 1, 2008 and is being amortized over the estimated average remaining service life of 12.2 years.  The net periodic pension expense for 2008 is expected to be approximately $1.2 million, of which $0.3 million has been recorded as a pension expense in the three months ended March 31, 2008.  A pension asset of $0.8 million and a pension liability of $0.8 million were recognized in the March 31, 2008 unaudited condensed consolidated balance sheet.  The Company funds the plan at the amount required by local legal requirements.

In March 2008, FASB released Statement No. 161, “Disclosures About Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133” (“SFAS 161”), which expands the disclosure requirements in SFAS 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) about an entity’s derivative instruments and hedging activities.  SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk related contingent features in derivative agreements.  This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early adoption encouraged.  The adoption of SFAS 161 will not affect our consolidated financial condition and results of operations, and the Company is currently assessing the impact of this statement on its’ disclosure requirements.

3.      Investments

Fair value disclosure

The valuation technique used to fair value 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 SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), the Company determined that its investments in U.S. government securities, equity securities and fixed income fund are stated at Level 1 fair value. Investments in corporate bonds, mortgage-backed securities, hedge fund, and asset backed securities and real estate investment trusts (“REITs”) are stated at Level 2 whereas investment funds that are private placement investments and catastrophe bonds are stated at Level 3 fair value.

As at March 31, 2008 and December 31, 2007, the Company’s investments are allocated between levels as follows:


5
 
FLAGSTONE REINSURANCE HOLDINGS LIMITED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for ratios, share and per share amounts)
 

 
   
Fair Value Measurement at March 31, 2008, using: 
                       
   
Fair Value
    
Quoted Prices in
Active Markets
    
Significant Other
Observable Inputs
    
Significant Other
Unobservable Inputs
   
Measurements
    
(Level 1)
    
(Level 2)
    
(Level 3)
Description
                      
Fixed maturity investments
   $ 709,393     $ 249,381     $ 460,012     $ -
Short term investments
     70,956       64,004       6,952       -
Equity investments
     86,854       86,854       -       -
      867,203       400,239       466,964       -
Other Investments
                              
Real estate investment trusts
     11,079       -       11,079       -
Investment funds
     30,834       -       18,620       12,214
Catastrophe bonds
     36,652       -       -       36,652
Fixed income fund
     244,342       244,342       -       -
      322,907       244,342       29,699       48,866
                               
Totals
   $ 1,190,110     $ 644,581     $ 496,663     $ 48,866
 
   
Fair Value Measurement at December 31, 2007, using:
                       
   
Fair Value
    
Quoted Prices in
Active Markets
    
Significant Other
Observable Inputs
    
Significant Other
Unobservable Inputs
   
Measurements
    
(Level 1)
    
(Level 2)
    
(Level 3)
Description
                      
Fixed maturity investments
   $ 1,109,105     $ 471,811     $ 637,294     $ -
Short term investments
     23,616       4,914       18,702       -
Equity investments
     74,357       74,357       -       -
      1,207,078       551,082       655,996       -
Other Investments
                              
Real estate investment trusts
     12,204       -       12,204       -
Investment funds
     31,249       -       20,041       11,208
Catastrophe bonds
     36,619       -       -       36,619
Fixed income fund
     212,982       212,982       -       -
      293,054       212,982       32,245       47,827
                               
Totals
   $ 1,500,132     $ 764,064     $ 688,241     $ 47,827
 
The table above does not include an equity investment of $112,000 in which the Company is deemed to have a significant influence and as such, is not accounted for at fair value under SFAS 159.

The reconciliation of the fair value for the Level 3 investments, including net purchases and sales, realized gains and change in unrealized gains, is set out below:

   
Investment
    
Catastrophe
   
funds
    
bonds
 
          
Beginning balance, December 31, 2007
   $ 11,208     $ 36,619
Total realized gains included in earnings
     -       -
Total unrealized gains included in earnings
     1,006       33
Net purchases and sales
     -       -
Closing fair value, March 31, 2008
   $ 12,214     $ 36,652
 
4.      Derivatives

The Company writes certain reinsurance contracts that are classified as derivatives under SFAS 133. In addition, the Company enters into derivative instruments such as interest rate futures contracts, interest rate swaps, foreign currency forward contracts and foreign 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 and total return swaps to gain or reduce its exposure to the underlying asset or index. 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 based on guidelines established by management and approved by the Board of Directors.
 
 
6
 
FLAGSTONE REINSURANCE HOLDINGS LIMITED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for ratios, share and per share amounts)
 
 
The Company has entered into certain foreign currency forward contracts that it has designated as hedges in order to hedge its net investments in foreign subsidiaries.  The accounting for the gains and losses associated with changes in fair value of the designated hedge instruments will be recorded in other comprehensive income as part of the cumulative translation adjustment, to the extent that it is effective as a hedge.  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 in the unaudited condensed consolidated financial statements.
 
Interest rate swaps

The Company uses interest rate swap contracts in the portfolio as protection against unexpected shifts in interest rates, which would affect the fair value of the fixed maturity portfolio.  By using interest rate swaps, the overall duration or interest rate sensitivity of the portfolio can be altered.  The Company also uses interest rate swaps to manage its borrowing costs on its long term debt.  As of March 31, 2008 and December 31, 2007, there were a total of $411.5 million and $389.9 million of interest rate swaps in the portfolio with a total fair value of $(6.0) million and $2.3 million, respectively.  During the three months ended March 31, 2008 and for the same period in 2007, the Company recorded $7.7 million and $nil, respectively, of realized and unrealized losses on interest rate swaps.

To convert the interest on long term debt from floating to fixed, the Company entered into interest rate swaps.  On December 7, 2007, the Company entered into interest rate swap agreements with Lehman Brothers Special Financing Inc. Under the terms of these agreements, the Company exchanged interest on notional amounts of $120.0 million and $25.0 million, respectively, will receive interest at three month London Interbank Offered Rate (“LIBOR”) and will pay 3.962% and 4.096% interest, respectively. These agreements will terminate on September 15, 2011 and September 15, 2012, respectively.  On December 7, 2007, the Company entered into an interest rate swap agreement with Citibank N.A.  Under the terms of the agreement, the Company exchanged interest on the notional amount of $100.0 million, and will receive three month LIBOR and will pay 4.095% interest.  The agreement will terminate on July 30, 2012.  At March 31, 2008 and December 31, 2007, the fair value of these swaps was $(9.2) million and $0.4 million, respectively.  During the three months ended March 31, 2008 and for the same period in 2007, the Company recorded $9.2 million and $nil, respectively, of realized and unrealized losses on those swaps.

Foreign currency swaps

The Company periodically uses foreign currency swaps to minimize the effect of fluctuating foreign currencies. In September 2006, the Company entered into a foreign currency swap, in relation to the Euro-denominated Deferrable Interest Debentures (“Deferrable Interest Debentures”). Under the terms of the foreign currency swap, the Company exchanged €13.0 million for $16.7 million, will receive Euro Interbank Offered Rate (“Euribor”) plus 354 basis points and will pay LIBOR plus 371 basis points. The swap expires on September 15, 2011 and had a fair value of $4.2 million and $2.5 million as at March 31, 2008 and December 31, 2007, respectively.  During the three months ended March 31, 2008 and 2007, the Company recorded $1.8 million of realized and unrealized gains and $0.2 million of realized and unrealized losses, respectively, on foreign currency swaps.

Foreign currency forwards

The Company and its subsidiaries use foreign currency forward contracts to manage currency exposure.  The contractual amount of these contracts as at March 31, 2008 and December 31, 2007 was $348.3 million and $311.1 million, and had a fair value of $1.0 million and $(7.1) million, respectively.  The Company designated $307.3 million and $264.4 million of foreign currency forwards contractual value as hedges, which had a fair value of $0.2 million and $(3.4) million as at March 31, 2008 and December 31, 2007, respectively.  During the three months ended March 31, 2008 and 2007, the Company recorded $5.6 million and $0.4 million, respectively, of realized and unrealized losses on foreign currency forward contracts.  During the three months ended March 31, 2008, the Company recorded $29.9 million of realized and unrealized losses directly into comprehensive income as part of the cumulative translation adjustment for the effective portion of the hedge.

Total return swaps

The Company uses total return equity swaps to gain exposure to the equity markets.  The total return swaps allow the Company to earn the return of the underlying index while paying floating interest plus a spread to the counterparty.  As of March 31, 2008, there were no total return swaps in the portfolio and as of December 31, 2007, the notional amount of the total return swaps were $14.2 million and had a fair value of $(4.9) million.  During the three months ended March 31, 2008 and 2007, the Company recorded $0.3 million of realized and unrealized losses and $1.1 million of realized and unrealized gains, respectively, on total return equity swaps.

To be announced mortgage backed securities

By acquiring a TBA, the Company makes a commitment to purchase a future issuance of mortgage-backed securities. For the period between purchase of the TBA and issuance of the underlying security, the Company’s position is accounted for as a derivative in the consolidated financial statements. At March 31, 2008 and December 31, 2007, the notional principal amount of TBAs was $31.1 million and $18.2 million and the fair value was $0.6 million and $0.2 million, respectively. During the three months ended March 31, 2008 and 2007, the Company recorded $0.4 million and $0.1 million, respectively, of realized and unrealized gains on TBAs.

Futures

The Company has entered into equity index and interest rate futures. At March 31, 2008 and December 31, 2007, the notional amount of index and interest rate futures were $464.8 million and $421.0 million, respectively. The net fair value of futures contracts was $(0.7) million and $(2.2) million as at March 31, 2008 and December 31, 2007, respectively. During the three months ended March 31, 2008 and 2007, the Company recorded $20.1 million of realized and unrealized losses and $0.1 million of realized and unrealized gains, respectively, on futures.

Industry loss warranties

The Company has entered into industry loss warranty (“ILW”) transactions that are structured as reinsurance or derivatives. For those transactions determined to be derivatives, the fair value was $(0.6) million and $(1.3) million at March 31, 2008 and December 31, 2007, respectively. During the three months ended March 31, 2008 and 2007, the Company recorded $0.7 million and $0.1 million, respectively, of realized and unrealized gains on ILWs determined to be derivatives.
 
7
 
FLAGSTONE REINSURANCE HOLDINGS LIMITED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for ratios, share and per share amounts)
 
 
Weather derivatives

The Company entered into weather derivatives during the first quarter of 2008 to gain hurricane exposure during the 2008 hurricane season.  The Company entered into futures options block trades on a major hurricane index.  Net option premiums of $0.3 million were received on a total maximum exposure of $3.0 million based on the underlying hurricane index.  The net fair value of the options were recorded on the balance sheet, with purchase options of $1.5 million recorded in other assets and written options of $1.8 million recorded in other liabilities.  There were no net realized and unrealized gains (losses) recorded on the weather derivatives during the quarter.

Fair value disclosure

In accordance with SFAS 157, the fair value of derivative instruments held as of March 31, 2008 and December 31, 2007 is allocated between levels as follows:

   
Fair Value Measurement at March 31, 2008, using:
  
                         
   
Fair Value
  
Quoted Prices in
Active Markets
    
Significant Other
Observable Inputs
    
Significant Other
Unobservable Inputs
  
   
Measurements
  
(Level 1)
    
(Level 2)
    
(Level 3)
  
Derivatives
                        
Futures contracts
   $ (735 )   $ (735 )   $ -     $ -  
Swaps
     (1,792 )     -       (1,792 )     -  
Forward currency contracts
     954       -       954       -  
Mortgage backed securities TBA
     603       -       603       -  
Other reinsurance derivatives
     (904 )     -       (313 )     (591 )
Total derivatives
   $ (1,874 )   $ (735 )   $ (548 )   $ (591 )
 
   
Fair Value Measurement at December 31, 2007, using:
  
                         
   
Fair Value
  
Quoted Prices in
Active Markets
    
Significant Other
Observable Inputs
    
Significant Other
Unobservable Inputs
  
   
Measurements
  
(Level 1)
    
(Level 2)
    
(Level 3)
  
Derivatives
                        
Futures contracts
   $ (2,228 )   $ (2,228 )   $ -     $ -  
Swaps
     (153 )     -       (153 )     -  
Forward currency contracts
     (7,067 )     -       (7,067 )     -  
Mortgage backed securities TBA
     173       -       173       -  
Other reinsurance derivatives
     (1,305 )     -       -       (1,305 )
Total derivatives
   $ (10,580 )   $ (2,228 )   $ (7,047 )   $ (1,305 )
 
Derivatives are recorded on the balance sheet as other assets or other liabilities.

The reconciliation of the fair value for the Level 3 derivative instruments, including net purchases and sales, realized gains and changes in unrealized gains, is as follows:
 
Other reinsurance derivatives
  
Opening fair value, December 31, 2007
   $ (1,305 )
Total realized gains included in earnings
     -  
Total unrealized gains included in earnings
     714  
Net purchases and sales
     -  
Closing fair value, March 31, 2008
   $ (591 )
 
5.      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 Deferable Interest Debentures (the “Notes”), to the earliest they may be called by the Company.  For the three months ended March 31, 2008 and 2007, the Company incurred interest expense and amortization of debt offering expenses of $5.3 million, and $3.3 million on the Notes.  Also, at March 31, 2008 and December 31, 2007, the Company had $1.5 million and $1.9 million, respectively, of interest payable included in other liabilities in the unaudited condensed consolidated balance sheets.

8
 
FLAGSTONE REINSURANCE HOLDINGS LIMITED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for ratios, share and per share amounts)
 
Letter of credit facility

In August 2006, the Company entered into a $200.0 million uncommitted letter of credit facility agreement with Citibank N.A.  In April 2007, the Company increased its uncommitted letter of credit facility agreement with Citibank N.A. from $200.0 million to $400.0 million. As at March 31, 2008 and December 31, 2007, $73.2 million and $73.8 million, respectively, had been drawn under this facility, and the drawn amount of the facility was secured by $81.3 million and $82.0 million, respectively, of fixed maturity securities from the Company’s investment portfolio.

In September 2007, the Company entered into a $200.0 million uncommitted letter of credit facility agreement with Wachovia Bank, N.A.  While the Company has not drawn upon this facility as at March 31, 2008, if drawn upon, the utilized portion of the facility will be secured by an appropriate portion of securities from the Company’s investment portfolio.

6.      Share Based Compensation

The Company accounts for share based compensation in accordance with SFAS No. 123(R), “Share Based Payments” (“SFAS 123(R)”), which requires entities to measure the cost of employee services received 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 over the period during which an employee is required to provide service in exchange for the award.

Performance Share Units

The 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 of the Directors (the “Committee”), Performance Share Units (“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, 2008 and changes during the three months ended March 31, 2008 are as follows:
 
   
Three Months Ended March 31, 2008
  
   
Number
    
Weighted average grant date fair value
    
Weighted average remaining contractual term
(years)
  
                   
Outstanding at December 31, 2007
     1,658,700     $ 12.07       1.7  
Granted
     727,958       13.90          
Forfeited
     (78,000 )     12.54          
Outstanding at March 31, 2008
     2,308,658       12.63       1.8  
 
As at March 31, 2008 and December 31, 2007, there was a total of $20.3 million and $11.9 million, respectively, of unrecognized compensation cost related to non-vested PSUs; that cost is expected to be recognized over a period of approximately 2.2 and 2.1 years, respectively.  A compensation expense of $2.2 million and $1.3 million has been recorded in general and administrative expenses for the three months ended March 31, 2008 and 2007, respectively, in relation to the PSU Plan.

No PSUs have vested or been cancelled since the inception of the Plan.

Restricted Share Units

Beginning July 1, 2006, the Company granted Restricted Share Units (“RSUs”) to certain employees and directors of the Company.  The RSU grants to employees vest over a period of approximately two years while RSUs granted to directors vest on the grant date.

A summary of the activity under the RSU Plan as at March 31, 2008 and changes during the three months ended March 31, 2008 are as follows:

   
Three Months Ended March 31, 2008
  
   
Number
    
Weighted average grant date fair value
    
Weighted average remaining contractual term
(years)
  
                   
Outstanding at December 31, 2007
     326,610     $ 12.45       0.6  
Granted
     230,715       13.89          
Forfeited
     (16,950 )     13.74          
Converted into common shares
     (7,817 )     11.51          
Outstanding at March 31, 2008
     532,558       13.04       0.8  
 
As at March 31, 2008 and December 31, 2007, there was a total of $2.9 million and $1.3 million, respectively, of unrecognized compensation cost related to non-vested RSUs; that cost is expected to be recognized over a period of approximately 1.4 and 0.9 years, respectively.  A compensation expense of $1.4 million and $0.3 million has been recorded in general and administrative expenses for the three months ended March 31, 2008 and 2007, respectively, in relation to the RSU Plan.

9
 
FLAGSTONE REINSURANCE HOLDINGS LIMITED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for ratios, share and per share amounts)
 
No RSUs granted to employees have vested or been cancelled since the inception of the RSU Plan in July 2006. During the three months ended March 31, 2008 and 2007, 55,715 and nil RSU’s, respectively, were granted to the directors.

7.      Earnings Per Common Share

The computation of basic and diluted earnings per common share for the three months ended March 31, 2008 and 2007 is as follows:

   
Three Months Ended
  
   
March 31, 2008
    
March 31, 2007
  
Basic earnings per common share
            
Net income
   $ 32,860     $ 35,610  
Weighted average common shares outstanding
     85,311,942       71,692,335  
Weighted average vested restricted share units
     157,328       53,827  
Weighted average common shares outstanding—Basic
     85,469,270       71,746,162  
Basic earnings per common share
   $ 0.38     $ 0.50  
                 
Diluted earnings per common share
                
Net income
   $ 32,860     $ 35,610  
Weighted average common shares outstanding
     85,311,942       71,692,335  
Weighted average vested restricted share units outstanding
     157,328       53,827  
      85,469,270       71,746,162  
Share equivalents:
                
Weighted unvested restricted share units
     221,472       93,400  
Weighted average common shares outstanding—Diluted
     85,690,742       71,839,562  
Diluted earnings per common share
   $ 0.38     $ 0.50  
 
As at March 31, 2008 and 2007, there was a warrant outstanding which would result in the issuance of 8,585,747 common shares that were excluded from the computation of diluted earnings per common share because the effect would be anti-dilutive.  Because the number of shares contingently issuable under the PSU Plan depends on the average DROE over a three year period, the 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.  As at March 31, 2008 and 2007, there were 2,308,658 and 1,381,000 PSUs outstanding, respectively.  The maximum number of common shares that could be issued under the PSU plan at March 31, 2008 and 2007 was 4,617,316 and 2,762,000, respectively.

8.      Legal Proceedings

In the normal course of business, the Company may become involved in various claims litigation and legal proceedings.  As at March 31, 2008, the Company was not a party to any litigation or arbitration proceedings.

9.      Segment Reporting

To better align the Company’s operating and reporting structure with its current strategy, as a result of the strategic significance of Island Heritage Holdings Company’s (“Island Heritage”) insurance business, to the Company, and given the relative size of revenues generated by its insurance business, the Company revised its segment structure, effective January 1, 2008.  The Company determined that the allocation of resources and the assessment of performance should now be reviewed separately for both segments.  The Company is currently organized into two business segments: Reinsurance and Insurance.  We regularly review our financial results and assess our performance on the basis of these two operating segments.

Those segments are more fully described as follows:

Reinsurance

Our Reinsurance segment has three main units:

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.  All property per risk and pro rata business is written with loss limitation provisions, such as per occurrence or per event caps, in place to limit exposure to catastrophic events.


10
 
FLAGSTONE REINSURANCE HOLDINGS LIMITED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for ratios, share and per share amounts)
 
 
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.  Most short-tail specialty and casualty reinsurance is written with loss limitation provisions.  During 2008, we expect to continue increasing our specialty writings based on our assessment of the market environment.

Insurance

The Company has established a new Insurance segment for the three months ended March 31, 2008, as a result of the insurance business operated through Island Heritage, a property insurer based in the Cayman Islands which primarily is in the business of insuring homes, condominiums and office buildings in the Caribbean region.  The Company gained controlling interest of Island Heritage (54.6%) in the third quarter of 2007, and as a result, there are no comparatives for the three months ended March 31, 2007.

The following tables provide a summary of gross and net written and earned premiums, underwriting results, total assets, reserves and ratios for each of our business segments for the three months ended March 31, 2008 and 2007:
 
   
Three Months Ended March 31, 2008
  
   
Reinsurance
    
Insurance
    
Total
  
Underwriting Revenues
                  
Gross premiums written
   $ 223,141     $ 19,105     $ 242,246  
Premiums ceded
     (5,320 )     (10,694 )     (16,014 )
Net written premiums
     217,821       8,411       226,232  
Change in net unearned premiums
     (89,700 )     (1,275 )     (90,975 )
Net premiums earned
     128,121       7,136       135,257  
Other insurance related income
     212       829       1,041  
Total underwriting revenues
     128,333       7,965       136,298  
Underwriting Expenses
                        
Loss and loss adjustment expenses (recoveries)
     39,802       (35 )     39,767  
Acquisition costs
     20,910       3,255       24,165  
General and administrative expenses
     24,133       2,416       26,549  
Total underwriting expenses
     84,845       5,636       90,481  
Underwriting Income
   $ 43,488     $ 2,329     $ 45,817  
Total Assets   $ 2,153,579     $ 88,306     $  2,241,885  
Net reserves for loss and loss adjustment expenses
   $ 197,874     $ 2,728     $ 200,602  
Ratios
                        
Loss ratio
     31.1%       -0.5%       29.4%  
Expense ratio
     35.1%       79.5%       37.5%  
Combined ratio
     66.2%       79.0%       66.9%  
 

11
 
FLAGSTONE REINSURANCE HOLDINGS LIMITED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for ratios, share and per share amounts)
 
 
   
Three Months Ended March 31, 2007
  
   
Reinsurance
    
Insurance
    
Total
  
Underwriting Revenues
                  
Gross premiums written
   $ 207,013     $ -     $ 207,013  
Premiums ceded
     (8,245 )     -       (8,245 )
Net written premiums
     198,768       -       198,768  
Change in net unearned premiums
     (97,542 )     -       (97,542 )
Net premiums earned
     101,226       -       101,226  
Other insurance related income
     225       -       225  
Total underwriting revenues
     101,451       -       101,451  
Underwriting Expenses
                        
Loss and loss adjustment expenses
     47,748       -       47,748  
Acquisition costs
     12,718       -       12,718  
General and administrative expenses
     14,669       -       14,669  
Total underwriting expenses
     75,135       -       75,135  
Underwriting Income
   $ 26,316     $ -     $ 26,316  
Total Assets   $ 1,649,190     $ -     $ 1,649,190  
Net reserves for loss and loss adjustment expenses
   $ 66,540     $ -     $ 66,540  
Ratios
                        
Loss ratio
     47.2%       0.0%       47.2%  
Expense ratio
     27.1%       0.0%       27.1%  
Combined ratio
     74.3%       0.0%       74.3%  
 
The following table reconciles underwriting income to income before income taxes, minority interest and interest in earnings of equity investments for the three months ended March 31, 2008 and 2007:
 
   
Three Months Ended
  
   
March 31, 2008
    
March 31, 2007
  
             
Underwriting income
   $ 45,817     $ 26,316  
Net investment income
     18,696       13,631  
Net realized and unrealized (losses) gains - investments
     (12,412 )     4,508  
Net realized and unrealized (losses) gains - other
     (12,237 )     6  
Other income
     683       448  
Interest expense
     (5,340 )     (3,264 )
Net foreign exchange gains
     6,699       1,282  
Income before income taxes, minority interest and interest in earnings of equity investments
   $ 41,906     $ 42,927  
 
 

12
 
FLAGSTONE REINSURANCE HOLDINGS LIMITED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in tables expressed in thousands of U.S. dollars, except for ratios, share and per share amounts)
 
 
The following tables set forth a breakdown of the Company’s consolidated gross premiums written by line of business and geographic area of risks insured for the periods indicated:

   
Three Months Ended March 31, 2008
    
Three Months Ended March 31, 2007
  
   
Gross premiums written
    
Percentage of total
    
Gross premiums written
    
Percentage of total
  
Line of business
                        
Reinsurance
                        
  Property catastrophe
   $ 164,616       68.0 %   $ 158,368       76.5 %
  Property
     18,921       7.8 %     24,556       11.9 %
  Short-tail specialty and casualty
     39,604       16.3 %     24,089       11.6 %
Insurance
     19,105       7.9 %     -       0.0 %
Total
   $ 242,246       100.0 %   $ 207,013       100.0 %
 
 
 
   
Three Months Ended March 31, 2008
    
Three Months Ended March 31, 2007
  
   
Gross premiums written
    
Percentage of total
    
Gross premiums written
    
Percentage of total
  
Geographic area of risk insured(1)
                    
North America
   $ 78,683       32.5 %   $ 90,751       43.8 %
Europe
     64,675       26.7 %     66,968       32.3 %
Worldwide risks(2)
     56,864       23.5 %     25,606       12.4 %
Caribbean (3)
     25,720       10.6 %     7,363       3.6 %
Japan and Australasia
     9,292       3.8 %     11,639       5.6 %
Other
     7,012       2.9 %     4,686       2.3 %
Total
   $ 242,246       100.0 %   $ 207,013       100.0 %
 
(1)  
Except as otherwise noted, each of these categories includes contracts that cover risks located primarily in the designated geographic area.
(2)  
This geographic area includes contracts that cover risks primarily in two or more geographic zones.
(3)  
Gross written premiums related to the insurance segment are included in the Caribbean geographic area.
 
 
For the three months ended March 31, 2008 and 2007, premiums produced by brokers were as follows:

   
Three Months Ended March 31, 2008
    
Three Months Ended March 31, 2007
  
   
Gross premiums written
    
Percentage of total
    
Gross premiums written
    
Percentage of total
  
Name of broker
                        
Benfield
   $ 73,103       30.2 %   $ 68,633       33.2 %
Guy Carpenter
     54,840       22.6 %     50,559       24.4 %
Aon Re Worldwide
     33,733       13.9 %     29,279       14.1 %
Willis Group
     19,324       8.0 %     31,546       15.2 %
Other brokers(1)
     61,246       25.3 %     26,996       13.1 %
Total
   $ 242,246       100.0 %   $ 207,013       100.0 % 

(1) Other brokers includes the gross written premiums related to the insurance segment
10.      Subsequent Events

Alliance International Reinsurance Public Company Limited

On April 28, 2008, the Company announced its intention to purchase, via a subsidiary, up to 29.9% of Alliance International Reinsurance Public Company Limited (“Alliance Re”) from current shareholders.  The transaction, subject to regulatory approvals, satisfactory due diligence and closing conditions, is expected to close in the second quarter of 2008 and is estimated to cost approximately $13.1 million.

Alliance Re, domiciled in the Republic of Cyprus and publicly traded on the Cyprus Stock Exchange (ALL), is a specialist property and casualty reinsurer writing multiple lines of business in Europe, Asia, and the Middle East and North Africa regions.  As part of the relationship, Flagstone may provide technical support in the form of modeling and actuarial resources and a quota share arrangement in order to further assist in the growth and development of Alliance Re.
 

13
 
 
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, 2008 and December 31, 2007 and our results of operations for the three months ended March 31, 2008 and 2007.  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 Form 10-Q 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 the Company’s Form 10-K for the year ended December 31, 2007.  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 Item 1A, “Risk Factors” contained in our Form 10-K, filed with the SEC on March 19, 2008, 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 on Form 10-Q to the “Company”, “we”, “us”, and “our” refer to Flagstone Reinsurance Holdings Limited and/or its subsidiaries, including Flagstone Reinsurance Limited, its wholly-owned Bermuda reinsurance company, Flagstone Réassurance Suisse SA, its wholly-owned Switzerland reinsurance company, Island Heritage Holdings Limited, its Cayman-based insurance company and any other direct or indirect subsidiary, unless the context suggests otherwise.  References to “Flagstone” refer to Flagstone Reinsurance Limited and its wholly-owned subsidiaries.  References to “Flagstone Suisse” refer to Flagstone Réassurance Suisse SA and its wholly-owned subsidiaries and references to “Island Heritage” refer to Island Heritage Holdings Limited and its subsidiaries.  References in this Form 10-Q to “dollars” or “$” are to the lawful currency of the United States of America, 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 and percentages.

Executive Overview

We are a global reinsurance company. Through our reinsurance subsidiaries, we write primarily property, property catastrophe and short-tail specialty and casualty reinsurance and through Island Heritage, we primarily write insurance.

Because we have a limited operating history, period to period comparisons of our results of operations are limited and may not be meaningful in the near future. Our financial statements are prepared in accordance with U.S. GAAP and our fiscal year ends on December 31.  Since a substantial portion of the reinsurance we write 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 insurance coverages we offer to clients affected by these events.  This may result in volatility in our results of operations 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 changes in market conditions.

We measure our financial success through long term growth in diluted book value per share plus accumulated dividends measured over intervals of three years, which we believe is the most appropriate measure of the performance of the Company, a measure that focuses on the return provided to the Company’s common shareholders. Diluted book value per share is obtained by dividing shareholders’ equity by the number of common shares and common share equivalents outstanding.

We derive our revenues primarily from net premiums earned from the reinsurance and insurance policies we write, net of any retrocessional coverage purchased, net investment 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 twelve months.

Our expenses consist primarily of the following types: loss and loss adjustment expenses incurred on the policies of reinsurance and insurance 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 PSU and RSU Plans, and other general operating expenses; interest expenses related to our debt obligations; and minority interest, which represents the interest of external parties with respect to the net income of Mont Fort Re Ltd. (“Mont Fort”) and Island Heritage.  We are also subject to taxes in certain jurisdictions in which we operate; however, since the majority of our income is currently earned in Bermuda, a non-taxable jurisdiction, the tax impact to our operations has historically been minimal.

To better align the Company’s operating and reporting structure with its current strategy, as a result of the strategic significance of Island Heritage's insurance business to the Company, and given the relative size of revenues generated by its insurance business, the Company revised its segment structure, effective January 1, 2008.  The Company determined that the allocation of resources and the assessment of performance should now be reviewed separately for both segments.  The Company is currently organized into two business segments: Reinsurance and Insurance.  We regularly review our financial results and assess our performance on the basis of these two operating segments.

Those segments are more fully described as follows:

Reinsurance

Our Reinsurance segment has three main units:
 
(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.  All property per risk and pro rata business is written with loss limitation provisions, such as per occurrence or per event caps, in place 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.  Most short-tail specialty and casualty reinsurance is written with loss limitation provisions. During 2008, we expect to continue increasing our specialty writings based on our assessment of the market environment.
 
 
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Insurance

The Company has established a new Insurance segment for the three months ended March 31, 2008, which included the insurance business generated through Island Heritage, a property insurer based in the Cayman Islands which primarily is in the business of insuring homes, condominiums and office buildings in the Caribbean region.  The Company gained controlling interest of Island Heritage in the third quarter of 2007.

Critical Accounting Policies

Critical accounting policies at March 31, 2008 have not changed compared to December 31, 2007.  The Company’s critical accounting policies are discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

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 management to make assumptions and best estimates to determine the reported values.  If events or other factors, including those described in Item 1A, “Risk Factors,” of our Form 10-K, 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.

New Accounting Pronouncements

Post Retirement Benefits

The Company maintains a contributory defined benefit plan that covers certain employees at Flagstone Suisse.  The Company accounts for this pension plan using the accrual method, consistent with the requirements of FASB Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Post-retirement Plans, an amendment of FASB Statement No. 87, 88, 106 and 132” (“SFAS 158”), which was adopted by the Company on January 1, 2008.  SFAS 158 requires an employer to recognize the over-funded or under-funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in funded status through comprehensive income in the year in which the changes occur.  An unfunded transitional liability of $0.6 million was recorded in accumulated other comprehensive income at January 1, 2008 and is being amortized over the estimated average remaining service life of 12.2 years.  The net periodic pension expense for 2008 is expected to be approximately $1.2 million, of which $0.3 million has been recorded as a pension expense in the three months ended March 31, 2008.  A pension asset of $0.8 million and a pension liability of $0.8 million were recognized in the March 31, 2008 unaudited condensed consolidated balance sheet.  The Company funds the plan at the amount required by local legal requirements.
 
FASB recently released Statement No. 161, “Disclosures About Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133” (“SFAS 161”), which expands the disclosure requirements in SFAS 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) about an entity’s derivative instruments and hedging activities.  SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk related contingent features in derivative agreements.  This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early adoption encouraged.  The adoption of SFAS 161 will not affect our consolidated financial condition and results of operations, but may require additional disclosures.

Recent Developments

Alliance International Reinsurance Public Company Limited

On April 28, 2008, the Company announced its intention to purchase, via a subsidiary, up to 29.9% of Alliance Re from current shareholders.  The transaction, subject to regulatory approvals, satisfactory due diligence and closing conditions, is expected to close in the second quarter of 2008, and is estimated to cost approximately $13.1 million.

Alliance Re, domiciled in the Republic of Cyprus and publicly traded on the Cyprus Stock Exchange (ALL), is a specialist property and casualty reinsurer writing multiple lines of business in Europe, Asia, and the Middle East and North Africa regions.  As part of the relationship, Flagstone may provide technical support in the form of modeling and actuarial resources and a quota share arrangement in order to further assist in the growth and development of Alliance Re.

Investments

Fair value disclosure

Following the issuance by the FASB of SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115” (“SFAS 159”), the Company elected to adopt the fair value option for all fixed maturity investments, equity investments (excluding investments accounted for under the equity method of accounting), real estate investment trusts (“REITs”), investment funds, catastrophe bonds, and fixed income funds effective January 1, 2007.  This election requires the Company to adopt SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), regarding fair value measurements. The valuation technique used to fair value the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets.

The Company’s U.S. government securities, equity securities and fixed income fund are stated at fair value as determined by the quoted market price of these securities as provided either by independent pricing services or exchange market prices or, when such prices are not available, by reference to broker or underwriter quotes.  For securities priced using broker or underwriter quotes, we have determined that these quotes are the best estimates of the fair value of these securities when the market for the securities is considered active and multiple quotes with identical prices can be obtained.  The fair value of the corporate bonds, mortgage-backed securities, asset-backed securities and REITs are derived from broker quotes based on inputs that are observable for the asset, either directly or indirectly, such as yield curves and transactional history.  Investment funds and other investments are stated at fair value as determined by either the most recently published net asset value -- being the fund’s holdings in quoted securities adjusted for administration expenses -- or the most recently advised net asset value as advised by the fund adjusted for cash flows -- where the fund’s holdings are in private equity investments.  Catastrophe bonds are stated at fair value as determined by reference to broker indications.  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.  The private equity investments are valued by the investment fund managers using the valuations and financial statements provided by the general partners on a quarterly basis.  These valuations are then adjusted by the investment fund managers for the cash flows since the most recent valuation.  The valuation methodology used for the investment funds are consistent with the investment industry.  Derivative instruments are stated at fair value and are determined by the quoted market price for futures contracts and by observable market inputs for foreign currency forwards, total return swaps, currency swaps, interest rates swaps, and to-be-announced securities (“TBAs”).  The Company fair values reinsurance derivative contracts using internal valuation models, with the significant inputs to the valuation models being the underlying risk exposure and the time left to the end of the contract.
 
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At March 31, 2008, the fair value of the securities classified as Level 3 under SFAS 157 was $48.9 million, or approximately 4.1% of total investment assets measured at fair value.  There were no changes in the SFAS 157 classifications for the invested assets during the quarter.  Refer to Notes 3 and 4 of the unaudited condensed financial statements for a breakdown of the fair value measurements.

Investments are recorded on a trade date basis and realized gains and losses on sales of investments are determined on a first-in, first-out basis.


Results of Operations - For the Three Months Ended March 31, 2008 and 2007

The Company’s reporting currency is the U.S. dollar.  The Company’s subsidiaries have one of the following functional currencies: U.S. dollar, Euro, Swiss franc, Indian rupee, British pound or Canadian dollar.  As a significant portion of the Company’s operations is transacted in foreign currencies, fluctuations in foreign exchange rates may affect period-to-period comparisons.  To the extent that fluctuations in foreign exchange rates affect comparisons, their impact has been quantified, when possible, and discussed in each of the relevant sections.  See Note 2 to the consolidated financial statements in Item 8, “Financial Statements and Supplementary Data”, in the Company’s Form 10-K filed with the SEC on March 19, 2008, for a discussion on translation of foreign currencies.

During the quarter ended March 31, 2008, the U.S. dollar weakened approximately 14.0% against the Swiss franc and 8.0% against the Euro, and strengthened approximately 3.8% against the Canadian dollar.

Summary Overview
 
We generated $32.9 million of net income for the three months ended March 31, 2008, compared to net income of $35.6 million for the same period in 2007.  The results of Island Heritage were not consolidated in our results of operations for the three months ended March 31, 2007.  The decrease in net income for the first quarter of 2008 is due primarily to:
 
-  
an increase in gross written and earned premiums of $35.2 million and $34.0 million, respectively, as discussed below;
-  
a decrease in the loss ratio of 17.8%, from 47.2% in the first quarter 2007 to 29.4% in the first quarter of 2008, due to the impact of Windstorm Kyrill, which generated net losses in the amount of $29.3 million in the first quarter of 2007;
-  
an increase in investment income of $5.1 million primarily due to returns on a higher investable asset base;
-  
an increase in the net realized and unrealized losses on investments and other derivative instruments of $29.2 million;
-  
an increase in general and administrative expenses of $11.9 million due to the increase in staffing levels as we continue to build our global platform;
-  
an increase in interest expense of $2.1 million due to interest on the additional debt issued in June and September 2007; and
-  
an increase in foreign exchange gains of $5.4 million due to net monetary assets and liabilities denominated in foreign currencies that appreciated against the U.S. dollar.
 
As a result of our net income for the three months ended March 31, 2008, our diluted book value per share plus accumulated dividends increased to $14.20, compared to $13.95 at December 31, 2007, representing an increase of 1.8%.
 
   
For the Three Months Ended
  
   
March 31, 2008
    
March 31, 2007
  
REVENUES
            
Gross premiums written
   $ 242,246     $ 207,013  
Premiums ceded
     (16,014 )     (8,245 )
Net premiums written
     226,232       198,768  
Net premiums earned
     135,257       101,226  
Net investment income
     18,696       13,631  
Net realized and unrealized (losses) gains - investments
     (12,412 )     4,508  
Net realized and unrealized (losses) gains - other
     (12,237 )     6  
Other income
     1,724       673  
Total revenues
     131,028       120,044  
                 
EXPENSES
                
Loss and loss adjustment expenses
     39,767       47,748  
Acquisition costs
     24,165       12,718  
General and administrative expenses