Edgar Filing: Flagstone Reinsurance Holdings Ltd

form10q-093008.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 September 30, 2008

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)

(441) 278-4300

(Registrant's telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

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 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 o
Non-accelerated filer þ (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 November 6, 2008 the Registrant had 84,685,896 common voting shares outstanding, with a par value of $0.01 per share.

FLAGSTONE REINSURANCE HOLDINGS LIMITED

INDEX TO FORM 10-Q

		Page
	PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements

	Condensed Consolidated Balance Sheets as at September 30, 2008 (Unaudited) and December 31, 2007	1

	Unaudited Condensed Consolidated Statements of Operations and Comprehensive (Loss) Income for the Three and Nine Months Ended September 30, 2008 and 2007	2

	Unaudited Condensed Consolidated Statements of Changes in Shareholders' Equity for the Nine Months Ended September 30, 2008 and 2007	3

	Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and 2007	4

	Notes to Unaudited Condensed Consolidated Financial Statements	5

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	19

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	41

Item 4.	Controls and Procedures	45

	PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	46

Item 1A.	Risk Factors	46

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	46

Item 3.	Defaults Upon Senior Securities	46

Item 4.	Submission of Matters to a Vote of Security Holders	46

Item 5.	Other Information	46

Item 6.	Exhibits	46

Index

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 September 30, 2008		As at December 31, 2007
	(Unaudited)
ASSETS
Investments:
Fixed maturities, at fair value (Amortized cost: 2008 - $710,100; 2007 - $1,099,149)	$	697,839	$	1,109,105
Short term investments, at fair value (Amortized cost: 2008 - $29,896; 2007 - $23,660)		29,888		23,616
Equity investments, at fair value (Cost: 2008 - $84,301; 2007 - $73,603)		78,426		74,357
Other investments		423,144		293,166
Total Investments		1,229,297		1,500,244
Cash and cash equivalents		635,623		362,680
Premium balances receivable		275,778		136,555
Unearned premiums ceded		41,789		14,608
Reinsurance recoverable		14,599		1,355
Accrued interest receivable		5,854		9,915
Receivable for investments sold		31,749		-
Deferred acquisition costs		52,502		30,607
Funds withheld		11,915		6,666
Goodwill		13,068		10,781
Intangible assets		775		775
Other assets		101,974		29,587
Due from related parties		293		-
Total Assets	$	2,415,216	$	2,103,773

LIABILITIES
Loss and loss adjustment expense reserves	$	392,462	$	180,978
Unearned premiums		350,786		175,607
Insurance and reinsurance balances payable		32,984		12,088
Payable for investments purchased		4,944		41,750
Long term debt		252,838		264,889
Other liabilities		104,772		33,198
Total Liabilities		1,138,786		708,510

Minority Interest		192,011		184,778

SHAREHOLDERS' EQUITY
Common voting shares, 150,000,000 authorized, $0.01 par value, issued and outstanding (2008 - 85,346,325; 2007 - 85,309,107)		853		853
Additional paid-in capital		899,920		905,316
Accumulated other comprehensive income		8,608		7,426
Retained earnings		175,038		296,890
Total Shareholders' Equity		1,084,419		1,210,485

Total Liabilities, Minority Interest and Shareholders' Equity	$	2,415,216	$	2,103,773

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 LIMITED

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE (LOSS) INCOME

(Expressed in thousands of U.S. dollars, except share and per share data)

	For the Three Months Ended						For the Nine Months Ended
	September 30, 2008			September 30, 2007			September 30, 2008			September 30, 2007

REVENUES
Gross premiums written	$	173,219		$	123,704		$	686,643		$	512,062
Premiums ceded		(21,984	)		(32,572	)		(76,433	)		(40,817	)
Net premiums written		151,235			91,132			610,210			471,245
Change in net unearned premiums		37,406			47,667			(144,545	)		(119,378	)
Net premiums earned		188,641			138,799			465,665			351,867
Net investment income		16,056			17,022			48,031			51,184
Net realized and unrealized (losses) gains - investments		(138,677	)		17,980			(160,428	)		18,747
Net realized and unrealized losses - other		(1,039	)		(9,682	)		(2,144	)		(7,836	)
Other income		1,418			1,961			5,269			2,885
Total revenues		66,399			166,080			356,393			416,847

EXPENSES
Loss and loss adjustment expenses		199,768			37,439			295,833			162,444
Acquisition costs		27,452			28,795			78,827			56,238
General and administrative expenses		16,271			19,763			67,034			48,232
Interest expense		3,722			5,873			13,671			12,657
Net foreign exchange losses (gains)		8,331			(1,842	)		3,262			(3,180	)
Total expenses		255,544			90,028			458,627			276,391
(Loss) income before income taxes, minority interest and interest in earnings of equity investments		(189,145	)		76,052			(102,234	)		140,456
Provision for income tax		(585	)		(229	)		(1,892	)		(351	)
Minority interest		3,657			(9,317	)		(7,139	)		(24,942	)
Interest in earnings of equity investments		(475	)		(257	)		(475	)		1,390
NET (LOSS) INCOME	$	(186,548	)	$	66,249		$	(111,740	)	$	116,553

Change in currency translation adjustment		5,833			8,310			1,647			6,293
Change in defined benefit pension plan - transitional obligation		57			-			(465	)		-
COMPREHENSIVE (LOSS) INCOME	$	(180,658	)	$	74,559		$	(110,558	)	$	122,846

Weighted average common shares outstanding—Basic		85,499,283			85,413,479			85,479,861			80,816,529
Weighted average common shares outstanding—Diluted		85,499,283			85,491,561			85,479,861			80,937,061
Net (loss) income per common share outstanding—Basic	$	(2.18	)	$	0.78		$	(1.31	)	$	1.44
Net (loss) income per common share outstanding—Diluted	$	(2.18	)	$	0.77		$	(1.31	)	$	1.44
Dividends declared per common share	$	0.04		$	0.04		$	0.12		$	0.04

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 LIMITED

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

(Expressed in thousands of U.S. dollars, except share data)

	For the Nine Months Ended
	September 30, 2008			September 30, 2007
Common voting shares:
Balance at beginning of year		85,309,107			71,547,891
Issued during the period, net		37,218			13,750,000
Balance at end of period		85,346,325			85,297,891

Share capital:
Common voting shares
Balance at beginning of year	$	853		$	715
Issued during period, net		-			138
Balance at end of period		853			853

Additional paid-in capital
Balance at beginning of year		905,316			728,378
Issue of shares, net		(364	)		185,488
Subsidiary stock issuance		(126	)		-
Issuance costs (related party: 2008 - $nil ; 2007 - $3,430)		-			(16,839	)
Share based compensation expense		(4,906	)		6,193
Balance at end of period		899,920			903,220

Accumulated other comprehensive income (loss)
Balance at beginning of year		7,426			(4,528	)
Change in currency translation adjustment		1,647			6,293
Defined benefit pension plan - transitional obligation		(465	)		-
Cumulative effect adjustment from adoption of new accounting principle SFAS 159		-			4,009
Balance at end of period		8,608			5,774

Retained earnings
Balance at beginning of year		296,890			139,954
Cumulative effect adjustment from adoption of accounting principle		-			(4,009	)
Dividend declared		(10,112	)		(3,412	)
Net (loss) income for the period		(111,740	)		116,553
Balance at end of period		175,038			249,086
	$	1,084,419		$	1,158,933

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 LIMITED

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Expressed in thousands of U.S. dollars)

	For the Nine Months Ended
	September 30, 2008			September 30, 2007
Cash flows provided by (used in) operating activities:
Net (loss) income	$	(111,740	)	$	116,553
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Net realized and unrealized (losses) gains		162,572			(10,911	)
Minority interest		7,139			24,942
Depreciation expense		3,515			1,508
Share based compensation expense		(4,780	)		6,193
Interest in earnings of equity investments		475			(1,390	)
Accretion/amortization on fixed maturities		(16,524	)		(7,720	)
Changes in assets and liabilities, excluding net assets acquired:
Reinsurance premium receivable		(139,756	)		(105,334	)
Unearned premiums ceded		(29,610	)		(18,024	)
Deferred acquisition costs		(22,619	)		(20,128	)
Funds withheld		(5,208	)		(6,606	)
Loss and loss adjustment expense reserves		212,087			136,436
Unearned premiums		179,650			135,126
Insurance and reinsurance balances payable		21,560			16,391
Reinsurance recoverable		(11,652	)		-
Other changes in assets and liabilities, net		2,337			5,085
Net cash provided by operating activities		247,446			272,121

Cash flows provided by (used in) investing activities:
Net cash received in acquisitions of subsidiaries		4,855			5,302
Purchases of fixed income securities		(885,082	)		(1,182,347	)
Sales and maturities of fixed income securities		1,245,168			841,636
Purchases of equity securities		(120,950	)		(25,171	)
Sales of equity securities		81,122			3,723
Purchases of other investments		(492,260	)		(211,107	)
Sales of other investments		246,316			(5,116	)
Purchases of fixed assets		(21,063	)		(6,558	)
Sale of fixed asset under a sale lease-back transaction		-			18,500
Net cash provided by (used in) investing activities		58,106			(561,138	)

Cash flows (used in) provided by financing activities:
Issue of common shares, net of issuance costs paid		(491	)		171,644
Issue of notes, net of issuance costs paid		-			123,684
Contribution of minority interest		(166	)		83,100
Repurchase of minority interest		(8,652	)		(14,353	)
Dividend paid on common shares		(10,239	)		(3,412	)
Repayment of long term debt		(9,840	)		-
Amortization of financing costs		-			(17,063	)
Other		(3,406	)		1,263
Net cash (used in) provided by financing activities		(32,794	)		344,863

Effect of foreign exchange rate on cash and cash equivalents		185			5,570

Increase in cash and cash equivalents		272,943			61,416
Cash and cash equivalents - beginning of year		362,680			261,352
Cash and cash equivalents - end of period	$	635,623		$	322,768

Supplemental cash flow information:
Receivable for investments sold	$	31,749		$	-
Payable for investments purchased	$	4,944		$	8,248
Interest paid	$	13,486		$	10,165

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

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)

Index

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 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, estimates of premiums written, premiums earned, acquisition costs 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.

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.

These interim 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. Prior to 2008, the Company operated through one reportable segment, consisting of Reinsurance. Following a review of its operating segments in 2008, the Company revised its reportable business segments and is currently organized into two reportable business segments: Reinsurance and Insurance. Prior periods have been re-segmented to conform with the current presentation.

2. New Accounting Pronouncements

New accounting pronouncements issued during 2008 impacting the Company are as follows:

The Company maintains a contributory defined benefit pension plan (the “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 and $0.8 million has been recorded as a pension expense in the three and nine months ended September 30, 2008, respectively. A pension asset of $0.7 million and a pension liability of $1.3 million were recognized in the September 30, 2008 unaudited condensed consolidated balance sheet. The Company funds the Plan at the amount required by local legal requirements.

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)

Index

In March 2008, the 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 have no impact on the Company’s results of operations or consolidated financial condition but it is expected to change the Company’s current disclosures regarding its derivative instruments.

In May 2008, the FASB issued Statement No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”) which identifies the sources of generally accepted accounting principles and provides a framework, or hierarchy, for selecting the principles to be used in preparing U.S. GAAP financial statements for nongovernmental entities. SFAS 162 makes the GAAP hierarchy explicitly and directly applicable to preparers of financial statements, a step that recognizes preparers’ responsibilities for selecting the accounting principles for their financial statements. The hierarchy of authoritative accounting guidance is not expected to change current practice but is expected to facilitate the FASB’s plan to designate as authoritative its forthcoming codification of accounting standards. This Statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board’s (“PCAOB”) related amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles”, to remove the GAAP hierarchy from its auditing standards.

In May 2008, the FASB issued Statement No. 163, “Accounting for Financial Guarantee Insurance Contracts – an Interpretation of FASB Statement No. 60” (“SFAS 163”) which prescribes the accounting for premium revenue and claims liabilities by insurers of financial obligations, and requires expanded disclosures about financial guarantee insurance and reinsurance contracts. SFAS 163 applies to financial guarantee insurance and reinsurance contracts issued by insurers subject to Statement No. 60 “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”). SFAS 163 does not apply to insurance contracts that are similar to financial guarantee insurance contracts such as mortgage guaranty or trade-receivable insurance, financial guarantee contracts issued by noninsurance entities, or financial guarantee contracts that are derivative instruments within the scope of SFAS 133. SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years, except for certain disclosure requirements about the risk-management activities of the insurance enterprise which are effective for the first quarter beginning after SFAS 163 was issued. Except for those disclosures, early application is prohibited. SFAS 163 is not expected to have an effect on the Company as the Company does not enter into financial guarantee contracts.

On October 10, 2008, the FASB also issued a FASB staff position No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“SFAS 157-3”) to clarify the application of FASB Statement No. 157, “Fair Value Measures” (“SFAS 157”) in a market that is not active. SFAS 157-3 provides that determination of fair value in a dislocated market depends on facts and circumstances and may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales. The use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available. Regardless of the valuation technique used, an entity must include appropriate risk adjustments that market participants would make for nonperformance and liquidity risks. SFAS 157-3 is effective immediately, including prior periods for which financial statements have not been issued. The Company has considered the provisions of SFAS 157-3 on the current quarter and determined that the application of SFAS 157-3 does not have an effect on the Company’s current financial position.

3.	Reorganization

On September 30, 2008, the Company completed the restructuring of its global reinsurance operations by merging its two wholly-owned subsidiaries, Flagstone Reinsurance Limited and Flagstone Suisse into one succeeding entity, Flagstone Suisse with its existing Bermuda branch. The merger consolidated the Company’s underwriting capital into one main operating entity. Because both companies were wholly-owned subsidiaries of the Company, the merger did not result in any changes in the previously recorded carrying values of assets or liabilities of the merged entities. Total costs associated with the reorganization were $2.1 million which were expensed in the period incurred.

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)

Index

4.	Acquisitions

Alliance International Reinsurance Public Company Limited (“Alliance Re”)

On April 28, 2008, the Company announced its intent to acquire up to 30.0% of Alliance Re from current shareholders. The Company completed its acquisition on August 12, 2008, through the purchase of 10,498,164 shares (representing 15.4% of its common shares) for $6.8 million. The acquisition was partially completed in the second quarter of 2008 through the purchase of 9,977,664 shares (representing 14.6% of its common shares) for $6.8 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 & North Africa regions.

On August 13, 2008, Flagstone Suisse announced its decision to submit a Voluntary Public Offer (the “Offer”) for the acquisition of up to 100% of the 68,347,215 issued and outstanding common share capital of Alliance Re. The consideration for the Offer is €0,48 per share, payable in cash to all accepting shareholders. During September 2008, the Company acquired 4,427,189 Alliance Re shares on the open market for total consideration of $3.0 million, bringing the Company’s total ownership interest to 24,903,017 shares or 36.4% at September 30, 2008.

Following additional share purchases in the open market and a successful acceptance of the Offer, as of October 27, 2008, the Company owned 63,436,487 shares or 92.8% of the share capital of Alliance Re. According to the Offer terms, if the Company were to acquire more than 90% of the share capital of Alliance Re, it would exercise its right pursuant to Part VIII, article 36(4)(a) of the Cyprian Public Offering and Acquisition Law 2007, to acquire the remaining outstanding shares at €0,48 cash per share, so as to acquire 100% of the shares of Alliance Re. This right must be exercised within three months from the expiry of the period of acceptance of the Offer. On October 29, 2008, the Company exercised its right under article 36 to acquire the remaining 7.2% of the Alliance Re shares at €0,48 cash per share, the same amount as the Offer.

5. 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, listed equity securities and fixed income fund are stated at Level 1 fair value. Investments in corporate bonds, mortgage-backed securities, equity exchange traded funds, investment funds that are hedge funds, asset backed securities, real estate investment trust (“REITs”) and REIT funds are stated at Level 2, whereas the investment funds that are private equity investments and catastrophe bonds are stated at Level 3 fair value. The investment in Alliance Re is now accounted for as an equity investment and is not accounted for at fair value under SFAS 159 (see Note 4).

The Company has reviewed its Level 3 investments and the valuation methods are as follows: 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 of the funds on a quarterly basis. These valuations are then adjusted by the investment fund managers for cash flows since the most recent valuation. The valuation methodology used for investment funds is consistent with the methodology that is generally employed in the investment industry.

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)

Index

As at September 30, 2008 and December 31, 2007, the Company’s investments are allocated between levels as follows:

	Fair Value Measurement at September 30, 2008, using:
			Quoted Prices in		Significant Other		Significant Other
	Fair Value		Active Markets		Observable Inputs		Unobservable Inputs
Description	Measurements		(Level 1)		(Level 2)		(Level 3)
Fixed maturity investments	$	697,839	$	343,800	$	354,039	$	-
Short term investments		29,888		29,888		-		-
Equity investments		78,426		3,946		74,480		-
		806,153		377,634		428,519		-
Other Investments
Real estate investment trust funds		56,308		-		56,308		-
Investment funds		30,237		-		18,461		11,776
Catastrophe bonds		39,888		-		-		39,888
Fixed income fund		281,662		281,662		-		-
		408,095		281,662		74,769		51,664

Totals	$	1,214,248	$	659,296	$	503,288	$	51,664

For reconciliation purposes, the table above does not include an equity investment in Alliance Re of $15.0 million in which the Company is deemed to have a significant influence and is accounted for under the equity method and as such, this investment is not accounted for at fair value under SFAS 159.

	Fair Value Measurement at December 31, 2007, using:
			Quoted Prices in		Significant Other		Significant Other
	Fair Value		Active Markets		Observable Inputs		Unobservable Inputs
Description	Measurements		(Level 1)		(Level 2)		(Level 3)
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

For reconciliation purposes, the table above does not include an equity investment of $112,000 in which the Company is deemed to have a significant influence and is accounted for under the equity method and as such, is not accounted for at fair value under SFAS 159.

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)

Index

The reconciliation of the fair value for the Level 3 investments for the three and nine months ended September 30, 2008, including net purchases and sales, realized gains and change in unrealized gains, is set out below:

	For the Three Months Ended September 30, 2008
	Investment			Catastrophe			Alliance
Description	funds			bonds			Re
Fair value, June 30, 2008	$	11,864		$	40,081		$	6,846
Total realized gains included in earnings		644			278			-
Total unrealized losses included in earnings		(1,532	)		(471	)		-
Net purchases and sales		800			-			6,805
Transfers to equity investment		-			-			(13,651	)
Fair value, September 30, 2008	$	11,776		$	39,888		$	-

	For the Nine Months Ended September 30, 2008
	Investment			Catastrophe			Alliance
Description	funds			bonds				Re
Fair value, December 31, 2007	$	11,208		$	36,619		$	-
Total realized gains included in earnings		644			278			-
Total unrealized losses included in earnings		(1,382	)		(509	)		-
Net purchases and sales		1,306			3,500			13,651
Transfers to equity investment		-			-			(13,651	)
Fair value, September 30, 2008	$	11,776		$	39,888		$	-

The Company purchased a 14.6% interest in Alliance Re during the quarter ended June 30, 2008, and had recorded the investment in Alliance Re at fair value based on the recently completed arms length purchase negotiated between the Company and external third parties. On August 12, 2008, the Company purchased an additional 10,498,164 shares of Alliance Re (15.4%) for $6.8 million. The investment in Alliance Re is now accounted for as an equity investment and is not accounted for at fair value under SFAS 159.

6. 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 and futures options on weather indexes as part of its reinsurance activities. The Company manages the exposure to these instruments based on guidelines established by management and approved by the Board of Directors.

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 gains and losses associated with changes in fair value of the designated hedge instruments 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.

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)

Index

Interest rate swaps

The Company has previously used 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 has also used interest rate swaps to manage its borrowing costs on its long term debt. As of September 30, 2008, the Company did not have any interest rate swaps and as of December 31, 2007, there were a total of $389.9 million of interest rate swaps in the portfolio with a total fair value of $2.3 million. During the three months ended September 30, 2008 and 2007, the Company recorded realized and unrealized losses on interest rate swaps of $0.1 million and $nil, respectively, and for the nine months ended September 30, 2008 and 2007, the Company recorded realized and unrealized gains of $0.2 million and realized and unrealized losses of $0.2 million on interest rate swaps, respectively.

Foreign currency swaps

The Company periodically uses foreign currency swaps to minimize the effect of fluctuating foreign currencies. The Company has 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 $18.4 million, will receive Euro Interbank Offered Rate (“Euribor”) plus 354 basis points and will pay London Interbank Offering Rate (“LIBOR”) plus 367 basis points. The swap expires on September 15, 2011 and had a fair value of $(0.2) million and $2.5 million as at September 30, 2008 and December 31, 2007, respectively. During the three months ended September 30, 2008 and 2007, the Company recorded realized and unrealized losses of $2.7 million and realized and unrealized gains of $1.0 million, respectively. During the nine months ended September 30, 2008 and 2007, the Company recorded realized and unrealized losses of $0.7 million and realized and unrealized gains of $1.5 million, 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 September 30, 2008 and December 31, 2007 was $561.3 million and $311.1 million, respectively, and these contracts had a fair value of $5.6 million and $(7.1) million, respectively. The Company has designated $494.6 million and $264.4 million of foreign currency forwards contractual value as hedge instruments, which had a fair value of $11.7 million and $(3.4) million as at September 30, 2008 and December 31, 2007, respectively. During the three months ended September 30, 2008 and 2007, the Company recorded $0.1 million and $11.4 million, respectively, of realized and unrealized losses on foreign currency forward contracts and for the nine months ended September 30, 2008 and 2007, the Company recorded $3.1 million and $10.4 million of realized and unrealized losses, respectively, on foreign currency forward contracts. During the three and nine months ended September 30, 2008, the Company recorded $31.3 million and $5.7 million of realized and unrealized gains, respectively, 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 swaps to gain exposure to the U.S. real estate market. 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 September 30, 2008, there were total return swaps with a notional amount of $85.4 million and a fair value of $(0.5) million in the portfolio and as of December 31, 2007, the notional amount of the total return swaps was $14.2 million and they had a fair value of $(4.9) million. During the three months ended September 30, 2008 and 2007, the Company recorded $0.5 million and $0.1 million of realized and unrealized losses, respectively, on total return swaps and for the nine months ended September 30, 2008 and 2007, the Company recorded $5.3 million and $2.9 million of realized and unrealized losses, respectively, on total return 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 September 30, 2008 and December 31, 2007, the notional principal amount of TBAs was $50.9 million and $18.2 million and the fair value was $(0.4) million and $0.2 million, respectively. During the three months ended September 30, 2008 and 2007, the Company recorded $0.9 million of realized and unrealized gains and $nil, respectively. During the nine months ended September 30, 2008 and 2007, the Company recorded $0.6 million of realized and unrealized gains and $0.6 million, respectively, of realized and unrealized losses on TBAs.

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)

Index

Futures

The Company has entered into equity index, commodity index, bond index and interest rate futures. At September 30, 2008 and December 31, 2007, the notional amount of these futures was $362.1 million and $421.0 million, respectively. The net fair value of futures contracts was $(24.1) million and $(2.2) million as at September 30, 2008 and December 31, 2007, respectively. During the three months ended September 30, 2008 and 2007, the Company recorded $69.8 million of realized and unrealized losses and $2.6 million of realized and unrealized gains, respectively, on futures. During the nine months ended September 30, 2008 and 2007, the Company recorded $70.7 million of realized and unrealized losses and $12.3 million of realized and unrealized gains, respectively, on futures.

Other reinsurance derivatives

The Company has entered into industry loss warranty (“ILW”) transactions that may be structured as reinsurance or derivatives. For those transactions determined to be derivatives, the fair value was $(1.3) million and $(1.3) million at September 30, 2008 and December 31, 2007, respectively. During the three months ended September 30, 2008 and 2007, the Company recorded $1.5 million and $0.6 million, respectively, of realized and unrealized gains on ILWs determined to be derivatives and for the nine months ended September 30, 2008 and 2007, the Company recorded $2.6 million and $1.0 million, respectively, of realized and unrealized gains on ILWs determined to be derivatives.

Beginning in 2008, the Company entered into futures options contracts, both purchased and written, on major hurricane indexes that are traded on the Chicago Mercantile Exchange. The net notional exposure is determined based on the futures exchange futures specifications. The net fair value of the options was recorded on the balance sheet, with purchased options of $0.8 million recorded in other assets and written options of $3.0 million recorded in other liabilities. The realized and unrealized gains recorded on the hurricane indexes were $0.4 million and $0.4 million, respectively, during the three months and nine months ended September 30, 2008.

Fair value disclosure

In accordance with SFAS 157, the fair value of derivative instruments held as of September 30, 2008 and December 31, 2007 is allocated between levels as follows:

	Fair Value Measurement at September 30, 2008, using:
				Quoted Prices in			Significant Other			Significant Other
	Fair Value			Active Markets			Observable Inputs			Unobservable Inputs
	Measurements			(Level 1)			(Level 2)			(Level 3)
Derivatives
Futures contracts	$	(24,116	)	$	(24,116	)	$	-		$	-
Swaps		(642	)		-			(642	)		-
Forward currency forwards		5,555			-			5,555			-
Mortgage backed securities TBA		(379	)		-			(379	)		-
Other reinsurance derivatives		(3,433	)		-			(2,148	)		(1,285	)
Total derivatives	$	(23,015	)	$	(24,116	)	$	2,386		$	(1,285	)

Derivatives are recorded in other assets and other liabilities with balances as at September 30, 2008 of $40.2 million and $63.2 million, respectively.

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)

Index

	Fair Value Measurement at December 31, 2007, using:
				Quoted Prices in			Significant Other			Significant Other
	Fair Value			Active Markets			Observable Inputs			Unobservable Inputs
	Measurements			(Level 1)			(Level 2)			(Level 3)
Derivatives
Futures contracts	$	(2,228	)	$	(2,228	)	$	-		$	-
Swaps		(153	)		-			(153	)		-
Forward currency forwards		(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	)

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:

	Three Months Ended			Nine Months Ended
	September 30, 2008			September 30, 2008
Other reinsurance derivatives
Opening fair value	$	(127	)	$	(1,305	)
Total unrealized gains included in earnings		1,453			2,631
Net purchases and sales		(2,611	)		(2,611	)
Fair value, September 30, 2008	$	(1,285	)	$	(1,285	)

7. Debt and Financing Arrangements

Long term debt

The Company repurchased, in a privately negotiated transaction, $11.25 million of principal amount of its outstanding $100.0 million Floating Rate Deferrable Interest Junior Subordinated Notes (the “Notes”) during the quarter ended June 30, 2008. The purchase price paid for the Notes was 81% of face value, representing a discount of 19%. The repurchase resulted in a gain of $2.0 million, net of unamortized debt issuance costs of $0.1 million that were written off. As a result, the gain has been included as a gain on early extinguishment of debt under other income.

Interest expense includes interest payable and amortization of debt offering expenses. The debt offering expenses are amortized over the period from the issuance of the Deferrable Interest Debentures to the earliest date that they may be called by the Company. For the three months ended September 30, 2008 and 2007, the Company incurred interest expense of $3.7 million and $5.9 million, respectively, and for the nine months ended September 30, 2008 and 2007, the Company incurred interest expense of $13.7 million and $12.7 million, respectively, on the Deferrable Interest Debentures. Also, at September 30, 2008 and December 31, 2007, the Company had $1.4 million and $1.9 million, respectively, of interest payable included in other liabilities.

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 September 30, 2008 and December 31, 2007, $72.6 million and $73.8 million, respectively, had been drawn under this facility, and the drawn amount of the facility was secured by $80.6 million and $82.0 million, respectively, of fixed maturity securities from the Company’s investment portfolio.

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)

Index

In September 2007, the Company entered into a $200.0 million uncommitted secured letter of credit facility agreement with Wachovia Bank, N.A. (“Wachovia”). While the Company has not drawn upon this facility as at September 30, 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. Given the recently announced merger of Wachovia and Wells Fargo Inc., there is some uncertainty as to our ability to access this facility, however we believe that our inability to access this facility would have no material impact on our business.

These facilities are used to provide security to reinsureds and are collateralized by the Company, at least to the extent of the letters of credit outstanding at any given time.

8. Stock Transaction of Subsidiary

On July 1, 2008, Island Heritage Holdings Company (“Island Heritage”), in which the Company holds a controlling interest, issued 1,789 shares to certain of its employees under a performance share unit plan. Prior to this transaction, the Company held an ownership interest in Island Heritage of 59.6% and now holds an interest of 59.2%.

The Company accounts for the issuance of a subsidiary’s stock in accordance with SEC Staff Accounting Bulletin Topic 5H “Accounting for sales of stock by a subsidiary”, which requires that the difference between the carrying amount of the parent’s investment in a subsidiary and the underlying net book value of the subsidiary after the issuance of stock by the subsidiary be reflected as either a gain or loss in the statement of operations or reflected as an equity transaction. The Company has elected to record gains and losses resulting from the issuance of subsidiary’s stock as an equity transaction. Accordingly, the Company recorded a loss of $0.1 million as a decrease to additional paid-in capital.

9. 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 Directors, 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 September 30, 2008, and changes during the three months and nine months ended September 30, 2008, is as follows:

	Three Months Ended September 30, 2008							Nine Months Ended September 30, 2008
	Number expected to vest			Weighted average grant date fair value		Weighted average remaining contractual term		Number expected to vest			Weighted average grant date fair value		Weighted average remaining contractual term

Outstanding at beginning of period		2,312,658		$	12.63		1.5		1,658,700		$	12.07		1.7
Granted		83,000			11.79				814,958			13.68
Forfeited		(17,000	)		12.76				(95,000	)		12.58
Change in assumptions		(2,272,836	)		12.71				(2,272,836	)		12.71
Outstanding at end of period		105,822			10.19		0.3		105,822			10.19		0.3

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)

Index

The Company reviews its assumptions in relation to the PSUs on a quarterly basis. The issuance of shares with respect to the PSUs is contingent upon the attainment of certain levels of average DROE over a three year period. Considering the net loss incurred in the nine months ended September 30, 2008, the Company reviewed is DROE estimates for the applicable performance periods and accordingly revised the number of PSUs expected to vest. As a result, compensation expense of $(11.9) million and $(7.1) million has been recorded in general and administrative expenses in relation to the PSU Plan for the three and nine months ended September 30, 2008, respectively. For the three and nine months ended September 30, 2007, respectively, $1.6 million and $4.4 million has been recorded in general and administrative expenses in relation to the PSU Plan. As at September 30, 2008 and December 31, 2007, there was a total of $0.1 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 0.3 years and 2.1 years, respectively.

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

Restricted Share Units

Beginning July 1, 2006, the Company granted Restricted Share Units (“RSUs”) to certain employees and directors of the Company. The purpose of the Restricted Share Unit Plan (“RSU Plan”) is to encourage employees and directors of the Company to further the development of the Company and to attract and retain key employees for the Company’s long-term success. The RSUs granted to employees vest over a period of approximately two years while RSUs granted to directors vest on the grant date.

A summary of the activity under the RSU Plan as at September 30, 2008 and changes during the three and nine months ended September 30, 2008 is as follows:

	Three Months Ended September 30, 2008							Nine Months Ended September 30, 2008
	Number expected to vest			Weighted average grant date fair value		Weighted average remaining contractual term		Number expected to vest			Weighted average grant date fair value		Weighted average remaining contractual term

Outstanding at beginning of period		477,508		$	13.32		0.7		326,610		$	12.45		0.6
Granted		16,046			11.98				255,361			13.71
Forfeited		(38,850	)		13.68				(59,750	)		13.67
Vested in the period		-			-				(67,517	)		10.81
Outstanding at end of period		454,704			13.24		0.5		454,704			13.24		0.5

As at September 30, 2008 and December 31, 2007, there was a total of $1.6 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 1.0 year and 0.9 years, respectively. A compensation expense of $0.3 million and $0.4 million has been recorded in general and administrative expenses for the three months ended September 30, 2008 and 2007, respectively, and $2.4 million and $1.8 million has been recorded in general and administrative expenses for the nine months ended September 30, 2008 and 2007, respectively, in relation to the RSU Plan.

Since the inception of the RSU Plan in July 2006, 59,700 RSUs granted to employees have vested and no RSUs granted to employees have been cancelled. During the three months ended September 30, 2008 and September 30, 2007, no RSUs were granted to the directors. During the nine months ended September 30, 2008 and September 30, 2007, respectively, 55,715 and 61,761 RSUs were granted to the directors.

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)

Index

10. Earnings Per Common Share

The computation of basic and diluted earnings per common share for the three and nine months ended September 30, 2008 and 2007 is as follows:

	Three Months Ended					Nine Months Ended
	September 30, 2008			September 30, 2007		September 30, 2008			September 30, 2007
Basic (loss) earnings per common share
Net (loss) income	$	(186,548	)	$	66,249	$	(111,740	)	$	116,553
Weighted average common shares outstanding		85,346,325			85,297,891		85,325,277			80,730,125
Weighted average vested restricted share units		152,958			115,588		154,584			86,404
Weighted average common shares outstanding—Basic		85,499,283			85,413,479		85,479,861			80,816,529
Basic (loss) earnings per common share	$	(2.18	)	$	0.78	$	(1.31	)	$	1.44

Diluted (loss) earnings per common share
Net (loss) income	$	(186,548	)	$	66,249	$	(111,740	)	$	116,553
Weighted average common shares outstanding		85,346,325			85,297,891		85,325,277			80,730,125
Weighted average vested restricted share units outstanding		152,958			115,588		154,584			86,404
		85,499,283			85,413,479		85,479,861			80,816,529
Share equivalents:
Weighted average unvested restricted share units		-			78,082		-			120,532
Weighted average common shares outstanding—Diluted		85,499,283			85,491,561		85,479,861			80,937,061
Diluted (loss) earnings per common share	$	(2.18	)	$	0.77	$	(1.31	)	$	1.44

Dilutive share equivalents have been excluded in the weighted average common shares used for the calculation of earnings per share in periods of net loss because the effect of such securities would be anti-dilutive. The number of anti-dilutive share equivalents that have been excluded in the computation of diluted earnings per share for the three and nine months ended September 30, 2008, were 130,891and 236,876 respectively. Also at September 30, 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 September 30, 2008 and 2007, there were 105,822 and 1,538,000 PSUs outstanding, respectively. The maximum number of common shares that could be issued under the PSU Plan at September 30, 2008 and 2007 was 4,757,316 and 3,076,000, respectively.

11. Legal Proceedings

In the normal course of business, the Company may become involved in various claims litigation and legal proceedings. As at September 30, 2008, the Company was not a party to any litigation or arbitration proceedings.

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)

Index

12. Segment Reporting

The Company holds a controlling interest in Island Heritage, whose primary business is insurance. As a result of the strategic significance of the insurance business to the Company, and given the relative size of revenues generated by the insurance business, the Company revised its segment structure, effective January 1, 2008, to better align the Company’s operating and reporting structure with its current strategy. The Company determined that the allocation of resources and the assessment of performance should be reviewed separately for both segments. The Company is currently organized into two reportable business segments: Reinsurance and Insurance. The 2007 comparative information below reflects our current segment structure. The Company regularly reviews its financial results and assesses performance on the basis of these two reportable business 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, which serve to limit exposure to catastrophic events.

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.

Insurance

The Company has established an Insurance segment for the nine months ended September 30, 2008, as a result of the insurance business operated through Island Heritage, a property insurer based in the Cayman Islands which is primarily in the business of insuring homes, condominiums and office buildings in the Caribbean region. The Company gained a controlling interest in Island Heritage in the third quarter of 2007, and as a result, the comparatives for the nine months ended September 30, 2007 include the results of Island Heritage for the quarter ended September 30, 2007 only.

The following tables provide a summary of gross and net written and earned premiums, underwriting results, a reconciliation of underwriting income to income before income taxes, minority interest and interest in earnings of equity investments, total assets, reserves and ratios for each of our business segments for the three and nine months ended September 30, 2008 and 2007:

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)

Index

	Three Months Ended September 30, 2008									Three Months Ended September 30, 2007
	Reinsurance			Insurance			Total			Reinsurance			Insurance			Total
Gross premiums written	$	155,508		$	17,711		$	173,219		$	101,912		$	21,792		$	123,704
Net premiums written		137,171			14,064			151,235			81,095			10,037			91,132
Net premiums earned	$	178,611		$	10,030		$	188,641		$	132,197		$	6,602		$	138,799
Other insurance related (loss) income		(326	)		1,608			1,282			418			1,422			1,840
Loss and loss adjustment expenses		198,076			1,692			199,768			37,105			334			37,439
Acquisition costs		23,859			3,593			27,452			25,381			3,414			28,795
General and administrative expenses		13,911			2,360			16,271			18,130			1,633			19,763
Underwriting (Loss) Income	$	(57,561	)	$	3,993		$	(53,568	)	$	51,999		$	2,643		$	54,642

Loss ratio		110.9	%		16.9	%		105.9	%		28.1	%		5.1	%		27.0	%
Acquisition cost ratio		13.3	%		35.8	%		14.6	%		19.2	%		51.7	%		20.7	%
General and administrative expense ratio		7.8	%		23.5	%		8.6	%		13.7	%		24.7	%		14.2	%
Combined ratio		132.0	%		76.2	%		129.1	%		61.0	%		81.5	%		61.9	%
Total assets	$	2,343,057		$	72,159		$	2,415,216		$	1,991,604		$	75,092		$	2,066,696

Reconciliation:
Underwriting (Loss) Income							$	(53,568	)							$	54,642
Net investment income								16,056									17,022
Net realized and unrealized (losses) gains - investments								(138,677	)								17,980
Net realized and unrealized losses - other								(1,039	)								(9,682	)
Other income								136									121
Interest expense								(3,722	)								(5,873	)
Net foreign exchange (losses) gains								(8,331	)								1,842
(Loss) Income before income taxes, minority interest and interest in earnings of equity investments							$	(189,145	)							$	76,052

	Nine Months Ended September 30, 2008									Nine Months Ended September 30, 2007
	Reinsurance			Insurance			Total			Reinsurance			Insurance			Total
Gross premiums written	$	623,155		$	63,488		$	686,643		$	490,270		$	21,792		$	512,062
Net premiums written		584,458			25,752			610,210			461,208			10,037			471,245
Net premiums earned	$	441,020		$	24,645		$	465,665		$	345,265		$	6,602		$	351,867
Other insurance related income		456			2,095			2,551			840			1,422			2,262
Loss and loss adjustment expenses		294,030			1,803			295,833			162,110			334			162,444
Acquisition costs		68,842			9,985			78,827			52,824			3,414			56,238
General and administrative expenses		60,731			6,303			67,034			46,599			1,633			48,232
Underwriting Income	$	17,874		$	8,648		$	26,522		$	84,572		$	2,643		$	87,215

Loss ratio		66.7	%		7.3	%		63.5	%		47.0	%		5.1	%		46.2	%
Acquisition cost ratio		15.6	%		40.5	%		16.9	%		15.3	%		51.7	%		16.0	%
General and administrative expense ratio		13.8	%		25.6	%		14.4	%		13.5	%		24.7	%		13.7	%
Combined ratio		96.1	%		73.4	%		94.8	%		75.8	%		81.5	%		75.9	%
Total assets	$	2,343,057		$	72,159		$	2,415,216		$	1,991,604		$	75,092		$	2,066,696

Reconciliation:
Underwriting Income							$	26,522								$	87,215
Net investment income								48,031									51,184
Net realized and unrealized (losses) gains - investments								(160,428	)								18,747
Net realized and unrealized losses - other								(2,144	)								(7,836	)
Other income								2,718									623
Interest expense								(13,671	)								(12,657	)
Net foreign exchange (losses) gains								(3,262	)								3,180
(Loss) Income before income taxes, minority interest and interest in earnings of equity investments							$	(102,234	)							$	140,456

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)

Index

13. Subsequent Events

Share buyback program

On September 22, 2008, the Company announced that its Board of Directors had approved the potential repurchase of Company stock. The buyback program allows the Company to purchase, from time to time, the Company's outstanding stock up to a value $60.0 million. Purchases under the buyback program are made with cash, at market prices, through a brokerage firm. During the period from October 2, 2008 to November 4, 2008 the Company purchased 660,429 shares for total consideration of $6.3 million. The timing and amount of repurchase transactions will be determined by the Company’s management, based on its evaluation of a number of factors, including share price and market conditions. The Company may decide at any time to suspend or discontinue the program.

Marlborough Underwriting Agency Limited (“Marlborough”)

On October 17, 2008, the Company announced that it has entered into an agreement to acquire 100% of the common shares of Marlborough Underwriting Agency Limited, the managing agency for Lloyd's Syndicate 1861 - a Lloyd's syndicate underwriting a specialist portfolio of short-tail insurance and reinsurance, from the Berkshire Hathaway Group. The acquisition does not include the existing corporate Lloyd’s member or any liability for business written during or prior to 2008. The Company is in the process of licensing its own corporate capital vehicle which is expected to be the capital provider for Lloyd’s Syndicate 1861 for fiscal year 2009 onwards. The transaction is subject to Lloyd's and UK Financial Services Authority approval. Total consideration for the acquisition of the shares of Marlborough is £32 million. The acquisition is expected to close in the fourth quarter of 2008. It provides the Company with a Lloyd’s platform with access to both London business and that sourced globally from our network of offices.

Review of asset allocation

Our investment portfolio on a risk basis, at September 30, 2008, comprised 67.8% fixed maturities, short-term investments and cash and cash equivalents, 20.4% equities and the balance in other investments. In October 2008, given the turbulent worldwide financial markets, the Finance Committee of the Board decided to revise its asset allocation and accordingly, significantly reduce the risk of the Company’s portfolio by eliminating its direct exposure to equities and to non-U.S. real estate and by lowering its exposure to commodities. The net realized and unrealized losses incurred since September 30, 2008 on the investments disposed of per the revised allocation policy is approximately $81.2 million which will be recorded in the three month period ended December 31, 2008. The estimated portfolio mix following the change in allocation comprises approximately 91.7% fixed maturities, short-term investment and cash and cash equivalents, 2.3% equities and the balance in other investments.

Index

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 September 30, 2008 and December 31, 2007 and our results of operations for the three and nine months ended September 30, 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 Annual Report on 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 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 Suisse” refer to Flagstone Réassurance Suisse SA and its wholly-owned subsidiaries, including its Bermuda branch, 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.

On September 30, 2008, the Company completed the restructuring of its global operations by merging its two wholly-owned subsidiaries, Flagstone Reinsurance Limited and Flagstone Suisse into one succeeding entity, Flagstone Suisse with its existing Bermuda branch. The merger consolidated the Company’s underwriting capital into one main operating entity, thus maximizing capital efficiency and creditworthiness, while still offering a choice of either Bermuda or Swiss underwriting access. Because both companies were wholly-owned subsidiaries of the Company, the merger did not result in any changes to prior periods or to significant accounting policies. The change in corporate structure does not result in any change of management or corporate control, or any changes to the Board of Directors.

Executive Overview

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