UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
  
 FORM
10-K
 
 
 x
              ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 
 For
the fiscal year ended December 31, 2007
  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, Bermuda
                (Address
      of principal executive offices)
              
              HM
      11
                (Zip
      Code)
 
 441-278-4300
 (Registrant’s
telephone number, including area code)
 
  Securities
registered pursuant to Section 12(b) of the Act:
 
 Title
      of each class
              
              Name
      of each exchange on which registeredCommon
      Shares, $ 0.01 par value per share
              
              New
      York Stock ExchangeBermuda
      Stock Exchange
 
 
 
 Securities
registered pursuant to Section 12(g) of the Act:  None
 
  Indicate by check mark if
the registrant is a well-known seasoned issuer, as defined in Rule 405 of the
Securities Act.    Yes  o    
No 
x
  Indicate by check mark if
the registrant is not required to file reports pursuant to Section 13 or
Section 15(d) of the Act.    Yes  o    
No 
x
  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 x No  o
  Indicate by check mark if
disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is
not contained herein, and will not be contained, to the best of Registrant’s
knowledge, in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any amendment to this Form
10-K.  x
  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. (Check
one)
 
 Large Accelerated
Filer  o    Accelerated
Filer  o    Non-Accelerated
Filer  x
 
 Indicate by check mark
whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act.)Yes  o    No  x
 
 The aggregate
market value of the voting stock held by non-affiliates of the Registrant as of
most recently completed second fiscal quarter (June 30,
2007),was $389,695,501based on the closing sales
price of theRegistrant’s
common shares of $13.32 on June 29, 2007.
   
   The number of the Registrant’s common
shares (par value $.01 per share) outstanding as of March 19, 2008 was
85,316,924.
 
 Documents
Incorporated by Reference:
 
 Document
              
              Part(s) Into Which
                IncorporatedPortions of the Registrant’s
      definitive proxy statement to be filed with the Securities and Exchange
      Commission pursuant to Regulation 14A under the Securities Exchange Act of
      1934, as amended, relating to the Registrant’s Annual General Meeting of
      Shareholders scheduled to be held May 16, 2008 are incorporated by
      reference into Part III of this report. With the exception of the portions
      of the Proxy Statement specifically incorporated herein by reference, the
      Proxy Statement is not deemed to be filed as part of this
      report.
              
              Part
      III
  
  TABLE OF CONTENTS
 
 PagePART
      IItem 1.
              Business
              
              1Item 1A.
              Risk Factors
              
              12Item 1B.
              Unresolved Staff
      Comments
              
              21Item 2.
              Properties
              
              21Item 3.
              Legal
    Proceedings
              
              22Item 4.
              Submission of Matters to a Vote of
      Security Holders
              
              22PART
      IIItem 5.
              Market for Registrant’s Common
      Equity, Related Stockholder Matters and Issuer Purchases of Equity
      Securities
              
              23Item 6.
              Selected Financial
      Data
              
              24Item 7.
              Management’s Discussion and Analysis of 
      Financial Condition and Results of Operations
              
              25Item 7A.
              Quantitative and Qualitative Disclosures
      About Market Risk
              
              46Item 8.
              Financial Statements and Supplementary
      Data
              
              48Item 9.
              Changes in and Disagreements with Accountants on
      Accounting and Financial Disclosure
              
              86Item 9A.
              Controls and
      Procedures
              
              86Item 9B.
              Other
    Information
              
              86PART IIIItem 10.
              Directors, Executive Officers and Corporate
      Governance
              
              87Item 11.
              Executive
      Compensation
              
              87Item 12.
              Security Ownership of Certain
      Beneficial Owners, Management and Related Stockholder
      Matters
              
              87Item 13.
              Certain Relationships and Related
      Transactions, and Director Independence
              
              87Item 14.
              Principal Accountant Fees and
      Services
              
              87PART IVItem 15.
              Exhibits and Financial Statement
      Schedules
              
              88


Table of Contents




PART I





References in this Annual Report on
Form 10-K 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 and any
other direct or indirect wholly-owned 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.  References in this Form 10-K to “dollars” or “$”
are to the lawful currency of the United States of America, unless the context
otherwise requires.








Cautionary
Statement Regarding Forward-Looking Statements.





This
Form 10-K contains, and the Company may from time to time make, written or oral
“forward-looking
statements”within the
meaning of the U.S. federal securities laws, which are made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995. All
forward-looking statements rely on a number of assumptions concerning future
events and are subject to a number of uncertainties and other factors, many of
which are outside the Company’s control, that could cause actual results to
differ materially from such statements. In particular, statements using words
such as “may”, “should”, “estimate”, “expect”, “anticipate”, “intend”, “believe”, “predict”, “potential”, or words of similar import
generally involve forward-looking statements.




Important events and uncertainties that could cause
the actual results to differ include, but are not necessarily limited to: market
conditions affecting the Company’s common share price; the possibility of severe
or unanticipated losses from natural or man-made catastrophes; the effectiveness
of our loss limitation methods; our dependence on principal employees; the
cyclical nature of the reinsurance business; the levels of new and renewal
business achieved; opportunities to increase writings in our core property and
specialty reinsurance and insurance lines of business and in specific areas of
the casualty reinsurance market; the sensitivity of our business to financial
strength ratings established by independent rating agencies; the estimates
reported by cedents and brokers on pro-rata contracts and certain excess of loss
contracts where the deposit premium is not specified in the contract; the
inherent uncertainties of establishing reserves for loss and loss adjustment
expenses, our reliance on industry loss estimates and those generated by
modeling techniques; unanticipated adjustments to premium estimates; changes in
the availability, cost or quality of reinsurance or retrocessional coverage;
changes in general economic conditions; changes in governmental regulation or
tax laws in the jurisdictions where we conduct business; the amount and timing
of reinsurance recoverables and reimbursements we actually receive from our
reinsurers; the overall level of competition, and the related demand and supply
dynamics in our markets relating to growing capital levels in the reinsurance
industry; declining demand due to increased retentions by cedents and other
factors; the impact of terrorist activities on the economy; and rating agency
policies and practices.




These
and other events that could cause actual results to differ are discussed in
detail in Item 1A, “Risk Factors”and Item 7,
“Management’s Discussion and Analysis of Financial
Condition and Results of Operations” in this Form 10-K.The Company undertakes no obligation to
publicly update or revise any forward-looking statements, whether as a result of
new information, future events or otherwise, except as required by U.S. federal
securities laws. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date on which they are
made.





ITEM 1.        BUSINESS




General
Development





The Company, a reinsurance holding
company, was incorporated under the laws of Bermuda in October 2005 and
commenced operations in December 2005.  Through our operating
subsidiaries, we write primarily property, property catastrophe and short-tail
specialty and casualty reinsurance. We diversify our risks across business lines
by risk zones, each of which combines a geographic zone with one or more types
of peril (for example, Texas Windstorm). The majority of our reinsurance
contracts contain loss limitation provisions such as fixed monetary limits to
our exposure and per event caps. We specialize in underwriting where sufficient
data exists to analyze effectively the risk/return profile, and where we are
subject to legal systems we deem reasonably fair and reliable.





Our largest business is providing
property catastrophe reinsurance coverage to a broad range of select insurance
companies, primarily on an excess of loss basis. These policies provide coverage
for claims arising from major natural catastrophes, such as hurricanes and
earthquakes, in excess of a specified loss. We also provide coverage for claims
arising from other natural and man-made catastrophes such as winter storms,
freezes, floods, fires and tornados. Our specialty lines, which represent a
growing proportion of our business, cover such risks as aviation, energy,
accident and health, satellite, marine and workers’ compensation
catastrophe.





Business
Strategy





The Company is in the business of
taking two kinds of risk which we refer to as our Franchise Risks: these are
insurance risk and investment risk. Our goal with respect to these risks is to
be well rewarded for the risks we take, and well diversified so as to produce an
acceptable return on equity with moderate volatility. The ultimate
responsibility for the levels of Franchise Risk rests with our Executive
Chairman and our Chief Executive Officer, reporting to the Board of Directors.
We endeavor to minimize other risks such as operational and reputational
risks, which we refer to as Enterprise Risks, and the responsibility for
managing them lies with our Chief Enterprise Risk Officer, reporting to the
Chief Financial Officer and to the Audit Committee.




Our two
primary financial goals are to maintain multiple credit ratings in the “A”
range, and to produce growth in diluted book value per share, averaging 17%
annually with moderate volatility.  We believe that prudent management
of our underwriting risks, relative to our capital base, together with effective
investment of our capital and premium income, will achieve our financial goals
and deliver attractive risk-adjusted returns for our shareholders. To achieve
this objective, our strategies are as follows:





Maintain our
Continued Commitment to Diversified and Disciplined Underwriting. We will
continue to use our disciplined and data-driven underwriting approach to select
a diversified portfolio of risks that we believe will generate an attractive
return on capital over the long term. Neither our underwriting nor our
investment strategies are designed to generate smooth or predictable quarterly
earnings, but rather to optimize growth in diluted book value per share over a
moving three-year horizon.





Continue Our
Focus on Risk Management. We treat risk management as an integral part of
our underwriting and business management processes. Substantially all of our
reinsurance contracts contain loss limitation provisions, and we will continue
to limit our net exposure under those contracts to any single event. This limits
our absolute exposure to peak risk zones and produces what we believe to be a
more balanced portfolio. Our strategy of limiting our exposure by risk zone
means that we expect lower returns than some of our competitors in years where
there are lower than average catastrophe losses but that our capital will be
better protected in the event of large losses.




1
 Table of Contents




Leverage and
Expand Our Strong Broker and Customer Relationships. We will continue to
strengthen our relationships with brokers and customers and build our franchise.
We will seek to enhance our reputation with brokers by responding promptly to
submissions, as quickly as within one business day, if necessary, and by
providing a reasoned analysis to support our pricing. Members of our senior
management team will continue to spend a significant amount of time meeting with
brokers and potential new clients and strengthening existing
relationships.





Employ a
Sophisticated Investment Approach. A substantial allocation of our
assets have been invested in high-grade fixed maturity securities, with the
remainder generally invested in a diversity of other asset classes, such as U.S.
equities, developed and emerging market equities, commodities, and cash
equivalents. A smaller portion of our investments is allocated to private equity
and real estate.  Our strategy has been designed to produce higher
expected total returns on our portfolio while still maintaining sufficient
liquidity to pay potential claims and preserving our excellent financial
strength rating.





Leverage Our
Efficient Global Operating Platform. We will continue to integrate and
grow our global operating platform. We believe that by accessing lower cost, yet
highly educated and qualified talent, selected from certain of our locations
outside of Bermuda, and integrating them into our operations through our
technology platform, we will be able to achieve greater capabilities than other
Bermuda-based reinsurance companies of comparable capital size.





Expand into
Attractive Markets. Our management team has considerable experience in
evaluating various market opportunities in which our business may be
strategically or financially expanded or enhanced. Such opportunities could take
the form of quota share reinsurance contracts, joint ventures, renewal rights
transactions, corporate acquisitions of another insurer or reinsurer, or the
formation of insurance or reinsurance platforms in new markets. We believe the
environment in the reinsurance and insurance markets will continue to produce
opportunities for us, through organic expansion or through acquisitions, and
that we are well qualified to evaluate and, as appropriate, take advantage of
such opportunities.





Employ Our
Capital Markets Expertise. The
capital markets experience of our senior management team will be leveraged to
access capital markets in innovative ways. For example, we have created Mont
Fort Re Limited, or Mont Fort, an entity that raises capital from investors
through offerings of its preferred shares, and uses the proceeds of those
offerings to underwrite reinsurance ceded to it by Flagstone. Because we control
both Mont Fort and Flagstone, and because Mont Fort benefits from Flagstone’s
underwriting expertise and writes reinsurance only for Flagstone, this type of
arrangement is often referred to as a sidecar. Through sidecars, we can optimize
our retained risk profile while earning attractive fees for creating and
managing these facilities.





Preserve Our
Financial Position. We will continue to manage our capital prudently
relative to our risk exposures in order to maximize sustainable long term growth
in our diluted book value per common share. Our strategy of limiting our
exposure by risk zone means that we may achieve lower returns than some of our
competitors in years with lower than average catastrophe losses but that our
capital will be better protected in the event of large losses. We are committed
to maintaining our excellent capitalization, financial strength and ratings over
the long term.





Segment
Information





Management views the operations and
management of the Company as one operating segment and does not differentiate
its lines of business into separate reporting segments. We regularly review our
financial results and assess our performance on the basis of our single
operating segment.  Financial data relating to our segment is included
in Note 18 to our Consolidated Financial Statements (Item 8 below).








Reinsurance
Products and Operations





Reinsurance
Products





We write primarily property, property
catastrophe, and short-tail specialty and casualty reinsurance from our offices
in Bermuda and Switzerland.  For a discussion of our Global Operating
Platform, please see “Operations—Global Operating
Platform”
below.





Substantially all of the reinsurance
products we currently seek to write are in the form of treaty reinsurance
contracts. When we write treaty reinsurance contracts, we do not evaluate
separately each of the individual risks assumed under the contracts and are
therefore largely dependent on the individual underwriting decisions made by the
cedent. Accordingly, as part of our initial review and renewal process, we
carefully review and analyze the cedent’s risk management and underwriting
practices in deciding whether to provide treaty reinsurance and in appropriately
pricing the treaty.





Our contracts can be written on either
a pro rata or on an excess of loss basis, generally with a per-event cap. With
respect to pro rata reinsurance, we share the premiums as well as the losses and
expenses in an agreed proportion with the cedent and typically provide a ceding
commission to the client in order to pay for part of their business origination
expenses. In the case of reinsurance written on an excess of loss basis, we
receive the premium for the risk assumed and indemnify the cedent against all or
a specified portion of losses and expenses in excess of a specified dollar or
percentage amount.  For the years ended December 31, 2007 and 2006,
our reinsurance contracts have been primarily written on an excess of loss
basis.





The bulk of our portfolio of
risks is assumed pursuant to traditional reinsurance contracts. We may also
from time to time take underwriting risk by purchasing a catastrophe-linked
bond, or via a transaction booked as an industry loss warranty (as described
below under “Property
Catastrophe Reinsurance”) or an indemnity swap. An
indemnity swap is an agreement which provides for the exchange between two
parties of different portfolios of catastrophe exposure with similar expected
loss characteristics (for example, U.S. earthquake exposure for Asian earthquake
exposure). We believe our internal capital markets experience is useful in being
able to analyze and evaluate underwriting risks independently from their legal
form. All underwriting risks, regardless of the form in which they are entered
into, are managed by the underwriting team as part of our overall risk
portfolio.





Presently, we primarily focus on
writing the following products:





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, 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
 Table of Contents




We also
provide industry loss warranty covers, which are triggered by loss and loss
adjustment expenses incurred by the cedent and some pre-determined absolute
level of industry-wide losses resulting from an insured event or by specific
parameters of a defined event (such as a magnitude 8 earthquake or a category 4
hurricane).





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.





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. During 2008, we
expect to continue increasing our specialty writings based on our assessment of
the market environment. Most short-tail specialty and casualty reinsurance is
written with loss limitation provisions.





Our
short-tail casualty portfolio of risks focuses on selected classes, with an
initial emphasis on workers’ compensation, personal accident catastrophe and
“casualty clash”excess of loss reinsurance
business. Under a casualty clash reinsurance agreement, the ceding insurer
retains an amount which is generally higher than the limit on any one reinsured
policy with the same insurer. Thus, two or more coverages, policies or lives
must be involved in the same event for coverage to apply under the reinsurance
agreement. For example, coverage under an automobile casualty clash reinsurance
agreement would apply in the case of a multi-car accident in which several of
the individuals involved have their own policies. Likewise, casualty clash
coverage would be applicable in the case of an accident involving an insured
commercial vehicle which resulted in a workers’ compensation claim against the
same insured party by one of its employees.





For the years ended December 31, 2007
and 2006, approximately 70% of the risks we reinsured were related to natural
catastrophes, such as hurricanes and earthquakes, in North America, the
Caribbean and Europe, although we also have written a significant amount of
catastrophe business in Japan and Australasia. Details of gross premiums written
by line of business and by geographic area of risk insured are provided
below:




Year
      Ended December 31, 2007
              
              
              Year
      Ended December 31, 2006Gross
      premiums written
              
              Percentage
      of total
              
              Gross
      premiums written
              
              Percentage
      of total($ in thousands)Line of
      businessProperty
      catastrophe
              
              $
              411,566
              
              
              
              71.3
              %
              
              $
              219,102
              
              
              
              72.4
              %Property
              
              
              94,503
              
              
              
              16.4
              %
              
              
              56,417
              
              
              
              18.7
              %Short-tail
      specialty and casualty
              
              
              71,081
              
              
              
              12.3
              %
              
              
              26,970
              
              
              
              8.9
              %Total
              
              $
              577,150
              
              
              
              100.0
              %
              
              $
              302,489
              
              
              
              100.0
              %Year
      Ended December 31, 2007
              
              
              Year
      Ended December 31, 2006Gross
      premiums written
              
              Percentage
      of total
              
              Gross
      premiums written
              
              Percentage
      of total($ in thousands)Geographic area of risk
      insured(1)North
      America
              
              $
              297,928
              
              
              
              51.6
              %
              
              $
              160,384
              
              
              
              53.0
              %Worldwide
      risks(2)
              
              
              99,365
              
              
              
              17.2
              %
              
              
              37,815
              
              
              
              12.5
              %Europe
              
              
              79,894
              
              
              
              13.8
              %
              
              
              45,737
              
              
              
              15.1
              %Caribbean
              
              
              48,103
              
              
              
              8.3
              %
              
              
              10,291
              
              
              
              3.4
              %Japan
      and Australasia
              
              
              39,547
              
              
              
              6.9
              %
              
              
              31,690
              
              
              
              10.5
              %Other
              
              
              12,313
              
              
              
              2.2
              %
              
              
              16,572
              
              
              
              5.5
              %Total
              
              $
              577,150
              
              
              
              100.0
              %
              
              $
              302,489
              
              
              
              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.





Operations
- Global Operating Platform





We have offices in Bermuda,
Switzerland, India, the United Kingdom, Canada, Puerto Rico, Isle of Man and
Dubai. Most of our senior management, primary underwriting and risk management
functions are located in Bermuda and use the support services from the other
offices, with lower operating costs or specialized functions, to deliver
products and services to brokers and customers. This provides significant
efficiencies in our operations and provides us with access to a large and highly
qualified staff at a relatively low cost. We believe that we are positioned to
perform and grow these functions outside of Bermuda to an extent that
distinguishes us among Bermuda-based reinsurance companies of comparable capital
size.





Our Bermuda-based underwriters are
complemented with a separately licensed and staffed European underwriting
platform, Flagstone Suisse based in Martigny in the canton of Valais,
Switzerland. We believe that for many lines of business we can be more effective
in marketing and attracting continental European business in Switzerland than in
Bermuda, and that for many clients, a Swiss counterparty would be preferred.
Through this local presence, we will be in a position to closely follow and
respond effectively to the changing needs of the various European insurance
markets. Flagstone Suisse is licensed by the Federal Office of Private
Insurance, or FOPI, in Switzerland.





Our research and development efforts
and part of our catastrophe modeling and risk analysis team are based in
Hyderabad, India. Our office is located in the state of Andhra Pradesh, a region
with many highly educated and talented financial analysis professionals, and the
operating costs are substantially below those in Bermuda and
Halifax.





In London, England, we have an
international reinsurance marketing operation promoting Flagstone to
international and multinational clients. Our U.K. operations work alongside our
underwriters to develop global business opportunities and maintain relationships
with existing clients.




3
 Table of Contents




In Halifax, Nova Scotia, Canada, we
have a computer data center where we run support services such as accounting,
claims, application support, administration and software development. Halifax
has a concentration of university graduates with professional backgrounds and
credentials in such areas as finance, information technology and science which
are appropriate for our back-office functions. In general, the cost of employing
a highly skilled work force in Halifax is lower than in Bermuda. In addition,
Halifax is in the same time zone as Bermuda, which facilitates communications
between our offices.





Our Puerto Rico office, established in
2007 and licensed with the Office of the Commissioner of Insurance of
Puerto Rico, provides an underwriting platform targeting the Caribbean and
Latin American regions, primarily on behalf of Flagstone Suisse.





In Dubai, we have established and
licensed a reinsurance intermediary operation with the Dubai Financial Services
Authority to provide marketing and underwriting support for the Middle East and
North Africa on behalf of Flagstone and Flagstone Suisse.





We believe our operating platform
affords us the capability and flexibility to deploy our capital and expertise
strategically, efficiently and tactically throughout the global markets. For
example, compared to our competitors, we believe these capabilities allow us to
process new business submissions quickly and thoroughly, to review relatively
more risks in the search for attractive opportunities and to explore new markets
where the accumulation and analysis of data is a time-consuming
activity.





Ratings




Financial strength ratings have become
an increasingly important factor in establishing the competitive position of
insurance and reinsurance companies. Rating organizations continually review the
financial positions of insurers and reinsurers, including
Flagstone.  The following are Flagstone’s and Flagstone Suisse’s
current financial strength ratings from internationally recognized rating
agencies:




Rating
      Agency
            Financial
              Strength
      RatingA.
      M. Best
            
            A−
            
            
            Excellent
      (Stable outlook)Moody’s
      Investor Services
            
            A3
            
            
            Strong
      (Stable outlook)Fitch
            
            A-
            
            
            Adequate
      (Stable outlook)




Our
ability to underwrite business is dependent upon the quality of our claims
paying and financial strength ratings as evaluated by independent rating
agencies. In the event that we are downgraded by any of the agencies below where
our ratings currently are, we believe our ability to write business would be
adversely affected. In the normal course of business, we evaluate our capital
needs to support the volume of business written in order to maintain our claims
paying and financial strength ratings. We regularly provide financial
information to rating agencies to both maintain and enhance existing
ratings.





These ratings are not evaluations
directed to investors in our securities or a recommendation to buy, sell or hold
our securities. Our ratings may be revised or revoked at the sole discretion of
the rating agencies.




Underwriting
and Risk Management





We view underwriting and risk
management as an integrated process. We commence work underwriting a risk only
after we have an initial understanding of how its addition to our existing
portfolio would impact our total single event loss potential by risk zone. After
completing our detailed underwriting analysis, and before we provide an
indication of terms and price, we ensure that we understand the change this risk
will make in the overall risk of our insurance portfolio. We constantly review
our global exposures as new opportunities are shown to us, as we bind new
business, and as policies mature to ensure that we are continuously aware of our
overall underwriting risk.  A principal focus of Flagstone is to
develop and effectively utilize sophisticated computer models and other
analytical tools to assess the risks that we underwrite and to optimize our
portfolio of underwriting and investment risks.




Underwriting





Our principal underwriting objective is
to create a balanced portfolio of risks, diversified by risk zone. Underwriting
and pricing controls are exercised through our chief underwriting officers
and our chief actuary. The underwriting team is supported by additional
underwriters, catastrophe risk analysts, an actuarial team, acatastrophe
modeling and research team and a full complement ofunderwriting
administrative support positions.





We underwrite to specific disciplines
as set out in our underwriting guidelines developed by our senior executives and
approved by the Underwriting Committee of our Board of Directors. In general our
underwriting and risk management approach is to:




●
              focus
      on ceding insurers that are leaders in their geographic zone with high
      quality underlying data;●
              devote
      significant time and resources to data evaluation and
      cleansing;●
              use
      multiple analytical models to price each risk, including varying
      techniques and vendor models;●
              ensure
      correct application of vendor model options for each specific risk factor
      (such as demand surge, which is the tendency for costs such as
      construction to increase following a large
catastrophe);●
              leverage
      our research and development team’s in-depth knowledge of the strengths
      and weaknesses of third-party models in pricing and risk
      selection;subject
      all risks to peer review, which is the detailed review of each risk we
      plan to write by an underwriter other than the individual responsible for
      the transaction, and subject large risks to additional approval by the
      Chief Executive Officer, the Management Committee, or the Underwriting
      Committee of the Board of Directors, depending on the size of the risk;
      and●
              quickly
      reject risks that do not meet our
requirements.




Risk
Management





We apply an integrated approach to risk
management, employing a variety of tools, both proprietary and commercially
available, along with prudent analysis and management from actuarial and
underwriting professionals.




4
 Table of Contents




We have invested significant resources
in developing state of the art risk monitoring capabilities.  Our
Multiple Operational Sourced and Integrated Control Database, that we refer to
as our MOSAIC system, provides a flexible framework for assimilating various
data and informational formats for risk modeling, pricing, underwriting and
reporting.  Our proprietary systems allow us significant flexibility
in evaluating our loss potential from a variety of commercial vendor models and
varying segments of our business, primarily regional and peril.





Property catastrophe risks along with
other aggregating exposures are monitored in a variety of fashions including
probable maximum loss and absolute zonal limits exposed.  Internal
risk guidelines govern the maximum levels of risk the Company may assume
including size of individual risk commitments.  We limit risks on both
an absolute zonal basis for property and probable maximum loss.





Probable Maximum Loss (“PML”).    We monitor
our PML on both a per occurrence and annual aggregate basis as part of our
internal risk guidelines.  Per occurrence refers to the potential size
of loss from a given event versus annual aggregate, which involves the use of
simulation to define hypothetical years containing sequences of
events.  For example, Hurricanes Katrina, Wilma or Rita would qualify
as individual events, but annual aggregate calculations identify the Company’s
exposure to all three of these events occurring in a single
year.





We also manage the risk of estimation
error by applying limits in each of our risk zones, which we refer to as zonal
limits. Substantially all of our contracts include loss limitation provisions,
and we limit the amount of exposure to a single event loss for a particular
peril that we can take on or retain from those contracts in any one risk zone.
Our approach to risk control imposes an absolute limit on our net maximum
potential loss for any single event in any one risk zone, which reduces the risk
to Flagstone of model error or inaccuracy.





Ceded Reinsurance.   In
addition to managing the risks in our portfolio by monitoring the zonal
exposures resulting from each underwriting decision, we also may choose to
protect our results and capital through the use of retrocessional coverage. This
coverage may be purchased on an indemnity basis as well as on an industry basis
(for example, industry loss warranties).





When we buy retrocessional coverage on
an indemnity basis, we are paid for an agreed-upon portion of the losses we
actually suffer. In contrast, when we buy an industry loss warranty cover, we
are paid only if both the Company and the industry suffer a loss (as reported by
one of a number of independent agencies) in excess of specified threshold
amounts. With an industry loss warranty, we bear the risk that we may suffer a
loss and yet receive no payment because the industry loss was less than the
specified threshold amount.





We only purchase retrocessional
coverage from reinsurers with a minimum financial strength rating of “A-” from A.M. Best or S&P
or “A3” from Moody’s, from
affiliates with whom we are able to control credit risk, or on a collateralized
basis.





We cede business to our sidecar, Mont
Fort. Mont Fort raises capital from third-party investors through offerings of
its preferred shares, and uses the proceeds of those offerings to underwrite
reinsurance which will be ceded to Mont Fort by Flagstone. Mont Fort is
organized to establish segregated accounts, referred to as cells. Each cell of
Mont Fort has a distinct business strategy, underwriting strategy and
underwriting risk management program. Flagstone may also cede business to
reinsurance companies other than Mont Fort.





We also use capital markets instruments
for risk management (e.g., catastrophe-linked bonds, or catastrophe bonds, which
is a type of financial instrument that is tied to a specific catastrophic event,
and other forms of risk securitization) where the pricing and capacity is
attractive and the structures provide a high degree of security and clear loss
settlement procedures.





Program
Limits.    We also seek to control our overall
exposure to risk by limiting the amount of reinsurance we will supply in
accordance with a particular program or contract. This helps us to diversify
within and across risk zones. Our Underwriting Committee sets an absolute dollar
limit on our maximum exposure to any one program or contract, which may be
exceeded for specific situations at the discretion of the Underwriting
Committee.




Marketing
and Distribution





Our customers generally are
sophisticated, long-established insurers who seek the assurance not only that
claims will be paid but also that reinsurance will continue to be available
after claims are paid. Catastrophic losses can be expected to adversely affect
our clients’ financial results from time to time, and we believe that our
financial stability, ratings, growth of capital, client service and innovation
are essential for creating long-term relationships. We believe that such
relationships are critical to creating long-term value for the Company and for
our shareholders.





The majority of our business is
produced through brokers and reinsurance intermediaries who receive a brokerage
commission on industry standard terms, usually equal to a percentage of gross
premiums. We seek to become the first choice of brokers and clients by
providing:





●
            a high
      level of technical expertise in the risks we
  write;


●
            rapid
      and informed quoting;


●
            timely
      payment of claims;


●
            large
      capacity within our underwriting guidelines on the high quality clients we
      target; and


●
            clear
      indications of the classes of risks we will and will not
      write.





Our objective is to build long-term
relationships with key reinsurance brokers, such as Aon Re Worldwide, Benfield
Group Limited, Guy Carpenter & Company, Inc. and Willis Group Holdings Ltd.,
and with many ceding companies.




5
 Table of Contents




The following table sets forth the
Company’s gross premiums written by broker:


Year
      Ended December 31, 2007
              
              
              Year
      Ended December 31, 2006Gross
      premiums written
              
              
              Percentage
      of total
              
              
              Gross
      premiums written
              
              
              Percentage
      of total($
      in thousands)Name
      of brokerGuy
      Carpenter
              
              $
              153,781
              
              
              
              26.6
              %
              
              $
              49,845
              
              
              
              16.5
              %Benfield
              
              
              149,651
              
              
              
              25.9
              %
              
              
              78,217
              
              
              
              25.9
              %Aon
      Re Worldwide
              
              
              96,013
              
              
              
              16.6
              %
              
              
              63,675
              
              
              
              21.1
              %Willis
      Group
              
              
              77,030
              
              
              
              13.3
              %
              
              
              72,424
              
              
              
              23.9
              %Other
      brokers
              
              
              100,675
              
              
              
              17.6
              %
              
              
              38,328
              
              
              
              12.6
              %Total
              
              $
              577,150
              
              
              
              100.0
              %
              
              $
              302,489
              
              
              
              100.0
              %


We believe that by maintaining close
relationships with brokers, we are able to obtain access to a broad range of
potential reinsureds. We meet frequently in Bermuda and elsewhere with brokers
and senior representatives of clients and prospective clients.





Claims
Management





The Company’s claims management process
is initiated upon receipt of reports from ceding companies.





An initial review is conducted by a
claims analyst who uses our proprietary claims validation tools to ensure
correct loss and reinstatement premium calculations prior to approval/entry into
our underwriting/claims/accounting system.





Underwriters, underwriting managers,
claims management and senior management review claims submissions for
authorization prior to entry and settlement. These authorizations, additional
management approvals and claims statuses are governed through our custom claims
workflow system. This is a key control in our claims process.





On occasions where legal contract
review is necessary, claims are subject to internal legal review from counsel.
Once the validity of the given claim is established, responsibility for
management of the claim is transferred to our claims department. As the claim
develops, the claims department is empowered to draw on those resources, both
internal and external, it deems appropriate to settle the claim
appropriately.





Where necessary, we will conduct or
contract for on-site audits periodically, particularly for large accounts and
for those whose performance differs from our expectations. Through these audits,
we will be able to evaluate ceding companies’ claims-handling practices,
including the organization of their claims departments, their fact-finding and
investigation techniques, their loss notifications, the adequacy of their
reserves, their negotiation and settlement practices and their adherence to
claims-handling guidelines.




Loss
Reserves





Loss reserves represent estimates,
including actuarial and statistical projections at a given point in time, of the
ultimate settlement and administration costs of claims incurred.  Loss
and loss adjustment expense reserves (or loss reserves) are typically comprised
of (1) case reserves, which are established for specific, individual
reported claims and (2) reserves for losses that have been incurred but for
which claims have not yet been reported to us, referred to as incurred but not
reported, or IBNR, reserves. Our estimates are not precise in that, among other
things, they are based on predictions of future developments and estimates of
future trends in claims severity and frequency and other variable factors such
as inflation. It is likely that the ultimate liability will be greater or less
than such estimates and that, at times, this variance will be
material.





The Company’s actuarial group performs
a quarterly loss reserve analysis on a contract by contract basis. This analysis
incorporates specific exposures, loss payment and reporting patterns, as well as
additional loss-sensitive contractual features such as reinstatement premiums,
profit commissions, and other relevant factors. This process involves the
segregation of risks between catastrophic and non-catastrophic risks to ensure
appropriate treatment.





For our property and other catastrophe
policies, we initially establish our loss reserves based on loss payments and
case reserves reported by ceding companies. We then add to these case reserves
our estimates for IBNR. To establish our IBNR estimates, in addition to the loss
information and estimates communicated by cedents, we also use industry
information, knowledge of the business written by us, management’s judgment and
general market trends observed from our underwriting activities. We may also use
our computer-based vendor and proprietary modeling systems to measure and
estimate loss exposure under the actual event scenario, if available. Although
the loss modeling systems assist with the analysis of the underlying loss, and
provide us with information and the ability to perform an enhanced analysis, the
estimation of claims resulting from catastrophic events is inherently difficult
because of the variability and uncertainty of property catastrophe claims and
the unique characteristics of each loss.





For non-catastrophe business, we
utilize a variety of standard actuarial methods in our analysis. The selections
from these various methods are based on the loss development characteristics of
the specific line of business and specific contracts. The actuarial methods we
use to perform our quarterly contract by contract loss reserve analysis include:
Paid Loss Development Method, Reported Loss Development Method, Expected Loss
Ratio Method, Bornheutter-Ferguson Paid Loss Method and Bornheutter-Ferguson
Reported Loss Method. See Item 7, “Management’s Discussion and
Analysis of Financial Condition and Results of Operations—Critical Accounting
Policies—Loss and Loss Adjustment Expense Reserves”.




6
 Table of Contents




We reaffirm the validity of the
assumptions we use in the reserving process on a quarterly basis during an
internal review process. During this process the actuaries verify that the
assumptions continue to form a sound basis for projection of future
liabilities.





Although we believe that we are prudent
in our assumptions and methodologies, we cannot be certain that our ultimate
payments will not vary, perhaps materially, from the estimates we have made. If
we determine that adjustments to an earlier estimate are appropriate, such
adjustments are recorded in the quarter in which they are identified. The
establishment of new reserves, or the adjustment of reserves for reported
claims, could result in significant upward or downward changes to our financial
condition or results of operations in any particular period. We regularly review
and update these estimates, using the most current information available to
us.





Our estimates are reviewed annually by
an independent actuary in order to provide additional insight into the
reasonableness of our loss reserves.





The
Company’s reserve development is composed of the change in ultimate losses from
what the Company originally estimated as well as the impact of the foreign
exchange revaluation on reserves.  The re-estimated ultimate claims
and claim expenses reflect additional information received from cedents or
obtained through reviews of industry trends, regarding claims incurred prior to
the end of the preceding financial year.  A redundancy (or deficiency)
arises when the re-estimation of reserves is less (or greater) than previously
estimated at the preceding year-end.  The cumulative redundancies (or
deficiencies) reflect cumulative differences between the initial reported net
reserves and the currently re-estimated net reserves.  Annual changes
in the estimates are reflected in the income statement for each year, as the
liabilities are re-estimated.  Reserves denominated in foreign
currencies are revalued at each year-end’s foreign exchange rates. The following
table presents the development of our loss and loss adjustment expense reserves
for December 31, 2006 through December 31, 2007, and the breakdown of
our loss and loss adjustment expense reserves as at December 31, 2007 per
accident year, net of claims paid (in thousands of U.S.
dollars):




Initial
      Estimate of
                Ultimate
      Claims and Claim
              
              Re-estimated
      Ultimate Claims
                and
      Claim Expenses as of
                December
      31, 2007
              
              Cumulative
      Redundancy
              
              %
                Decrease
              
              Loss
      and Loss Adjustment
                Expense
              
              %
      of ClaimsExpense
              
              2006
              
              2007
              
              (Deficiency)
              
              (Increase)
              
              Reserves
              
              UnpaidAccident
      year2006
              
              $
              26,660
              
              
              $
              26,660
              
              
              $
              22,785
              
              
              $
              3,875
              
              
              
              14.5%
              
              
              $
              11,693
              
              
              
              51.3
              %Accident
      year2007
              
              
              199,223
              
              
              
              -
              
              
              
              199,223
              
              
              
              -
              
              
              
              -
              
              
              
              166,559
              
              
              
              83.6
              %Foreign
      exchange on
                reserves
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              2,726
              
              
              
              -$
              225,883
              
              
              $
              26,660
              
              
              $
              222,008
              
              
              $
              3,875
              
              
              
              1.7%
              
              
              $
              180,978
              
              
              
              81.5
              %


Investments





The investment management guidelines of
the Company are set by the Finance Committee of our Board of Directors. The
Finance Committee establishes investment policies and guidelines for both
internal and external investment managers.





When the Company was formed, the
Finance Committee decided to invest initially in a conventional portfolio
consisting of mainly high grade bonds and a 10% component of passive U.S.
equities. This was decided in order to simplify our initial credit rating
process and to allow Company management to focus on underwriting the insurance
risks rather than managing the investment portfolio. This portfolio was an
appropriate component of our initial strategy to accomplish our first year’s
business objectives; however, it was not the optimum portfolio to achieve our
long term primary financial objective of growth in diluted book value per
share.





Subsequently, the Finance Committee
conducted a comprehensive asset allocation study, consistent with modern
practice in portfolio optimization, and developed a sophisticated optimization
model using asset classes the Company is allowed to invest in from fiscal,
regulatory, and liquidity aspects. The model aims at achieving higher expected
total returns while maintaining adequate liquidity to pay potential claims and
preserving our financial strength rating. The asset class composition of the
model output includes a significant allocation to high grade fixed maturities
securities, with the balance invested between other asset classes,
such as U.S. equities, developed and emerging market equities, commodities
and cash equivalents. A smaller portion of investments is allocated to
private equity, real estate and hedge funds. We started the gradual
implementation of the optimum portfolio driven by the model output in late 2006,
through a combination of internal and external portfolio managers.





Tactically, we have very small (about
2%) exposure to hedge funds, and a strong bias against active management in
favor of indexing and passive securities, that are generally the most liquid. A
number of our equity and other exposure implementations use futures contracts
and swaps, whereas the assets in a short term portfolio, managed by external
managers, back the futures contracts as if those assets were pledged and not
available for liquidity purposes. This implementation strategy gives us a low
cost and efficient way, using a mixture of passive assets and outside managers
to complement our in-house capability for overall portfolio management,
liquidity management and hedging.  With the incorporation of our Swiss
entity, we reoptimized the portfolio in February 2007, introducing four new
asset classes comprising Swiss bonds, Swiss equity, Euro equity, and Swiss short
term investments. The model is allowed to allocate only the Swiss entity capital
portion to these newly introduced asset classes.





During 2007, for the majority of the
asset class strategies we have been able to achieve investment returns in line
with expected benchmark returns, within acceptable tracking error. In the fourth
quarter of 2007, we performed our annual portfolio optimization exercise and
reran our model based on a revised allocation approval from A.M.
Best.  In December 2007, we completed the majority of our rebalancing
based on our updated model. The current allocation still keeps the high grade
fixed maturity component similar to previous levels, but achieves a better
diversification among the other asset classes. In particular, there is now less
allocation to U.S. equity and higher allocation to non-U.S. equity and
commodities. The portfolio implementation methodology remains the same as
before.





Sub-prime
Exposure




As at December 31, 2007 the Company had
no sub-prime exposure in our portfolio. Please see Item 7, “Management’s Discussion and
Analysis of Financial Condition and Results of Operations—Financial
Condition, Liquidity and Capital Resources—Investments” below for further
details.




7
 Table of Contents


Competition





The reinsurance industry is highly
competitive. We compete with major and mid-sized U.S., Bermuda and other
international reinsurers, some of which have greater financial, marketing and
management resources than we do. We also compete with government-sponsored
insurers and reinsurers, and with new companies which continue to be formed to
enter the reinsurance market. In addition, established competitors have
completed or may be planning to complete additional capital raising
transactions. Capital markets also offer alternative products that are intended
to compete with traditional reinsurance products.





In particular, we compete with
reinsurers that provide property-based lines of reinsurance, such as ACE Tempest
Reinsurance Ltd., AXIS Capital Holdings Ltd., Lloyd’s of London, Montpelier Re
Holdings Ltd., RenaissanceRe Holdings Ltd., XL Re Ltd., and similar
companies.





Competition in the types of business
that we underwrite is based on many factors, including:





●
            premiums
      charged and contractual terms and conditions
  offered;


●
            services
      provided, products offered and scope of business (both by size and
      geographic location);


●
            strength
      of client relationships;


●
            financial
      strength ratings assigned by independent rating
  agencies;


●
            speed
      of claims payment;


●
            reputation;


●
            perceived
      financial strength; and


●
            experience
      of the reinsurer in the line of reinsurance to be
  written.





Increased competition could result in
fewer submissions, lower premium rates, and less favorable policy terms, which
could adversely impact our growth and profitability. In addition, capital market
participants have recently created alternative products, such as catastrophe
bonds, that are intended to compete with reinsurance products.  We
believe that we are well positioned in terms of client services and underwriting
expertise. We also believe that our capitalization and strong financial ratios
provide us with a competitive advantage in the marketplace.





Other
Subsidiaries




Mont
Fort





We own all of the outstanding common
shares of Mont Fort. Mont Fort is organized under the laws of Bermuda as an
exempted company which is registered as a general business Class 3 insurer and
is also registered as a “segregated accounts” company under the Bermuda
Segregated Accounts Companies Act 2000 (as amended), or the SAC Act. The SAC Act
enables Mont Fort to establish segregated accounts, referred to as cells. Each
cell of Mont Fort has a distinct business strategy, underwriting strategy and
underwriting risk management program. Each cell of Mont Fort raises capital
through preferred shares issued by Mont Fort and linked to that cell,
underwrites its own risks and, to the fullest extent provided by the SAC
Act, is solely responsible for liabilities arising from those risks. Each
cell uses the proceeds of those offerings to underwrite reinsurance which will
be ceded to Mont Fort by Flagstone.





On June 6, 2006, Mont Fort closed
an offering of preferred shares relating to its first cell, Mont Fort ILW, which
yielded gross proceeds of $60.0 million including investments by Flagstone
of $5.0 million (8.3%) and LB I Group Inc., or LB I, of $50.0 million
(83.3%).  LB I is a related party due to its investment in common
shares of the Company.  On August 28, 2006, Mont Fort repurchased
the preferred shares held by Flagstone for $5.1 million. As at December 31,
2006, and for the year ended December 31, 2006, 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)”), the Company had
determined that Mont Fort was a Variable Interest Entity (“VIE”). The Company
was not considered to be the primary beneficiary and therefore, was not
required to consolidate Mont Fort into its financial statements. The Company was
deemed to have significant influence over the operating and financial policies
of Mont Fort due to its board representation and 100% voting interests.
Therefore Mont Fort was accounted for under the equity method of accounting.
Under this method, the Company recorded all of the income or loss from the
general account of Mont Fort but no income or losses arising from the activities
of the segregated account of Mont Fort.





On January 2, 2007, Mont Fort closed an
offering of preferred shares relating to its second cell, Mont Fort ILW 2 Cell,
which we refer to as Mont Fort ILW 2, which yielded gross proceeds of
$55.0 million from LB I.  Mont Fort, in respect of Mont Fort ILW
2, entered into a quota share reinsurance contract with Flagstone under which
Flagstone assumes 8.3% of the business written by Mont Fort
ILW 2.





On January 12, 2007, Mont Fort
closed an offering of preferred shares relating to a third cell, Mont Fort High
Layer or Mont Fort HL, which yielded gross proceeds of $28.1 million. The
investor in Mont Fort HL is Newcastle Special Opportunity Fund V, L.P., an
entity with no previous investments or affiliations with the Company or with
Mont Fort. Mont Fort, in respect of Mont Fort HL, entered into a quota share
reinsurance contract with Flagstone under which Flagstone assumes 9.0% of the
business written by Mont Fort HL.





The Company determined that the
establishment of these cells was a reconsideration event under the provisions of
paragraph 7 and paragraph 15 of FIN 46(R). Consequently, the Company
assessed whether or not Mont Fort continues to be a VIE and, if so, whether the
Company or another party was Mont Fort’s primary beneficiary. The Company
assessed the impact of these reconsideration events on its results and financial
position, and concluded that the establishment of the Mont Fort HL cell on
January 12, 2007 was the reconsideration event that resulted in the Company
being the primary beneficiary of Mont Fort. As such, the results of Mont Fort
are included in the Company’s consolidated financial statements with effect from
January 12, 2007. The portions of Mont Fort’s net income and shareholders’ equity
attributable to holders of the preferred shares for the year ended December 31,
2007 are recorded in the consolidated financial statements of the Company as
minority interest.





In addition, we do not count Mont
Fort’s contracts against our zonal limits or otherwise consider Mont Fort as a
subsidiary for our underwriting and risk management procedures.





Island
Heritage





Island Heritage Holdings Company, or
Island Heritage, is 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.  On July 3, 2007, we purchased
73,110 shares (representing a 21.4% interest) in Island Heritage for a purchase
price of $12.6 million. With this acquisition, we took a controlling interest in
Island Heritage by increasing its ownership to 54.6% of the voting
shares.  We had previously acquired 33.2% of the shares through three
purchases in March 2006 (18.7% interest), October 2006 (9.8% interest) and May
2007 (4.7% interest).  Following the acquisition, the Company’s
representation on Island Heritage’s board and the close working relationship
with its management allows us to promote and support best practices in the
underwriting of Island Heritage’s underlying business and to consequently
enhance the quality of data available to Flagstone to underwrite the reinsurance
of such business.




8
 Table of Contents




As a result of the acquisition of the
controlling interest, the results of operations of Island Heritage have been
included in the Company’s consolidated financial statements from July 1, 2007,
with the portions of Island Heritage’s net income and shareholders’ equity
attributable to minority shareholders recorded as minority interest in the
Company’s consolidated financial statements.





Employees





The Company had 270employees
at December 31, 2007.  We believe that our relations with our
employees are generally good.





Regulation





The business of reinsurance is now
regulated in most countries, although the degree and type of regulation varies
significantly from one jurisdiction to another. As a holding company, Flagstone
Reinsurance Holdings Limited is not subject to Bermuda insurance regulations,
but its various operating subsidiaries are subject to regulations as
follows:





Bermuda
Insurance Regulation





The Insurance
Act. As a holding company, we are not subject to Bermuda
insurance law and regulations. However, the Bermuda Insurance Act 1978 of
Bermuda, as amended, which we refer to as the Insurance Act, and related
regulations, regulate the insurance business of Flagstone. The Insurance
Act provides that no person shall carry on any insurance business in or from
within Bermuda unless registered as an insurer under the Insurance Act by the
Bermuda Monetary Authority (“BMA”), which is responsible for the day-to-day
supervision of insurers. The BMA, in deciding whether to grant registration, has
broad discretion to act as it thinks fit in the public interest. The BMA is
required by the Insurance Act to determine whether the applicant is a fit and
proper body to be engaged in the insurance business and, in particular, whether
it has, or has available to it, adequate knowledge and expertise to operate an
insurance business. Under the Insurance Act, insurance business includes
reinsurance business. The continued registration of a company as an insurer
under the Insurance Act is subject to its complying with the terms of its
registration and such other conditions as the BMA may impose from time to
time.





An Insurance Advisory Committee
appointed by the Bermuda Minister of Finance advises the BMA on matters
connected with the discharge of the BMA’s functions, and sub-committees thereof
supervise and review the law and practice of insurance in Bermuda, including
reviews of accounting and administrative procedures.





The Insurance Act imposes solvency and
liquidity standards and auditing and reporting requirements on Bermuda insurance
companies and grants to the BMA powers to supervise, investigate and intervene
in the affairs of insurance companies. Certain significant aspects of the
Bermuda insurance regulatory framework are set forth below.





Classification of Insurers.    The Insurance Act distinguishes between insurers
carrying on long-term business and insurers carrying on general business. There
are four classifications of insurers carrying on general business, with
Class 4 insurers subject to the most onerous regulation with the strictest
limits on their types of business. Flagstone and Mont Fort are registered
to carry on general business as Class 4 and Class 3 insurers in
Bermuda, respectively, and are regulated as such under the Insurance
Act. Flagstone and Mont Fort will not be permitted to carry on
long-term business. In general, long-term business includes life and long-term
disability insurance.





Cancellation of Insurer’s
Registration. An insurer’s registration may be canceled
by the BMA on certain grounds specified in the Insurance Act, including failure
of the insurer to comply with its obligations under the Insurance Act or if, in
the opinion of the BMA, the insurer has not been carrying on business in
accordance with sound insurance principles.





Principal
Representative. An insurer is required to maintain a
principal office in Bermuda and to appoint and maintain a principal
representative in Bermuda.





Independent Approved
Auditor.   Every registered insurer must
appoint an independent auditor who will annually audit and report on the
statutory financial statements and the statutory financial return of the
insurer, both of which, in the case of Flagstone, are required to be filed
annually with the BMA. The independent auditor of Flagstone must be approved by
the BMA and may be the same person or firm which audits Flagstone’s financial
statements and reports for presentation to its shareholders. Flagstone’s
independent auditor is Deloitte & Touche, Bermuda.





Loss Reserve
Specialist. As a registered Class 4 insurer,
Flagstone is required to submit an opinion of its approved loss reserve
specialist with its statutory financial return in respect of its loss and loss
expense provisions. The loss reserve specialist, who will normally be a
qualified property casualty actuary, must be approved by the BMA.  Our
Chief Actuary has been approved as our loss reserve specialist.





Statutory Financial
Statement. Flagstone must prepare annual statutory
financial statements. The Insurance Act prescribes rules for the preparation and
substance of such statutory financial statements (which include, in statutory
form, a balance sheet, an income statement, a statement of capital and surplus
and notes thereto). Flagstone is required to give detailed information and
analyses regarding premiums, claims, reinsurance and investments. The statutory
financial statements are not prepared in accordance with accounting
principles generally accepted in the United States of America (“U.S. GAAP”) and are
distinct from the financial statements prepared for presentation to the
shareholder of Flagstone (which is the Company) under the Companies Act, which
financial statements are prepared in accordance with U.S. GAAP. Flagstone, as a
general business insurer, is required to submit the annual statutory financial
statements as part of the annual statutory financial return. The statutory
financial statements and the statutory financial return do not form part of the
public records maintained by the BMA.





Annual Statutory Financial
Return.  Flagstone is required to file with the BMA
a statutory financial return no later than four months after its financial year
end (unless specifically extended upon application to the BMA). The statutory
financial return for a Class 4 insurer includes, among other matters, a
report of the approved independent auditor on the statutory financial statements
of such insurer, solvency certificates, the statutory financial statements
themselves, the opinion of the loss reserve specialist and a schedule of
reinsurance ceded. The solvency certificates must be signed by the principal
representative and at least two directors of the insurer who are required to
certify, among other matters, whether the minimum solvency margin has been met
and whether the insurer complied with the conditions attached to its certificate
of registration. The independent approved auditor is required to state whether
in its opinion it was reasonable for the directors to so certify. Where an
insurer’s accounts have been audited for any purpose other than compliance with
the Insurance Act, a statement to that effect must be filed with the statutory
financial return.





Minimum Solvency Margin and
Restrictions on Dividends and Distributions. Under the
Insurance Act, the value of the general business assets of a Class 4
insurer, such as Flagstone, must exceed the amount of its general business
liabilities by a prescribed amount. Flagstone is subject to the following
conditions:




9
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●
            is
      required, with respect to its general business, to maintain a minimum
      solvency margin equal to the greatest
of:


o
            100 million
      Bermudadollars; or


o
            50%
      of net premiums written (being gross premiums written less any premiums
      ceded by Flagstone but Flagstone may not deduct more than 25% of ceded
      premiums when computing net premiums written);
  or


o
            15%
      of net losses and loss adjustment expense
  reserves


●
            is
      prohibited from declaring or paying any dividends during any financial
      year if it is in breach of its minimum solvency margin or minimum
      liquidity ratio or if the declaration or payment of such dividends would
      cause it to fail to meet such margin or ratio (if it has failed to meet
      its minimum solvency margin or minimum liquidity ratio on the last day of
      any financial year, Flagstone will be prohibited, without the approval of
      the BMA, from declaring or paying any dividends during the next financial
      year);


●
            is
      prohibited from declaring or paying in any financial year dividends of
      more than 25% of its total statutory capital and surplus (as shown on its
      previous financial year’s statutory balance sheet) unless it files (at
      least 7 days before payment of such dividends) with the BMA an affidavit
      stating that it will continue to meet the required
  margins;


●
            is
      prohibited, without the approval of the BMA, from reducing by 15% or more
      its total statutory capital as set out in its previous year’s financial
      statements and any application for such approval must include an affidavit
      stating that it will continue to meet the required margins;
      and


●
            is
      required, at any time it fails to meet its solvency margin, within 30 days
      (45 days where total statutory capital and surplus falls to 75 million
      Bermuda dollars or less) after becoming aware of that failure or having
      reason to believe that such failure has occurred, to file with the BMA a
      written report containing certain
information.




Minimum Liquidity
Ratio.      The Insurance Act provides a
minimum liquidity ratio for general business insurers, such as Flagstone. An
insurer engaged in general business is required to maintain the value of its
relevant assets at not less than 75% of the amount of its relevant liabilities.
Relevant assets include cash and time deposits, quoted investments, unquoted
bonds and debentures, first liens on real estate, investment income due and
accrued, accounts and premiums receivable and reinsurance balances receivable.
There are certain categories of assets which, unless specifically permitted by
the BMA, do not automatically qualify as relevant assets, such as unquoted
equity securities, investments in and advances to affiliates and real estate and
collateral loans. Relevant liabilities are total general business insurance
reserves and total other liabilities less deferred income tax, sundry
liabilities (by interpretation, those not specifically defined), letters of
credit and guarantees.





Supervision, Investigation and
Intervention.       The BMA may
appoint an inspector with extensive powers to investigate the affairs of an
insurer if the BMA believes that an investigation is required in the interest of
the insurer’s policyholders or persons who may become policyholders. In order to
verify or supplement information otherwise provided to the BMA, the BMA may
direct an insurer to produce documents or information relating to matters
connected with the insurer’s business.





If it appears to the BMA that there is
a risk of Flagstone becoming insolvent, or that it is in breach of the Insurance
Act or any conditions imposed upon its registration, the BMA may, among other
things, direct the insurer:  (1) not to take on any new insurance
business; (2) not to vary any insurance contract if the effect would be to
increase the insurer’s liabilities; (3) not to make certain investments;
(4) to realize certain investments; (5) to maintain in, or transfer to
the custody of a specified bank, certain assets; (6) not to declare or pay
any dividends or other distributions or to restrict the making of such payments;
(7) to limit its premium income; (8) to remove a controller or
officer; and/or (9) to file a petition for the winding up of the
Company.





Disclosure of Information.   In addition to powers under the Insurance Act to
investigate the affairs of an insurer, the BMA may require certain information
from an insurer (or certain other persons) to be produced to them. The BMA also
may assist other regulatory authorities, including foreign insurance regulatory
authorities with their investigations involving insurance and reinsurance
companies in Bermuda, subject to restrictions. For example, the BMA must be
satisfied that the assistance being requested is in connection with the
discharge of regulatory responsibilities of the foreign regulatory authority,
and the BMA must consider whether to co-operate is in the public interest. The
grounds for disclosure are limited and the Insurance Act provides sanctions for
breach of the statutory duty of confidentiality.





Under the Companies Act, the Minister
of Finance has been given powers to assist a foreign regulatory authority which
has requested assistance in connection with enquiries being carried out by it in
the performance of its regulatory functions. The Minister’s powers include
requiring a person to furnish him with information, to produce documents to him,
to attend and answer questions and to give assistance in connection with
enquiries. The Minister must be satisfied that the assistance requested by the
foreign regulatory authority is for the purpose of its regulatory functions and
that the request is in relation to information in Bermuda which a person has in
his possession or under his control. The Minister must consider, among other
things, whether it is in the public interest to give the information
sought.





Certain
Other Bermuda Law Considerations





Both the Company and Flagstone are
incorporated as exempted companies limited by shares under the Companies
Act. Under Bermuda law, exempted companies are companies formed for the purpose
of conducting business outside Bermuda from a principal place in Bermuda. As a
result, we are exempt from Bermuda laws restricting the percentage of share
capital that may be held by non-Bermudians, but we may not, without the express
authorization of the Bermuda legislature or under a license granted by the
Minister of Finance, participate in certain business transactions,
including:





●
            the
      acquisition or holding of land in Bermuda, except land held by way of
      lease or tenancy agreement which is required for our business and held for
      a term not exceeding 50 years, or which is used to provide accommodation
      or recreational facilities for our officers and employees and held with
      the consent of the Bermuda Minister of Finance for a term not exceeding 21
      years;


●
            the
      taking of mortgages on land in Bermuda in excess of 50,000 Bermuda
      dollars;


●
            the
      acquisition of any bonds or debentures secured by any land in Bermuda,
      other than certain types of Bermuda government securities;
    or


●
            subject
      to some exceptions, the carrying on of business of any kind in Bermuda for
      which we are not licensed in
Bermuda.




While an insurer is permitted to
reinsure risks undertaken by any company incorporated in Bermuda and permitted
to engage in the insurance and reinsurance business, generally it is not
permitted without a special license granted by the Minister of Finance to insure
Bermuda domestic risks or risks of persons of, in or based in
Bermuda.





The Company and Flagstone will each
also need to comply with the provisions of the Companies Act regulating the
payment of dividends and making distributions from contributed surplus. Under
the Companies Act, a company may not declare or pay a dividend, or make a
distribution out of contributed surplus, if there are reasonable grounds for
believing that the company is, or would after the payment be, unable to pay its
liabilities as they become due or that the realizable value of the company’s
assets would thereby be less than the aggregate of its liabilities and its
issued share capital and share premium accounts. Issued share capital is the
aggregate par value of a company’s issued shares, and the share premium account
is the aggregate amount paid for issued shares over and above their par value.
Share premium accounts may be reduced in certain limited circumstances. The
Companies Act also regulates return of capital, reduction of capital and any
repurchase or redemption of shares by the Company. In addition, as discussed
above under “Bermuda
Insurance Regulation”,
certain provisions of the Insurance Act will limit Flagstone’s ability to pay
dividends to us.




As part of the BMA’s ongoing review of
Bermuda’s insurance supervisory framework, the BMA is introducing a new
risk-based capital model, or BSCR, as a tool to assist other insurers and the
BMA in measuring risk and determining appropriate capitalization.  It
is expected that formal legislation will become effective in 2008.  In
addition, the BMA intends to allow insurers to apply to the BMA to use their own
internal capital models if its internal capital model better reflects its risk
and capitalization profile.  We do not currently believe our capital
requirements will be impacted by the new regulations.




10
 Table of Contents




Although we are incorporated in
Bermuda, both the Company and Flagstone have been designated as non-resident for
exchange control purposes by the BMA. Both the Company and Flagstone are
required to obtain the permission of the BMA for the issue and free
transferability of all of their common shares. However, the BMA has pursuant to
its statement of June 1, 2005 given its general permission under the
Exchange Control Act 1972 (and its related regulations) for the issue and
transfer of the common shares of the Company to persons not resident in Bermuda
for exchange control purposes, subject to the condition that our common shares
shall be listed on an appointed stock exchange (as designated by the Bermuda
Minister of Finance under Section 2(9) of the Companies Act), which
includes the New York Stock Exchange. This general permission would cease to
apply if the Company’s shares were to cease to be so listed. Any person who
becomes a holder of at least 10%, 20%, 33% or 50% of the common shares of the
Company must notify the BMA in writing within 45 days of becoming such a holder
or 30 days from the date they have knowledge of having become such a holder,
whichever is later. The BMA may, by written notice, object to a person holding
10%, 20%, 33% or 50% of our common shares if it appears to the BMA that the
person is not fit and proper to be such a holder. The BMA may require the holder
to reduce their shareholding in us and may direct, among other things, that the
voting rights attaching to their common shares shall not be exercisable. A
person that does not comply with such a notice or direction from the BMA will be
guilty of an offense.





The transfer and issuance of our common
shares to any resident in Bermuda for exchange control purposes require specific
prior approval under the Exchange Control Act 1972. The BMA has granted its
consent to the issue and transfer of up to 20% of the Company’s common shares in
issue to persons resident in Bermuda for exchange control purposes, provided no
one such person owns more than 10% of the common shares, and has also given an
additional specific consent that Haverford (Bermuda) Ltd. (“Haverford”) may
hold, and our Executive Chairman, Mr. Byrne, and our Chief Executive
Officer, Mr. Brown, each may beneficially own, 10% or more of the common
shares. Because the Company and Flagstone are designated as non-resident for
Bermuda exchange control purposes, they are allowed to engage in transactions,
and to pay dividends to Bermuda non-residents who are holders of our common
shares, in currencies other than the Bermuda dollar.





In accordance with Bermuda law, share
certificates are issued only in the names of corporations, other separate legal
entities or individuals. In the case of an applicant acting in a special
capacity (for example, as an executor or trustee), certificates may, at the
request of the applicant, record the capacity in which the applicant is acting.
Notwithstanding the recording of any such special capacity, we are not bound to
investigate or incur any responsibility in respect of the proper administration
of any such estate or trust. We will take no notice of any trust applicable to
any of our common shares whether or not we have notice of such
trust.





Under Bermuda law, non-Bermudians
(other than spouses of Bermudians and holders of a permanent resident’s
certificate) may not engage in any gainful occupation in Bermuda without an
appropriate governmental work permit. Work permits may be granted or extended by
the Bermuda government upon showing that, after proper public advertisement in
most cases, no Bermudian (or spouse of a Bermudian or holder of a permanent
resident’s certificate) is available who meets the minimum standard requirements
for the advertised position. In 2001, the Bermuda government announced a policy
limiting the duration of work permits to six years, with certain exemptions for
key employees. We may not be able to use the services of one or more of our key
employees in Bermuda if we are not able to obtain work permits for them, which
could have an adverse effect on our business. In addition, exempted companies,
such as the Company and Flagstone, must comply with Bermuda resident
representation provisions under the Companies Act, which require that a minimum
number of offices must be filled by persons who are ordinarily resident in
Bermuda. We do not believe that such compliance will result in any material
expense to us.





The Bermuda government actively
encourages foreign investment in “exempted”entities like the Company
and Flagstone that are based in Bermuda, but do not operate in competition with
local businesses. As well as having no restrictions on the degree of foreign
ownership, the Company and Flagstone will not be subject to taxes computed on
profits or income or computed on any capital asset, gain or appreciation, or any
tax in the nature of estate duty or inheritance tax or to any foreign exchange
controls in Bermuda until March 28, 2016.





Other
Jurisdictions





Overview





We conduct business through our Bermuda
office, with our research and development effort and part of our catastrophe
modeling and risk analysis team in Hyderabad, India, underwriting in our
Martigny, Switzerland office, global marketing and business development in our
London, England office and back office and operational support in our Halifax,
Canada office. We do not intend to conduct any activities which may constitute
the actual transaction of the business of insurance in any jurisdiction in which
Flagstone or any other subsidiary of the Company is not licensed or otherwise
authorized to engage in such activities. However, the definition of such
activities is in some jurisdictions ambiguous and susceptible to judicial
interpretation. Accordingly, there can be no assurance that enquiries or
challenges to our insurance activities in such jurisdictions will not be raised
in the future or that our location or regulatory status, or restrictions on its
activities resulting therefrom, will not adversely affect us.





In addition to the regulatory
requirements imposed by the jurisdictions in which a reinsurer is licensed, a
reinsurer’s business operations are affected by regulatory requirements
governing “credit for
reinsurance” in other
jurisdictions in which its ceding companies are located. In general, a ceding
company which obtains reinsurance from a reinsurer that is licensed, accredited
or approved by the jurisdiction in which the ceding company files statutory
financial statements is permitted to reflect in its statutory financial
statements a credit in an aggregate amount equal to the liability for unearned
premiums and loss reserves and loss expense reserves ceded to the reinsurer.
Many jurisdictions also permit ceding companies to take credit on their
statutory financial statements for reinsurance obtained from unlicensed or
non-admitted reinsurers if certain prescribed security arrangements are made.
Because Flagstone will not be licensed, accredited or approved in any
jurisdiction except Bermuda, Flagstone expects that in certain instances its
reinsurance clients will require it to post a letter of credit or enter into
other security arrangements.








Switzerland





Our Swiss subsidiary, Flagstone Suisse,
is headquartered in Martigny, Switzerland and has a representative office in
Zurich. Flagstone Suisse is licensed by the FOPI in Switzerland to conduct
reinsurance business in accordance with the Federal Insurance Supervisory Law,
or ISL.





The conduct of reinsurance business by
a company headquartered in Switzerland requires a license granted by FOPI. In
addition, various regulatory requirements must be satisfied, as set forth
primarily by the three following sets of rules and regulations:





●
            the
      ISL;


●
            the
      Federal Insurance Supervision Ordinance;
and


●
            the
      FOPI Supervision Decree.




11
 Table of Contents




Under Swiss rules and regulations,
Swiss reinsurance companies are generally subject to the same provisions that
apply to direct insurers, and include the following obligations:


●
            sound
      corporate governance;


●
            minimum
      capital and capital resource
requirements;


●
            internal
      risk management and control
procedures;


●
            appointment
      of an independent and properly qualified actuary responsible for ensuring
      that solvency margins are calculated correctly, proper accounting
      principles are used, and adequate technical reserves are established;
      and


●
            compliance
      with the Swiss Solvency Test (“SST”)
  requirements.





The SST requires that a company have
adequate and unencumbered capital of its own at its disposal for all of its
activities (solvency margin requirements), as determined under two methods of
calculation: first, based on the volume of business (Solvency I); and
second, based on the risks to which the insurance company is exposed
(Solvency II).





Flagstone Suisse is required to comply
with each of the requirements above, as well as various reporting requirements
which include the following: Flagstone Suisse will be required to prepare an
annual report at the end of each financial year on the solvency margins
available, as well as an annual report on the calculation of target capital and
on risk bearing capital. Flagstone Suisse will also be required to prepare a
corporate report and a report on supervision. The report on supervision is to be
submitted to FOPI by June 30 of each year in electronic form together with
the annual report.




Where
You Can Find More Information





The Company’s Annual Reports on Form
10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and
amendments to those reports filed or furnished pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934, as amended, which we refer to as
the Exchange Act, are available free of charge through the investor information
pages of its website, located at www.flagstonere.bm.
Alternatively, the public may read or copy the Company’s filings with the
Securities and Exchange Commission (the “SEC”) at the SEC’s
Public Reference Room at 100 F Street, N.E., Room 1580, Washington, DC
20549.  The public may obtain information on the operation of the
Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also
maintains an internet site that contains reports, proxy and information
statements, and other information regarding issuers that file electronically
with the SEC (http://www.sec.gov).





ITEM
      1A.
            RISK
      FACTORS





Factors that could cause our actual
results to differ materially from those in the forward-looking statements
contained in this Form 10-K and other documents we file with the SEC
include the following:





Risks
Related to the Reinsurance
Business





The reinsurance business is
historically cyclical, and we expect to experience periods with excess
underwriting capacity which may result in fewer contracts written, lower premium
rates, increased expenses for customer acquisition and retention, and less
favorable policy terms and conditions.





The reinsurance industry has
historically been a cyclical business. Reinsurers have experienced significant
fluctuations in operating results due to competition, frequency of occurrence or
severity of catastrophic events, levels of underwriting capacity, general
economic conditions and other factors. The supply of reinsurance is related to
prevailing prices, the level of insured losses and the level of industry surplus
which, in turn, may fluctuate in response to changes in rates of return on
investments being earned in the reinsurance industry.





As a result, the reinsurance business
historically has been characterized by periods of intense competition on price
and policy terms due to excessive underwriting capacity as well as periods when
shortages of capacity permit favorable premium rates and policy terms and
conditions. These cycles have varied by line of business as the level of supply
and demand for any particular class of reinsurance risk does not always coincide
with that for other classes of risk.





Risks
Related to the Company





Claims arising from unpredictable and
severe catastrophic events could reduce our earnings and shareholders’ equity
and limit our ability to write new insurance policies.





Our reinsurance operations expose us to
claims arising out of unpredictable natural and other catastrophic events, such
as hurricanes, windstorms, tsunamis, severe winter weather, earthquakes, floods,
fires and explosions. In recent years, the frequency of major weather-related
catastrophes has increased.





The extent of losses from catastrophes
is a function of both the number and severity of the insured events and the
total amount of insured exposure in the areas affected. Increases in the value
and concentrations of insured property, the effects of inflation and changes in
cyclical weather patterns may increase the severity of claims from catastrophic
events in the future. Claims from catastrophic events could reduce our earnings
and cause substantial volatility in our results of operations for any fiscal
quarter or year, which could adversely affect our financial condition, possibly
to the extent of eliminating our shareholders’ equity. Our ability to write new
reinsurance policies could also be impacted as a result of corresponding
reductions in our capital.





Underwriting is inherently a matter of
judgment, involving important assumptions about matters that are unpredictable
and beyond our control, and for which historical experience and probability
analysis may not provide sufficient guidance. One or more catastrophic or other
events could result in claims that substantially exceed our
expectations.





We may experience significant losses on
short notice, which may require us to liquidate our investments rapidly and may
limit our ability to write new insurance policies.





Catastrophes such as hurricanes,
windstorms, tsunamis, severe winter weather, earthquakes, floods, fires and
explosions are difficult to predict. By reinsuring the damages resulting from
these catastrophes, we subject ourselves to large potential claims that may
arise on short notice. To meet our obligations with respect to those claims, we
may be forced to liquidate some of our investments rapidly, which may involve
selling a portion of our investments into a depressed market. Those sales would
decrease our liquidity, our returns from our investments, and our underwriting
capacity.




12
 Table of Contents




If our risk management and loss
limitation methods fail to adequately manage our exposure to losses from
catastrophic events, the losses we incur from a catastrophic event could be
materially higher than our expectations and our financial condition and results
of operations could be adversely affected.





We manage our exposure to catastrophic
losses by analyzing the probability and severity of the occurrence of
catastrophic events and the impact of such events on our overall reinsurance and
investment portfolio. We use various tools to analyze and manage the reinsurance
exposures we assume from ceding companies and risks from a catastrophic event
that could impact on our investment portfolio. Among the most important of these
is proprietary risk modeling software which we have developed and currently
utilize, and on which we expect to rely on to an increasing extent over
time. Our proprietary risk modeling software enables us to assess the adequacy
of risk pricing and to monitor our overall exposure to risk in correlated
geographic zones. We cannot assure you that the models and assumptions used by
the software will accurately predict losses in all situations. Further, we
cannot assure you that it is free of defects in the modeling logic or in the
software code.





In addition, much of the information
that we enter into our risk modeling software is based on third-party data that
we believe but cannot assure to be reliable, and estimates and assumptions that
are dependent on many variables, such as assumptions about loss adjustment
expenses, insurance-to-value, storm intensity in the aftermath of
weather-related catastrophes and demand surge, which is the temporary inflation
of costs for building materials and labor resulting from increased demand for
rebuilding services in the aftermath of a catastrophe. Accordingly, if the
estimates and assumptions that we enter into our proprietary risk model are
incorrect, or if our proprietary risk model proves to be an inaccurate
forecasting tool, the losses we might incur from an actual catastrophe could be
materially higher than our expectation of losses generated from modeled
catastrophe scenarios, and our financial condition and results of operations
could be adversely affected.





We also seek to limit our loss exposure
through loss limitation provisions in our policies, such as limitations on the
amount of losses that can be claimed under a policy, limitations or exclusions
from coverage and provisions relating to choice of forum, which are intended to
assure that our policies are legally interpreted as we intend. We cannot assure
you that these contractual provisions will be enforceable in the manner we
expect or that disputes relating to coverage will be resolved in our favor. If
the loss limitation provisions in our policies are not enforceable or disputes
arise concerning the application of such provisions, the losses we might incur
from a catastrophic event could be materially higher than our expectations, and
our financial condition and results of operations could be adversely
affected.





If we underestimate our loss reserves,
so that they are inadequate to cover our ultimate liability for losses, the
underestimation could materially adversely affect our financial condition and
results of operations.





We are required to maintain adequate
reserves to cover our estimated ultimate liabilities for loss and loss
adjustment expenses. These reserves are estimates based on actuarial and
statistical projections of what we believe the settlement and administration of
claims will cost based on facts and circumstances then known to us. Our success
depends on our ability to accurately assess the risks associated with the
businesses and properties that we reinsure. If unpredictable catastrophic events
occur, or if we fail to adequately manage our exposure to losses or fail to
adequately estimate our future reserve requirements, our actual loss and loss
adjustment expenses may deviate, perhaps substantially, from our future reserve
estimates.





Loss and loss adjustment expense
reserves (or loss reserves) are typically comprised of  case reserves
and IBNR reserves. Our IBNR reserves include a provision for unknown future
development on loss and loss adjustment expenses which are known to us. However,
under U.S. GAAP, we are not permitted to establish loss reserves with respect to
our property catastrophe reinsurance until an event which gives rise to a claim
occurs. As a result, only loss reserves applicable to losses incurred up to the
reporting date may be set aside on our financial statements, with no allowance
for the provision of loss reserves to account for possible other future losses
with respect to our property catastrophe reinsurance. Our loss reserve estimates
do not represent an exact calculation of liability. Rather, they are estimates
of what we expect the ultimate settlement and administration of claims will
cost. These estimates are based upon actuarial and statistical projections and
on our assessment of currently available data, predictions of future
developments and estimates of future trends and other variable factors such as
inflation. Establishing an appropriate level of our loss reserve estimates is an
inherently uncertain process. It is likely that the ultimate liability will be
greater or less than these estimates and that, at times, this variance will be
material. Our future reserve estimates are refined continually as experience
develops and claims are reported and settled. In addition, as a broker market
reinsurer, reserving for our business can involve added uncertainty. Because we
depend on information from ceding companies, there is a time lag inherent in
reporting information from the primary insurer to us, and ceding companies have
differing reserving practices. Moreover, these uncertainties are greater for
reinsurers like us than for reinsurers with a longer operating history because
we do not yet have an established loss history. Because of this uncertainty, it
is possible that our estimates for reserves at any given time could prove
inadequate.





To the extent we determine that actual
losses and loss adjustment expenses from events which have occurred exceed our
expectations and loss reserves reflected in our financial statements, we will be
required to immediately reflect these changes. This could cause a sudden and
material increase in our liabilities and a reduction in our profitability,
including operating losses and reduction of capital, which could materially
restrict our ability to write new business and adversely affect our financial
condition and results of operations.





Our historical financial results may
not accurately indicate our future performance due to our limited operating
history and the low number of catastrophic storms experienced globally in 2006
and 2007.





We were formed in October 2005 and
commenced operations in December 2005, and thus we have a limited operating
and financial history. As a result, there is limited historical financial and
operating information available to help you evaluate our past performance. We
are a developing company and face substantial business and financial risks and
may suffer significant losses. We must successfully establish operating
procedures, hire staff, install information management and other systems,
establish facilities and obtain licenses, as well as take other steps necessary
to conduct our intended business activities. As a result of these risks, it is
possible that we may not be successful in implementing our business strategy or
completing the development of the infrastructure necessary to run our
business.





While neither 2007 nor 2006 was
characterized by North American landfalling windstorm events resulting in
material industry losses, we believe, and recent scientific studies have
indicated, that the frequency of hurricanes has increased and may further
increase in the future relative to the historical experience over the past 100
years. We continuously monitor and adjust, as we believe appropriate, our risk
management models to reflect our judgment of how to interpret current
developments and information, such as these studies. However, it is possible
that, even after these adjustments, we have underestimated the frequency or
severity of hurricanes or other catastrophes.  Accordingly, we believe
that our financial results for the year ended December 31, 2007 may not be
indicative of our financial results for future periods when we expect major
storm occurrences will be more frequent than those experienced in 2006 and
2007.  As of December 31, 2007, we have not experienced any major
catastrophe events such as those experienced by the industry in 2005 (Hurricanes
Katrina, Rita and Wilma) and the events of September 11, 2001, and therefore, it
is uncertain how our business model or risk controls would respond to these
catastrophes.  For North America, the largest catastrophic event we
experienced was the California Wildfires occurring in early December 2007.
 Losses from other major landfalling hurricanes did not materialize despite
the potential of several major hurricanes passing through the Gulf of
Mexico.  Further, we believe that the lower hurricane activity in 2006
and 2007 will increase the available capacity of many reinsurers and thereby
increase competition for new business, which could result in lower premium
rates, increased customer acquisition expenses, and less favorable policy terms
and conditions.




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A failure to attract and retain key
personnel could impede the implementation of our business strategy, reduce our
revenues and decrease our operational effectiveness.





Our success substantially depends upon
our ability to attract and retain qualified employees and upon the ability of
our senior management and other key employees to implement our business
strategy. We believe there are only a limited number of available qualified
executives in the business lines in which we compete. We rely substantially upon
the services of David Brown, our Chief Executive Officer; Mark Byrne, the
Executive Chairman of our Board of Directors; James O’Shaughnessy, our Chief
Financial Officer; Gary Prestia, our Chief Underwriting Officer—North America;
Guy Swayne, the Chief Executive Officer of Flagstone Suisse; and David Flitman,
our Chief Actuary, among other key employees. Although we are not aware of any
planned departures, the loss of any of their services or the services of other
members of our management team or difficulty in attracting and retaining other
talented personnel could impede the further implementation of our business
strategy, reduce our revenues and decrease our operational effectiveness.
Although we have an employment agreement with each of the above named
executives, there is a possibility that these employment agreements may not be
enforceable in the event any of these employees leave. The employment agreements
for Messrs. Byrne and Brown provide that either party may terminate their
agreement upon 365 days’ advance written notice, the employment agreements
with Messrs. O’Shaughnessy, Prestia and Swayne provide that either party may
terminate the agreement upon 180 days’ advance written notice, and the
employment agreement with Mr. Flitman provides that either party may
terminate the agreement upon 90 days’ advance written notice. We do not
currently maintain key man life insurance policies with respect to them or any
of our other employees.





We are dependent on the policies,
procedures and expertise of ceding companies; these companies may fail to
accurately assess the risks they underwrite, which may lead us to inaccurately
assess the risks we assume. As a result, we could face significant underwriting
losses on these contracts.





Because we participate in reinsurance
markets, the success of our underwriting efforts depends, in part, upon the
policies, procedures and expertise of the ceding companies making the original
underwriting decisions. We face the risk that these ceding companies may fail to
accurately assess the risks that they underwrite initially, which, in turn, may
lead us to inaccurately assess the risks we assume. If we fail to establish and
receive appropriate premium rates, we could face significant underwriting losses
on these contracts.





We depend on a small number of
reinsurance brokers for a large portion of our revenues, and the loss of
business from one of these reinsurance brokers could limit our ability to write
new reinsurance policies and reduce our revenues.





We market our reinsurance on a
worldwide basis primarily through reinsurance brokers, and we depend on a small
number of reinsurance brokers for a large portion of our revenues. Since we
commenced operations in December 2005, substantially all  of our
gross premiums written were sourced through brokers. The following brokers,
Benfield Group Limited (25.9%), Willis Group
Holdings Ltd. (13.3%), Aon Re Worldwide
(16.6%) and Guy
Carpenter & Company, Inc. (26.6%),provided a
total of 82.4% of our gross premiums written for the year ended
December 31, 2007. Affiliates of these and other brokers have historically
co-sponsored the formation of Bermuda reinsurance companies that may compete
with us, and these brokers may favor their own reinsurers over other companies.
Loss of all or a substantial portion of the business provided by one or more of
these brokers could limit our ability to write new reinsurance policies and
reduce our revenues.





Because payments are frequently made
and received through reinsurance brokers, we could incur liabilities to ceding
insurers regardless of fault and lose our recourse to collect payments from
ceding insurers.





In accordance with industry practice,
we frequently pay amounts owed on claims under our policies to reinsurance
brokers, and these brokers, in turn, pay these amounts to the ceding insurers
that have reinsured a portion of their liabilities with us. In some
jurisdictions, if a broker fails to make such a payment, we may remain liable to
the ceding insurer for the deficiency. Conversely, in certain jurisdictions,
when the ceding insurer pays premiums to reinsurance brokers for payment to us,
these premiums are considered to have been paid and the ceding insurer will no
longer be liable to us for those amounts, regardless of whether we have received
the premiums. Consequently, consistent with industry practice, we assume a
degree of credit risk associated with reinsurance brokers.





The financial strength rating of
Flagstone may be revised downward which could affect our standing among brokers
and customers, result in a substantial loss of business and impede our ability
to conduct business.





Ratings have become an increasingly
important factor in establishing the competitive position of insurance and
reinsurance companies.  Flagstone and Flagstone Suisse have received
“A-”
financial strength ratings from both A.M. Best and Fitch Ratings, and “A3”
ratings from Moody’s Investor Services.  These ratings are financial
strength ratings and are designed to reflect our ability to meet our financial
obligations under our policies. These ratings do not refer to our ability to
meet non-reinsurance obligations and are not a recommendation to purchase any
policy or contract issued by us or to buy, hold or sell our
securities.





Flagstone’s and Flagstone Suisse’s
financial strength rating is subject to periodic review by, and may be revised
downward or revoked at the sole discretion of the rating agencies in
response to a variety of factors, including the risk factors described in this
section.





If Flagstone’s or Flagstone Suisse’s
financial strength ratings are reduced from their current levels, our
competitive position in the reinsurance industry would suffer, and it would be
more difficult for us to market our products. A downgrade could result in a
significant reduction in the number of reinsurance contracts we write and in a
substantial loss of business as our customers, and brokers that place such
business, move to other competitors with higher financial strength
ratings.





It is common for our reinsurance
contracts to contain terms that would allow the ceding companies to cancel the
contract for the remaining portion of our period of obligation if the financial
strength ratings of our insurance subsidiaries are downgraded below A-
by A.M. Best. Currently, virtually all of our contracts permit cancellation
if Flagstone’s or Flagstone Suisse’s financial strength rating is
downgraded.Whether
a ceding company would exercise this cancellation right would depend, among
other factors, on the reason for such downgrade, the extent of the downgrade,
the prevailing market conditions and the pricing and availability of replacement
reinsurance coverage. Therefore, we cannot predict in advance the extent to
which this cancellation right would be exercised, if at all, or what effect any
such cancellations would have on our financial condition or future operations,
but such effect could be material.





The indentures governing our Deferrable
Interest Debentures would restrict us from declaring or paying dividends on our
common shares if Flagstone or Flagstone Suisse (1) is downgraded
by A.M. Best to a financial strength rating below A- and fails to renew
more than 51% of its net premiums written during any twelve-month period;
(2) is downgraded to a financial strength rating below A- and sells more
than 51% of its rights to renew net premiums written over the course of a
twelve-month period; (3) is downgraded to a financial strength rating below
B++; or (4) withdraws its financial strength rating by A.M.
Best.





We may encounter difficulties
maintaining the information technology systems necessary to run our business
which could result in a loss or delay of revenues, higher than expected loss
levels, diversion of management resources, harm to our reputation or an increase
in costs.





The performance of our information
technology systems is critical to our business and reputation and our ability to
process transactions and provide high quality customer service. Such systems are
and will continue to be a very important part of our underwriting process. We
license the catastrophe modeling software of AIR Worldwide, Eqecat and Risk
Management Solutions Inc., which are the three major vendors of
industry-standard catastrophe modeling software, and we enhance the output from
these models with our proprietary software.   We cannot be certain
that we will be able to replace these service providers or consultants, if
necessary, without slowing our underwriting response time, or that our
proprietary technology will operate as intended. Any defect or error in our
information technology systems could result in a loss or delay of revenues,
higher than expected loss levels, diversion of management resources, harm to our
reputation or an increase in costs.




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We may be unable to purchase
reinsurance for our own account on commercially acceptable terms or to collect
under any reinsurance we have purchased.





We may acquire reinsurance purchased
for our own account to mitigate the effects of large or multiple losses on our
financial condition. From time to time, market conditions have limited, and in
some cases prevented, insurers and reinsurers from obtaining the types and
amounts of reinsurance they consider adequate for their business needs. For
example, following the September 11, 2001 terrorist attacks, terms and
conditions in the reinsurance markets generally became less attractive to buyers
of such coverage. Similar conditions occurred as a result of Hurricanes Katrina,
Rita and Wilma in 2005, and may occur in the future, and we may not be able to
purchase reinsurance in the areas and for the amounts required or desired. Even
if reinsurance is generally available, we may not be able to negotiate terms
that we deem appropriate or acceptable or to obtain coverage from entities with
satisfactory financial resources.





In addition, a reinsurer’s insolvency,
or inability or refusal to make payments under a reinsurance or retrocessional
reinsurance agreement with us, could have a material adverse effect on our
financial condition and results of operations because we remain liable to the
insured under the corresponding coverages written by us.





Our investment portfolio may suffer
reduced returns or losses which could adversely affect our results of operations
and financial condition. Any increase in interest rates, abrupt changes in
credit markets or volatility in the equity and debt markets could result in
significant losses in the fair value of our investment portfolio.





Our strategy is to derive a significant
portion of our income from our invested assets. As a result, our operating
results depend in part on the performance of our investment portfolio, as well
as the ability of our investment managers to effectively implement our
investment strategy.





The investment income derived from our
invested assets was $73.8 million, or 44.0% of our net income, for the year
ended December 31, 2007. Our investment policies seek capital appreciation
and thus will be subject to market-wide risks and fluctuations, as well as to
risks inherent in particular securities.  In particular, the
volatility of our claims may force us to liquidate securities, which may cause
us to incur capital losses.





Our investment performance may vary
substantially over time, and we cannot assure you that we will achieve our
investment objectives. Unlike more established reinsurance companies with longer
operating histories, the Company has a limited performance record to which
investors can refer. See Item
1, “Business—Investments.”





Investment returns are an important
part of our growth in diluted book value, and fluctuations in the fixed income
or equity markets could impair our financial condition and results of
operations. A significant period of time normally elapses between the receipt of
insurance premiums and the disbursement of insurance claims. We cannot assure
you that we will successfully match the structure of our investments with
Flagstone’s and Flagstone Suisse’s liabilities under its reinsurance contracts.
If our calculations with respect to these reinsurance liabilities are incorrect,
or if we improperly structure our investments to match such liabilities, we
could be forced to liquidate investments before maturity, potentially at a
significant loss.





Investment results will also be
affected by general economic conditions, market volatility, interest rate
fluctuations, liquidity and credit risks beyond our control. In addition, the
need for liquidity may result in investment returns below our expectations.
Also, with respect to certain of our investments, we are subject to pre-payment
or reinvestment risk. In particular, our fixed maturity portfolio is subject to
reinvestment risk and as at December 31, 2007, 23.6% of our total
investments is comprised of mortgage backed and asset backed securities which
are subject to prepayment risk. A significant increase
in interest rates could result in significant losses, realized or unrealized, in
the fair value of our investment portfolio and, consequently, could have an
adverse affect on our results of operations. In addition, we are exposed to
changes in the level or volatility of equity prices that affect the value of
securities or instruments that derive their value from a particular equity
security, a basket of equity securities or a stock index. These conditions are
outside of our control and could adversely affect the value of our investments
and our financial condition and results of operations.




The
movement in foreign currency exchange rates could adversely affect our operating
results because we enter into reinsurance contracts where the premiums
receivable and losses payable are denominated in currencies other than the U.S.
dollar and we maintain a portion of our investments and liabilities in
currencies other than the U.S. dollar.





Through our global reinsurance
operations, we conduct business in a variety of foreign (non-U.S.) currencies,
the principal exposures being the Euro, the British pound, the Swiss franc, the
Canadian dollar and the Japanese yen.  Assets and liabilities
denominated in foreign currencies are exposed to changes in currency exchange
rates.  Our reporting currency is the U.S. dollar, and exchange rate
fluctuations relative to the U.S. dollar may materially impact our results and
financial position.  We employ various strategies (including hedging)
to manage our exposure to foreign currency exchange risk.  To the
extent that these exposures are not fully hedged or the hedges are ineffective,
our results and level of capital may be reduced by fluctuations in foreign
currency exchange rates.





We may need additional capital in the
future, which may not be available to us or may not be available on favorable
terms, may have rights, preferences and privileges superior to those of our
common shares, could dilute your ownership in the Company, and may cause the
market price of our common shares to fall.




We may need to raise additional capital
in the future, through public or private debt or equity financings, to repay our
long term debt, comply with the terms of our letter of credit facility, write
new business successfully, cover loss and loss adjustment expense reserves
following losses, respond to any changes in the capital requirements that rating
agencies use to evaluate us, to acquire new businesses or invest in existing
businesses, or otherwise respond to competitive pressures in our industry. Due
to the uncertainty relating to some of these items, we are not able to quantify
our total future capital requirements. Any additional financing we may seek may
not be available on terms favorable to us, or at all. Furthermore, the
securities may have rights, preferences and privileges that are senior or
otherwise superior to those of our common shares. Any additional capital raised
through the sale of equity will dilute your ownership percentage in our company
and may decrease the market price of our common shares.




Our complex global operating platform
increases our exposure to systems or human failures, which may limit our
revenues, increase our costs and decrease our net income from
operations.





We are subject to operational risks
including fraud, employee errors, failure to document transactions properly or
to obtain proper internal authorization, failure to comply with regulatory
requirements, information technology failures, or external events. Our reliance
in large part on the integration of our operations in Bermuda, the United
Kingdom, Switzerland, India, Canada, Puerto Rico and Dubai increases the
likelihood that losses from these risks, which may occur from time to time,
could be significant. As our business and operations grow more complex we are
exposed to a broader scope of risk in these areas. The occurrence of these types
of events may limit our revenues, increase our costs and decrease our net income
from operations.




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We may fail at acquiring and
integrating other reinsurance and insurance businesses in the future, and we may
need to incur indebtedness or issue additional equity due to these future
acquisition opportunities.





Part of our business strategy may
involve growing the Company in the future by acquiring other reinsurance and
insurance companies or parts or all of their businesses. Our ability to make
these acquisitions will depend upon many factors, including the availability of
suitable financing and the ability to identify and acquire businesses on a
cost-effective basis. Our ability to effectively integrate acquired personnel,
operations, products and technologies, to retain and motivate key personnel, and
to retain the goodwill and customers of acquired companies or businesses will
also be important. There can be no assurance that we can or will successfully
acquire and integrate such operations in the future. Furthermore, in connection
with future acquisition opportunities, we may need to incur indebtedness or
issue additional equity. If and when achieved, new acquisitions may adversely
affect our near-term operating results due to increased capital requirements,
transitional management and operating adjustments, interest costs associated
with acquisition debt, and other factors.





Some of our related parties have
continuing agreements and business relationships with us and these persons could
pursue business interests or exercise their voting power as shareholders in ways
that are detrimental to us.





Some of our executive officers,
directors, underwriters and affiliates of our principal shareholders engage in
transactions with our Company.





These persons could pursue business
interests or exercise their voting power as shareholders in ways that are
detrimental to us, but beneficial to themselves or their affiliates or to other
companies in which they invest or with whom they have a material
relationship.





Furthermore, affiliates of the
underwriters in the Company’s initial public offering may from time to time
compete with us, including by assisting, investing in the formation of, or
maintaining business relationships with other entities engaged in the insurance
and reinsurance business. In general, these affiliates could pursue business
interests in ways that are detrimental to us.





Unexpected industry practices and
conditions could extend coverage beyond our underwriting intent or increase the
number or size of claims, causing us to incur significant losses.





As industry practices and legal,
judicial, social and other environmental conditions change, unexpected and
unintended issues related to claims and coverage may emerge. These issues may
adversely affect our business by either extending coverage beyond our
underwriting intent or by increasing the number or size of claims. In some
instances, these changes may not become apparent until some time after we have
issued reinsurance contracts that are affected by the changes. As a result, the
full extent of liability under our reinsurance contracts may not be known for
many years after a contract is issued.





One example involves coverage for
losses arising from terrorist acts. Substantially all of the reinsurance
contracts that we have written exclude coverage for losses arising from the
peril of terrorism caused by nuclear, biological, chemical or radiological
attack. We are unable to predict the extent to which our future insurance
contracts will cover terrorist acts. We also are unsure how terrorist acts will
be defined in our current and future contracts and cannot assure you that losses
resulting from future terrorist attacks will not be incidentally or
inadvertently covered. If there is a future terrorist attack, the possibility
remains that losses resulting from such event could prove to be material to our
financial condition and results of operations. Terrorist acts may also cause
multiple claims, and there is no assurance that our policy limits will be
effective.




Although the Terrorism Risk Insurance
Act, or TRIA, was scheduled to expire at the end of 2007, the Terrorism Risk
Insurance Program Reauthorization Act of 2007 was signed into law by the U.S.
President on December 26, 2007. This law renews the existing terrorism risk
insurance program for seven years, through December 31, 2014. Certain
provisions of TRIA were modified by the 2007 reauthorization. The program was
expanded to include domestic terrorism by eliminating from the definition of a
certified act of terrorism the requirement that such an act be perpetrated “on
behalf of any foreign person or foreign interest.” The insurer deductible is now
fixed at 20% of an insurer’s direct earned premium, and the federal share of
compensation is fixed at 85% of insured losses that exceed insurer deductibles.
The U.S. Treasury Department is required to promulgate regulations to determine
the pro-rata share of insured losses if they exceed the $100 billion cap. In
addition, clear and conspicuous notice to policyholders of the $100 billion cap
is required. Under the program reauthorization, the trigger at which federal
compensation becomes available remains fixed at $100 million per year through
2014.





The effects of these and other
unforeseen emerging claim and coverage issues are extremely difficult to
predict. If we are required to cover losses that we did not anticipate having to
cover under the terms of our reinsurance contracts, we could face significant
losses and as a result, our financial condition and results of operation could
be adversely affected.





The reinsurance industry is highly
competitive. Competitive pressures may result in fewer contracts written, lower
premium rates, increased expense for customer acquisition and retention, and
less favorable policy terms and conditions.





The reinsurance industry is highly
competitive. We compete with major global insurance and reinsurance companies
and underwriting syndicates, many of which have extensive experience in
reinsurance and may have greater financial resources available to them than us.
Other financial institutions, such as banks and hedge funds, now offer products
and services similar to our products and services. Alternative products, such as
catastrophe bonds, compete with our products. In the future, underwriting
capacity will continue to enter the market from these identified competitors and
perhaps other sources. After the September 11, 2001, terrorist attacks in
the United States, and then again following the three major hurricanes of 2005
(Katrina, Rita and Wilma), new capital flowed into Bermuda, and much of these
new proceeds went to a variety of Bermuda-based start-up companies. The full
extent and effect of this additional capital on the reinsurance market will not
be known for some time and current market conditions could reverse. These
continued increases in the supply of reinsurance may have negative consequences
for us, including fewer contracts written, lower premium rates, increased
expenses for customer acquisition and retention, and less favorable policy terms
and conditions. Insurance company customers of reinsurers may choose to retain
larger shares of risk, thereby reducing overall demand for
reinsurance.





In addition, while we believe our
global operating platform currently differentiates us among Bermuda-based
reinsurance companies of comparable capital size and provides significant
efficiencies in our operations, it is possible that our competitors will aim to
employ a similar platform in the future, or implement their own platforms with
equivalent or superior operational and cost structures to ours.





The availability and cost of security
arrangements for reinsurance transactions may impact our ability to provide
reinsurance to ceding insurers.





Flagstone is required to post
collateral security with respect to reinsurance liabilities it assumes from many
ceding insurers, especially those in many U.S. jurisdictions. The posting of
collateral security is generally required in order for these ceding companies to
obtain credit on their statutory financial statements with respect to
reinsurance liabilities ceded to reinsurers who are not licensed or accredited
in these jurisdictions. Under applicable statutory provisions, the security
arrangements may be in the form of letters of credit, reinsurance trusts
maintained by third-party trustees or “funds withheld”arrangements whereby the
assets are held in trust by the ceding company.




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Flagstone currently has the ability to
issue up to $600 million in letters of credit under the Company’s letter of
credit facilities, the renewal of which is reviewed annually. As at December 31,
2007, $73.8 million has been drawn under these facilities. If these facilities
are not sufficient or if the Company is unable to renew them or is unable to
arrange for other types of security on commercially acceptable terms, the
ability of Flagstone to provide reinsurance to some U.S.-based and international
clients may be severely limited.





In addition, the security arrangements
may subject our assets to security interests or require that a portion of our
assets be pledged to, or otherwise held by, third parties. Although the
investment income derived from our assets while held in trust typically accrues
to our benefit, the investment of these assets is governed by the investment
regulations of the jurisdiction of domicile of the ceding insurer, which may be
more restrictive than the investment regulations applicable to us under Bermuda
law. These restrictions may result in lower investment yields on these assets,
which could adversely affect our profitability.





We are a holding company and we and our
subsidiaries are subject to restrictions on paying dividends, repurchasing
common shares or otherwise returning capital to shareholders.





The Company is a holding company with
no significant operations or assets other than its ownership of its
subsidiaries, the most important of which is Flagstone. Dividends, distributions
and other permitted payments from Flagstone, which are limited under Bermuda law
and regulations, are expected to be the Company’s primary source of funds to pay
expenses and fund dividends, if any, or share repurchases.





Under the Bermuda Insurance Act 1978 of
Bermuda, as amended, and related regulations, which we refer to as the Insurance
Act, Flagstone will be required to maintain certain minimum solvency and paid-up
share capital levels and will be prohibited from declaring or paying dividends
that would result in noncompliance with such requirement. As a Bermuda
Class 4 reinsurer, Flagstone may not pay dividends in any financial year
which would exceed 25% of its total statutory capital and surplus as set out in
its previous year's statements, unless at least seven days before payment of
those dividends it files an affidavit with the BMA signed by at least two
directors and Flagstone’s principal representative, which states that in their
opinion, declaration of those dividends will not cause Flagstone to fail to meet
its prescribed solvency margin and liquidity ratio. Further, Flagstone may not
reduce by 15% or more its total statutory capital as set out in its previous
year’s statements without the prior approval of the BMA. This may limit the
amount of funds available for distribution to the Company, restricting the
Company’s ability to pay dividends, make distributions and repurchase any of its
common shares.





In addition, under the Bermuda
Companies Act 1981, as amended, and related regulations, which we refer to as
the Companies Act, the Company and Flagstone may only declare or pay a dividend
or make a distribution if, among other matters, there are reasonable grounds for
believing that each is, and will after the payment be, able to pay their
respective liabilities as they become due and that the realizable value of their
assets will not thereby be less than the sum of their liabilities and their
issued share capital and share premium accounts. In connection with any share
repurchase, as stipulated by the Companies Act, the Company may not repurchase
any of its common shares if the repurchase would reduce its minimum share
capital below the minimum share capital specified in the Company’s memorandum of
association or, if the Company is, or, as a result of such repurchase would be,
rendered insolvent.





Swiss law permits dividends to be
declared only after profits have been allocated to the reserves required by law
and to any reserves required by the articles of incorporation. The articles of
incorporation of Flagstone Suisse do not require any specific reserves.
Therefore, Flagstone Suisse must allocate any profits first to the reserve
required by Swiss law generally, and may pay as dividends only the balance of
the profits remaining after that allocation. In the case of Flagstone Suisse,
Swiss law requires that 5% of the company’s profits be allocated to a “general reserve” until the reserve reaches
20% of its paid-in share capital.





In addition, a Swiss reinsurance
company may pay a dividend only if, after payment of the dividend, it will
continue to comply with regulatory requirements regarding minimum capital,
special reserves and solvency margin requirements.





Risks
Related to Laws and Regulations Applicable to Us





Insurance statutes and regulations in
various jurisdictions could restrict our ability to operate.





The insurance laws of each state in the
United States and many non-U.S. jurisdictions regulate the sale of insurance
within that jurisdiction by alien insurers, such as Flagstone, which are not
authorized or admitted to do business in that jurisdiction. The laws and
regulations applicable to direct insurers could indirectly affect us, such as
collateral requirements in various U.S. states to enable such insurers to
receive credit for reinsurance ceded to us.  We expect that for so
long as Flagstone follows its operating guidelines, it will conduct its
activities in compliance with applicable insurance statutes and regulations.
However, insurance regulators in the United States or other jurisdictions who
review the activities of Flagstone may successfully take the position that
Flagstone is subject to the jurisdiction’s licensing requirements.





A number of new, proposed or potential
legislative developments could further increase competition in our industry.
These developments include programs in which state-sponsored entities provide
property insurance or reinsurance in catastrophe-prone areas. These legislative
developments could eliminate or reduce opportunities for us and other reinsurers
to write those coverages, and increase competition with our competitors for
contracts not covered by such state-sponsored programs. New competition from
these developments could result in fewer contracts written, lower premium rates,
increased expenses for customer acquisition and retention and less favorable
policy terms and conditions.





The insurance and reinsurance
regulatory framework of Bermuda recently has become subject to increased
scrutiny in many jurisdictions, including the United States. In the past, there
have been Congressional and other initiatives in the United States regarding
increased supervision and regulation of the insurance industry, including
proposals to supervise and regulate offshore reinsurers. Government regulators
are generally concerned with the protection of policyholders rather than other
constituencies, such as shareholders. Moreover, our exposure to potential
regulatory initiatives could be heightened by the fact that our principal
operating companies are domiciled in, and operate exclusively from, Bermuda.
Bermuda is a small jurisdiction and may be disadvantaged when participating in
global or cross border regulatory matters as compared with larger jurisdictions
such as the U.S. or the leading European Union countries. This disadvantage
could be amplified by the fact that Bermuda, which is currently an overseas
territory of the United Kingdom, may consider changes to its relationship with
the United Kingdom in the future, including potentially seeking independence. We
are not able to predict the future impact on Flagstone’s operations of changes
in the laws and regulations to which we, or companies acquired by us, are or may
become subject.





Our Indian subsidiary, West End Capital
Management BPO Services (India) Private Limited, (“West End (India)”), has been
duly incorporated under the Companies Act, 1956 in India and has specified as
its main object the provision of business process outsourcing services, which
permits it to provide us with back office information technology support
services. West End (India) is not considered to be engaged in the insurance or
reinsurance business and is not registered with India’s Insurance
Development & Regulatory Authority. In the future, however, it is
possible that regulators in India will take the position that West End (India)
is subject to the India’s Insurance Development & Regulatory Authority
or other insurance/reinsurance regulatory restrictions in India.




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We could lose the services of one or
more of our key employees if we are unable to obtain or renew work permits
required by Bermuda employment restrictions.





We may need to hire additional
employees to work in Bermuda. Under Bermuda law, non-Bermudians (other than
spouses of Bermudians and permanent resident permit holders) may not engage in
any gainful occupation in Bermuda without an appropriate governmental work
permit. Work permits may be granted or extended by the Bermuda government upon
showing that, after proper public advertisement in most cases, no Bermudian (or
spouse of a Bermudian) who meets the minimum standard requirements for the
advertised position is available. Bermuda government policy limits the duration
of work permits to six years, with certain exemptions for key employees. All of
our  Bermuda-based professional employees who require work permits,
including Mr. Byrne, our Executive Chairman; Mr. Prestia, our Chief
Underwriting Officer—North America; and Mr. Flitman, our Chief Actuary,
have been granted permits by the Bermuda government. The terms of these permits
range from three to five years depending on the individual.





It is possible that we could lose the
services of one or more of our key employees if we are unable to obtain or renew
their work permits, which could have an adverse effect on our
business.





It may be difficult to enforce a
judgment or effect service of process under Bermuda law on the Company,
Flagstone or related persons.





The Company and Flagstone are Bermuda
exempted companies limited by shares, and it may be difficult to enforce
judgments against them or their directors and executive officers.





We are incorporated pursuant to the
laws of Bermuda and our business is based in Bermuda. In addition, several of
our directors and most of our officers reside outside the United States, and all
or a substantial portion of our assets and the assets of such persons are
located in jurisdictions outside the United States. As such, it may be difficult
or impossible to effect service of process within the United States upon us or
those persons or to recover against us or them on judgments of U.S. courts,
including judgments predicated upon civil liability provisions of the U.S.
federal securities laws. Further, no claim may be brought in Bermuda against us
or our directors and officers in the first instance for violation of U.S.
federal securities laws because these laws have no extraterritorial jurisdiction
under Bermuda law and do not have force of law in Bermuda. A Bermuda court may,
however, impose civil liability, including the possibility of monetary damages,
on us or our directors and officers if the facts alleged in a complaint
constitute or give rise to a cause of action under Bermuda law.





We have been advised by
Attride-Stirling & Woloniecki, our special Bermuda counsel, that there
is doubt as to whether the courts of Bermuda would enforce judgments of U.S.
courts obtained in actions against us or our directors and officers, as well as
the experts named herein, predicated upon the civil liability provisions of the
U.S. federal securities laws or original actions brought in Bermuda against us
or such persons predicated solely upon U.S. federal securities laws. Further, we
have been advised by Attride-Stirling & Woloniecki that there is no
treaty in effect between the United States and Bermuda providing for the
enforcement of judgments of U.S. courts, and there are grounds upon which
Bermuda courts may not enforce judgments of U.S. courts. Some remedies available
under the laws of U.S. jurisdictions, including some remedies available under
the U.S. federal securities laws, may not be allowed in Bermuda courts as
contrary to that jurisdiction’s public policy. Because judgments of U.S. courts
are not automatically enforceable in Bermuda, it may be difficult for you to
recover against us based upon such judgments.





Risks Related to Our Common Shares





Future sales may affect the market
price of our common shares.





We cannot predict what effect, if any,
future sales of our common shares, or the availability of common shares for
future sale, will have on the market price of our common shares. Sales of
substantial amounts of our common shares in the public market, or the perception
that such sales could occur, could adversely affect the market price of our
common shares and may make it more difficult for you to sell your common shares
at a time and price which you deem appropriate.





As of March 19, 2008,
we had 85,316,924 commonshares outstanding.  Up to an
additional 3,644,010 common shares may be issuable upon the vesting and
exercise of outstanding performance share units (PSUs) and restricted share
units (RSUs).  In addition, our principal shareholders and their
transferees have the right to require us to register their common shares under
the Securities Act of 1933, as amended (the “Securities Act”) for sale to the
public.  The outstanding founder’s Warrant, which we refer to as the
Warrant, will be exercisable for 8,585,747 common shares during the month of
December 2010. These shares also will be entitled to demand registration.
Following any registration of this type, the common shares to which the
registration relates will be freely transferable.  We have also filed
a registration statement on Form S-8 under the Securities Act to register common
shares issued or reserved for issuance under Flagstone Reinsurance Holdings
Limited Performance Share Unit Plan, as amended (the “PSU
Plan”)
and the Amended and Restated Flagstone Reinsurance Holdings Limited Employee
Restricted Share Unit Plan (the “RSU
Plan”).  Subject
to the exercise of issued and outstanding stock options, shares registered under
the registration statement on Form S-8 will be available for sale to the
public.





We have reserved 5.6 million
common shares for issuance under the PSU Plan. For the RSU Plan, we annually
reserve 0.2% of our outstanding common shares for issuance (or as decided by the
Compensation Committee), plus the amount required to satisfy director fees paid
in common shares. Subject to the settlement of PSUs, which generally vest over
three years, and RSUs, which generally vest over two years, common shares
registered under the registration statement on Form S-8 will be available
for sale into the public markets after the expiration of the 180-day lock-up
agreements. We intend to file a “shelf” registration statement
under the Securities Act after we become eligible to do so.  The shelf
registration statement would enable us rapidly to issue and sell a variety of
securities, which may include additional common shares.





There are provisions in our charter
documents that may reduce or increase the voting rights of our common
shares.





There are provisions in our bye-laws
which may reduce or increase the voting rights of the common shares. In general,
and except as provided below, shareholders have one vote for each common share
held by them and are entitled to vote at all meetings of shareholders. However,
if, and so long as, the common shares of a shareholder are treated as “controlled shares” (as generally determined
under section 958 of the Internal Revenue Code of 1986, as amended (the
“Code”) and the Treasury
Regulations promulgated thereunder and under section 957 of the Code) of
any U.S. Person (as defined in section 7701(a)(30) of the Code) and such
controlled shares constitute 9.9% or more of the votes conferred by the
Company’s issued shares, the voting rights with respect to the controlled shares
of such U.S. Person (a “9.9% U.S.
Shareholder”) shall be
limited, in the aggregate, to a voting power of less than 9.9% under a formula
specified in our bye-laws. The reduction in votes is generally to be applied
proportionately among all the “controlled shares” of the 9.9% U.S.
Shareholder. The formula is applied repeatedly until the voting power of each
9.9% U.S. Shareholder has been reduced below 9.9%. In addition, the Board of
Directors may limit a shareholder’s voting rights where it deems it appropriate
to do so to (i) avoid the existence of any 9.9% U.S. Shareholder; and
(ii) avoid certain adverse tax, legal or regulatory consequences to the
Company or any of the Company’s subsidiaries or any shareholder or its
affiliates. “Controlled
shares” includes all
shares that a U.S. Person is deemed to own directly, indirectly or
constructively (within the meaning of Section 958 of the Code). The amount
of any reduction of votes that occurs by operation of the above limitations will
generally be reallocated proportionately among all other shareholders of the
Company so long as the reallocation does not cause any U.S. shareholder to
become a 9.9% U.S. Shareholder.





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Under
these provisions, certain shareholders may have their voting rights limited to
less than one vote per share, while other shareholders may have voting rights
increased to in excess of one vote per share. Moreover, these provisions could
have the effect of reducing the votes of certain shareholders who would not
otherwise be subject to the 9.9% limitation by virtue of their direct share
ownership. Our bye-laws provide that shareholders will be notified of their
voting interests before each shareholder vote.





The Company also has the authority to
request information from any shareholder for the purpose of determining whether
a shareholder’s voting rights are to be reallocated pursuant to our bye-laws. If
a shareholder fails to respond to a request for information from the Company or
submits incomplete or inaccurate information in response to a request, the
Company, in its reasonable discretion, may reduce or eliminate the shareholder’s
voting rights.





As a result of any reallocation of
votes, your voting rights might increase above 5% of the aggregate voting power
of the outstanding common shares, thereby possibly resulting in your becoming a
reporting person subject to Schedule 13D or 13G filing requirements under
the Exchange Act. In addition, the reallocation of your votes could result in
your becoming subject to filing requirements under Section 16 of the
Exchange Act.





U.S. persons who own our common shares
may have more difficulty in protecting their interests than U.S. persons who are
shareholders of a U.S. corporation.





The Companies Act, which applies to the
Company and Flagstone, differs in material respects from laws generally
applicable to U.S. corporations and their shareholders. Generally, the rights of
shareholders under Bermuda law are not as extensive as the rights of
shareholders under legislation or judicial precedent in many United States
jurisdictions. Class actions and derivative actions are generally not available
to shareholders under the laws of Bermuda. In addition, the Company’s bye-laws
also provide that shareholders waive all claims or rights of action that they
may have, individually or in the Company’s right, against any of the Company’s
directors or officers for any act or failure to act in the performance of such
director’s or officer’s duties, except with respect to any fraud or dishonesty
of such director or officer. The cumulative effect of some of these differences
between Bermuda law and the laws generally applicable to U.S. corporations and
their shareholders may result in shareholders having greater difficulties in
protecting their interests as a shareholder of our Company than as a shareholder
of a U.S. corporation. In particular, this affects, among other things, the
circumstances under which transactions involving an interested director are
voidable, whether an interested director can be held accountable for any benefit
realized in a transaction with our company, what approvals are required for
business combinations by our company with a large shareholder or a wholly-owned
subsidiary, what rights a shareholder may have to enforce specified provisions
of the Companies Act or our bye-laws, and the circumstances under which we may
indemnify our directors and officers.





Anti-takeover provisions in our
bye-laws could impede an attempt to replace or remove our directors, which could
diminish the value of our common shares.





Our bye-laws contain provisions that
may entrench directors and make it more difficult for shareholders to replace
directors even if the shareholders consider it beneficial to do so. In addition,
these provisions could delay or prevent a change of control that a shareholder
might consider favorable. For example, these provisions may prevent a
shareholder from receiving the benefit from any premium over the market price of
our common shares offered by a bidder in a potential takeover. Even in the
absence of an attempt to effect a change in management or a takeover attempt,
these provisions may adversely affect the prevailing market price of our common
shares if they are viewed as discouraging changes in management and takeover
attempts in the future.





Examples of provisions in our bye-laws
that could have this effect include:




●
            election
      of our directors is staggered, meaning that the members of only one
      of the three classes of our directors are elected each year,
      thus limiting your ability to replace
  directors;●
            the
      total voting power of any U.S. shareholder owning more than 9.9% of our
      common shares will be reduced below 9.9% of the total voting power of our
      common shares; and


●
            the
      affirmative vote of at least 75% of the directors then in office will be
      required to approve any merger, consolidation, amalgamation, continuation
      or similar transaction involving the
Company.





There are regulatory limitations on the
ownership and transfer of our common shares.





Common shares may be offered or sold in
Bermuda only in compliance with the provisions of the Companies Act 1981 of
Bermuda, as amended and the Bermuda Investment Business Act 2003, which
regulates the sale of securities in Bermuda. In addition, the BMA must approve
all issues and transfers of shares of a Bermuda exempted company. However, the
BMA has pursuant to its statement of June 1, 2005 given its general
permission under the Exchange Control Act 1972 (and related regulations) for the
issue and free transfer of our common shares to and among persons who are
non-residents of Bermuda for exchange control purposes as long as the shares are
listed on an appointed stock exchange, which includes the New York Stock
Exchange. This general permission would cease to apply if the Company were to
cease to be so listed. Bermuda insurance law requires that any person who
becomes a holder of at least 10%, 20%, 33% or 50% of the common shares of an
insurance or reinsurance company or its parent company must notify the BMA in
writing within 45 days of becoming such a holder or 30 days from the
date they have knowledge of having such a holding, whichever is later. The BMA
may, by written notice, object to a person holding 10%, 20%, 33% or 50% of our
common shares if it appears to the BMA that the person is not fit and proper to
be such a holder. The BMA may require the holder to reduce their shareholding in
us and may direct, among other things, that the voting rights attaching to their
shares shall not be exercisable. A person that does not comply with such a
notice or direction from the BMA will be guilty of an offense. In addition, we
will deliver to and file a copy of this prospectus with the Registrar of
Companies in Bermuda in accordance with Bermuda law.





Except in connection with the
settlement of trades or transactions entered into through the facilities of the
New York Stock Exchange, our Board of Directors may generally require any
shareholder or any person proposing to acquire our shares to provide the
information required under our bye-laws. If any such shareholder or proposed
acquirer does not provide such information, or if the Board of Directors has
reason to believe that any certification or other information provided pursuant
to any such request is inaccurate or incomplete, the Board of Directors may
decline to register any transfer or to effect any issuance or purchase of shares
to which such request is related. Although these restrictions on transfer will
not interfere with the settlement of trades on the New York Stock Exchange, we
may decline to register transfers in accordance with our bye-laws and Board of
Directors resolutions after a settlement has taken place.





We may repurchase your common shares
without your consent.





Under our bye-laws and subject to
Bermuda law, we have the option, but not the obligation, to require a
shareholder to sell to us at fair market value the minimum number of common
shares which is necessary to avoid or cure any adverse tax consequences or
materially adverse legal or regulatory treatment to us, our subsidiaries or our
shareholders if our Board of Directors reasonably determines, in good faith,
that failure to exercise our option would result in such adverse consequences or
treatment.




19
 Table of Contents






Risks
Related to Tax Matters





U.S. persons who hold common shares may
be subject to U.S. income taxation at ordinary income rates on undistributed
earnings and profits.





Controlled Foreign Corporation
Rules.    If the Company or any of its subsidiaries
is characterized as a controlled foreign corporation, or CFC, for an
uninterrupted period of 30 days or more during a taxable year, then any
United States person who owns, directly, indirectly through non-U.S. entities,
or under applicable constructive ownership rules, 10% or more of the shares of
the Company or any of its subsidiaries (based on voting power) on the last day
of our taxable year, whom we refer to as a “U.S. 10% shareholder,” would be required to
include in its U.S. federal gross income for the taxable year, as income subject
to taxation at ordinary income tax rates, its pro rata share of the relevant
company’s undistributed earnings and profits characterized as “subpart F income.” Subpart F income
generally includes passive investment income, such as interest, dividends or
certain rent or royalties and subpart F insurance income, which typically
includes certain insurance underwriting income and related investment income.
Additionally, a U.S. 10% shareholder may be taxable at the rates applicable to
dividends on any gain realized on a sale or other disposition (including by way
of repurchase or liquidation) of common shares to the extent of our current and
accumulated earnings and profits attributable to such common
shares.





Because of the anticipated dispersion
of the Company’s share ownership, provisions in our bye-laws that limit voting
power and other factors, no United States person who owns common shares of the
Company directly or indirectly through one or more non-U.S. entities should be
treated as a U.S. 10% shareholder. We cannot be certain, however, that the
Internal Revenue Service or IRS will not challenge the effectiveness of these
provisions or that a court would not sustain such a challenge, in which case an
investor in common shares could be adversely affected.





Related Person Insurance Income
Rules.    If the gross “related person insurance
income,” or RPII, of
any insurance subsidiary of the Company were to equal or exceed 20% of its gross
insurance income in any taxable year and if direct or indirect insureds (and
related persons) were to own 20% or more of either the voting power or value of
the common shares either directly or indirectly through entities, a United
States person owning any common shares directly or indirectly through non-U.S.
entities on the last day of the relevant subsidiary’s taxable year could be
required to include in gross income for United States federal income tax
purposes such person’s share of the subsidiary’s RPII for up to the entire
taxable year, determined as if all such RPII were distributed proportionately
only to such United States persons at that date, but limited by such person’s
share of the subsidiary’s current-year earnings and profits as reduced by the
person’s share, if any, of certain prior-year deficits in earnings and profits
attributable to the subsidiary’s insurance business. Upon the sale or other
disposition of any common shares, such person may also be subject to United
States federal income tax at the rates applicable to dividends to the extent of
the holder’s pro rata share of the subsidiary’s undistributed earnings and
profits, although we do not believe this should be the case since the Company
will not be directly engaged in the insurance business.





We do not expect the gross RPII of any
subsidiary of the Company to equal or exceed 20% of its gross insurance income
in any taxable year for the foreseeable future and do not expect direct or
indirect insureds (and related persons) to directly or indirectly through
entities own 20% or more of either the voting power or value of the common
shares, but we cannot be certain that this will be the case.





The RPII provisions have never been
interpreted by the courts or the U.S. Treasury Department in final regulations.
Regulations interpreting the RPII provisions of the Code exist only in proposed
form. It is not certain whether these regulations will be adopted in their
proposed form or what changes or clarifications might ultimately be made thereto
or whether any such changes, as well as any interpretation or application of
RPII by the IRS, the courts, or otherwise, might have retroactive effect. The
Treasury Department has authority to impose, among other things, additional
reporting requirements with respect to RPII. Accordingly, the meaning of the
RPII provisions and the application thereof is uncertain.





U.S. holders of common shares may be
subject to U.S. income taxation at the highest marginal income tax rates
applicable to ordinary income and be required to pay an interest
charge.





Passive Foreign Investment Company
Rules.    If the Company was characterized as a
passive foreign investment company, or PFIC, for any taxable year, U.S. holders
of common shares generally would be subject to adverse income tax consequences
for such year and each subsequent year including (i) taxation of any gain
attributable to the sale or other disposition (including by way of repurchase or
liquidation) of their common shares or any “excess distribution” with respect to their
common shares at the highest marginal income tax rates applicable to ordinary
income in the holder’s holding period for the common shares and (ii) an
interest charge on the deemed deferral of income tax, unless the holder properly
(a) elects to have us treated as a qualified electing fund and thus to
include in gross income each year a pro rata share of our ordinary earnings and
net capital gain for any year in which we constitute a PFIC or (b) makes a
PFIC mark to market election with respect to us.





The Company believes that it is not a
PFIC because it (through its insurance subsidiaries) will engage predominantly
in the active conduct of an insurance business. We can not be certain, however,
that the IRS or a court will concur that based on our activities and the
composition of our income and assets that we are not a PFIC.





U.S. tax-exempt organizations that own
common shares may recognize unrelated business taxable income.





A U.S. tax-exempt organization that
owns any of our common shares will be required to treat certain subpart F
insurance income, including RPII, as unrelated business taxable income. Although
we do not believe that any United States holders, including U.S. tax-exempt
organizations, should be allocated any subpart F insurance income, we cannot be
certain that this will be the case. Potential U.S. tax-exempt investors are
advised to consult their tax advisors.





Changes in U.S. tax laws may be
retroactive and could subject a U.S. holder of common shares to U.S. income
taxation on the Company’s undistributed earnings and to other adverse tax
consequences.





The tax laws and interpretations
regarding whether a company is engaged in a U.S. trade or business, is a CFC, is
a PFIC or has RPII are subject to change, possibly on a retroactive basis. There
are currently no regulations regarding the application of the PFIC provisions to
an insurance company and the regulations regarding RPII are in proposed form.
New regulations or pronouncements interpreting or clarifying such rules may be
forthcoming. We are not able to predict if, when or in what form such guidance
will be provided or whether such guidance will have a retroactive effect. The
tax treatment of non-U.S. insurance companies has been the subject of discussion
in the U.S. Congress. We cannot assure you that future legislative action will
not increase the amount of U.S. tax payable by us. If this happens, our
financial condition and results of operations could be adversely
affected.





We may be subject to taxation in the
U.S. which would negatively affect our results.





If the Company or its subsidiaries is
considered to be engaged in a business in the U.S., such company may be subject
to current U.S. corporate income and branch profits taxes on the portion of such
company’s earnings effectively connected to its U.S. business, including premium
income from U.S. sources (which represents a large portion of the reinsurance
written by Flagstone) and certain related investment income.  The
Company and its subsidiaries are incorporated under the laws of Bermuda and
other non-U.S. jurisdictions and intend to conduct substantially all of their
activities outside the United States and, except as described below, to limit
their U.S. contacts so that each of them will not be subject to U.S. taxation on
their income (other than excise taxes on reinsurance premium income attributable
to reinsuring U.S. risks and U.S. withholding taxes on certain U.S. source
investment income).




20
 Table of Contents




We may be subject to taxation in the
United Kingdom which would negatively affect our results.





None of our companies, except for
Flagstone Representatives Limited, are incorporated or managed in the United
Kingdom. Accordingly, none of our other companies should be treated as being
resident in the United Kingdom for corporation tax purposes unless the central
management and control of any such company is exercised in the United Kingdom.
The concept of central management and control is indicative of the highest level
of control of a company, which is wholly a question of fact. Each of our
companies currently intends to manage its affairs so that none of our companies,
apart from Flagstone Representatives Limited, are resident in the United Kingdom
for tax purposes. Each of our companies, apart from Flagstone Representatives
Limited, currently intends to operate in such a manner so that none of our
companies, apart from Flagstone Representatives Limited, carry on a trade
through a permanent establishment in the United Kingdom. If any of our companies
were treated as being resident in the United Kingdom for U.K. corporation tax
purposes, or if any of our companies, other than Flagstone Representatives
Limited, were to be treated as carrying on a trade in the United Kingdom through
a branch or agency or of having a permanent establishment in the United Kingdom,
our results of operations could be materially adversely affected.





We may be subject to taxation in
Switzerland which would negatively affect our results.





None of our companies, except for
Flagstone Suisse and Haverford Suisse, is incorporated or managed in
Switzerland. Accordingly, none of our other companies should be liable for Swiss
corporation taxation unless it carries on business through a permanent
establishment in Switzerland. From a Swiss tax perspective, a permanent
establishment is a fixed place of business through which a company performs
business activities that are considered as being quantitatively and
qualitatively significant by the tax authorities, and may include a branch,
office, agency or place of management. Each of our companies currently intends
to operate in such a manner so that none of our companies, apart from Flagstone
Suisse and Haverford Suisse, will carry on business through a permanent
establishment in Switzerland. If any of our companies were to be treated as
carrying on business in Switzerland through a branch or agency or of having a
permanent establishment in Switzerland, our results of operations could be
materially adversely affected.





We may be subject to taxation in Canada
which would negatively affect our results.





None of our companies, except for
Flagstone Management Services (Halifax) Limited, or Flagstone Halifax, is
resident in Canada for corporate tax purposes. Accordingly, none of our other
companies should be liable for Canadian corporate tax unless it is determined to
be carrying on business in Canada. Canada applies both a common law test and a
statutory test to determine whether a non-resident is carrying on business in
Canada. The common law test looks to where the contracts of the business are
made, and the location of operations from which profits arise. The statutory
test extends the concept of carrying on business to include a transaction by
which a non-resident solicits orders or offers anything for sale in Canada
through an agent or servant, whether the contract or transaction is to be
completed inside or outside Canada or partly inside or outside Canada. Each of
our companies currently intends to operate in such a manner so that none of our
companies, apart from Flagstone Halifax, will be deemed to be carrying on
business in Canada. If any of our companies were to be treated as carrying on
business in Canada, our results of operations could be materially adversely
affected.





We may be subject to taxation in India
which would negatively affect our results.





None of our companies, except for West
End (India), should be treated as being resident in India for corporate tax
purposes. Accordingly, none of our other companies should be liable for
corporate tax in India unless it receives or is deemed to receive income, from
whatever source derived, in India or it has income that arises or accrues (or is
deemed to arise or accrue) in India. Each of our companies currently intends to
operate in such a manner so that none of our companies, apart from West End
(India), receives or is deemed to receive income in India or has income that
arises or accrues in India for purposes of corporate tax in India. If any of our
companies were to be treated as receiving income in India or earning income that
arises or accrues in India, our results of operations could be materially
adversely affected.





West End (India) is registered under
the software technology park of India, or STPI, Scheme. Tax incentives
associated with businesses which are registered under the STPI Scheme generally
provide a complete exemption from Indian tax on business income generated
through these operations, and West End (India) has been granted a complete tax
holiday valid through March 31, 2009 subject to compliance with the
applicable requirements of the Income Tax Act, 1961 of India. Under the STPI tax
holiday, the entire income of the Indian operations from services provided to
Flagstone and other companies based outside India is exempt from tax in India
through the fiscal year ending March 31, 2009 subject to compliance with
the applicable requirements of the Income Tax Act, 1961 of India.




We may be subject to taxation in the
United States Virgin Islands which would negatively affect our
results.




None
of our Companies is incorporated or managed in the United States Virgin
Islands (“USVI”), and none of our
companies, except for Island Heritage, operates a trade or business in the
USVI.  Accordingly, none of our companies, except for Island Heritgage,
should be subject to taxation in the USVI.  If the Company or any
of its subsidiaries is considered to be engaged in a trade business in the USVI,
such company may be subject to current USVI corporate or branch profits taxes on
the portion of such company's earnings effectively connected to the USVI
business.


We
may become subject to taxation in Bermuda which would negatively affect our
results.


We have received an assurance from the
Bermuda Minister of Finance under The Exempted Undertakings Tax Protection Act
1966 of Bermuda to the effect that if there is enacted in Bermuda any
legislation imposing tax computed on profits or income, or computed on any
capital asset, gain or appreciation, or any tax in the nature of estate duty or
inheritance tax, then the imposition of any such tax shall not be applicable to
us or to any of our operations or common shares, debentures or other obligations
until March 28, 2016, except in so far as such tax applies to persons
ordinarily resident in Bermuda or is payable by us in respect of real property
owned or leased by us in Bermuda. We cannot assure you that a future Minister
would honor that assurance, which is not legally binding, or that after such
date we would not be subject to any such tax. If we were to become subject to
taxation in Bermuda, our results of operations could be adversely
affected.





The impact of Bermuda’s letter of
commitment to the Organization for Economic Cooperation and Development to
eliminate harmful tax practices is uncertain and could adversely affect our tax
status in Bermuda.





The Organization for Economic
Cooperation and Development, or the OECD, has published reports and launched a
global dialogue among member and non-member countries on measures to limit “harmful” tax competition. These
measures are largely directed at counteracting the effects of low-tax regimes in
countries around the world. In the OECD’s report dated April 18, 2002 and
updated as at June 2004 and November 2005 via a “Global Forum,” Bermuda was not listed as
an uncooperative tax haven jurisdiction because it had previously signed a
letter committing itself to eliminate harmful tax practices and to embrace
international tax standards for transparency, exchange of information and the
elimination of any aspects of the regimes for financial and other services that
attract business with no substantial domestic activity. We are not able to
predict what changes will arise from the commitment or whether such changes will
subject us to additional taxes.








ITEM
      1B.
            UNRESOLVED
      STAFF COMMENTS





None.





ITEM
      2.
            PROPERTIES





We
currently occupy office space in Hamilton, Bermuda. In addition, we lease office
space in Halifax, Canada; Hyderabad, India; London, England; Martigny,
Switzerland; Zurich, Switzerland; San Juan, Puerto Rico; Dubai, UAE; and the
Isle of Man. We are in the construction phase of building a more suitable office
building in India, and have paid for and been allotted a one-acre lot for this
purpose in a new government-promoted office park development. While we believe
that for the foreseeable future our current office spaces combined with the
project in India will be sufficient for us to conduct our operations, we
anticipate future growth and we will likely need to expand into additional
facilities to accommodate this growth.  To date, the cost of acquiring
and maintaining our office space has not been material.




21
 Table of Contents





ITEM
      3.
            LEGAL
      PROCEEDINGS





As of
December 31, 2007, the Company was not a party to any litigation or
arbitration that it believes could have a material adverse effect on the
financial condition or business of the Company.  We anticipate that,
similar to the rest of the insurance and reinsurance industry, we will be
subject to litigation and arbitration in the ordinary course of business of our
business operations. In addition to claims litigation, the Company and its
subsidiaries may be subject to lawsuits and regulatory actions in the normal
course of business that do not arise from or directly relate to claims on
reinsurance treaties.





ITEM
      4.
            SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY
HOLDERS





No
matters were submitted to a vote of shareholders of the Company during the
fourth quarter of the fiscal year ended December 31, 2007.






22
 Table of Contents


PART II




ITEM
5.                   MARKET
FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
OF EQUITY SECURITIES




Market
Information




On March
30, 2007, we sold 13,000,000 of our common shares, par value $0.01 per share, in
an initial public offering (“IPO”).  On April 30, 2007, the
underwriters of the IPO exercised their option to purchase an additional 750,000
common shares of the Company at the public offering price less underwriting
discounts and commissions. On April 4, 2007, we closed the IPO and on May 2,
2007, we closed on the exercise by the underwriters of their over-allotment
option. In this section, we refer to our IPO and the exercise by the
underwriters of their over-allotment option as the “Offering.” All of the
13,750,000 common shares in the Offering were newly issued shares sold by us.
The Offering was effected pursuant to a registration statement on Form S-1 (File
No. 333-138182) (the “Registration Statement”) that was declared effective by
the SEC on March 29, 2007.  Lehman Brothers Inc. (“Lehman”) and
Citigroup Global Markets Inc. acted as joint book running managers for the
Offering.


The
initial price of the Offering was $13.50 per share, or approximately $185.6
million in the aggregate. Underwriting discounts and commissions were
approximately $.91125 per share and approximately $12.5 million in the
aggregate. Other fees and expenses related to the Offering were approximately
$4.3 million. Net proceeds to the Company from the IPO were $159.3 million, and
net proceeds to the Company from the exercise by the underwriters of their
over-allotment option were $9.4 million.  We received aggregate net
proceeds of approximately $168.7 million from the Offering.
 
 None of
the underwriting discounts and commissions or Offering expenses was incurred or
paid to our directors or officers or their associates. Underwriting discounts
and commissions and other expenses were paid to Lehman.  As described
in the Registration Statement, certain affiliates of Lehman may be deemed to
directly or indirectly beneficially own in the aggregate over 10% of our common
shares after the Offering.
 
 The
Company has contributed the aggregate net proceeds of approximately $168.7
million from the Offering to Flagstone to increase its underwriting capacity and
Flagstone has invested the proceeds according to its investment
strategy.




Price
Range of Common Shares





The common shares of the Company began
trading on the New York Stock Exchange under the symbol “FSR” on March 30,
2007.  The following table presents, for the periods indicated, the high
and low prices per share of our common shares as reported for New York Stock
Exchange composite transactions:





2007High
            
            
            LowFirst
      quarter (commencing March 30,
      2007)
            $
            13.70
            
            
            $
            12.80Second
      quarter
            
            
            13.90
            
            
            
            12.80Third
      quarter
            
            
            13.80
            
            
            
            12.13Fourth
      quarter
            
            
            14.72
            
            
            
            12.30




At March
19, 2008, the number of record holders of the common shares of the Company was
approximately 49.





Dividends





The Company paid two quarterly cash
dividends at the rate of $0.04per
common share in 2007.  Subject
to the approval of our Board of Directors, we currently expect to continue to
pay a quarterly cash dividend of approximately $0.04 per common share. Any
future determination to pay cash dividends will be at the discretion of our
Board of Directors and will be dependent upon our results of operations and cash
flows, our financial position and capital requirements, general business
conditions, rating agency guidelines, legal, tax, regulatory and any contractual
restrictions on the payment of dividends and any other factors our Board of
Directors deems relevant.




As a holding company, our principal
source of income is dividends or other permissible payments from our
subsidiaries.  The ability of our subsidiaries to pay dividends is
limited by applicable laws and regulations of the various countries in which we
operate. See Item 1, “Business—Regulation.”




Repurchases
of Equity Securities




During
the fourth quarter of 2007, no purchases of the Company’s common shares were
made by or on behalf of the Company or any affiliated person.





Recent
Sales of Unregistered Securities





There have been no recent sales of
unregistered securities.





Performance
Graph





The following graph compares the
cumulative return on our common shares including reinvestment of our dividends
on our common shares to such return for the Standard & Poor’s
(“S&P”) 500 Composite Stock Price Index (“S&P 500”) and S&P
Supercomposite Property-Casualty Index (“S&P P/C”), for the period
commencing March 30, 2007, the date of our initial IPO, through
December 31, 2007, assuming $100 was invested on March 30, 2007. Each
measurement point on the graph below represents the cumulative shareholder
return as measured by the last sale price at the end of each month during the
period from March 30, 2007 through December 31, 2007. As depicted in the
graph below, during this period, the cumulative return was (1) 3.1% on our
common shares; (2) 3.3% for the S&P 500 Composite Stock Price Index; and (3)
(12.0%) for the S&P Property-Casualty Industry Stock Price
Index.










Equity
Compensation Plans




“Security Ownership of
Certain Beneficial Owners, Management and Related Stockholders
Matters ” in
this Form 10-K.


Comparison of
cumulative total return $120.00 $115.00 $110.00 $105.00 $100.00 $95.00
$90.00 $85.00 $80.00 FSR S&P 500 S&P P/C 39142 39173 39203 39234
39264 39295 39326 39356 39387 39417


23
 Table of Contents




ITEM 6. SELECTED
FINANCIAL DATA
  Statement
of operations data and balance sheet data of the Company for the years ended
December 31, 2007 and 2006 and for the period October 4, 2005
through December 31, 2005 are derived from our audited consolidated
financial statements included in Item 8 of this Form 10-K, which have been
prepared in accordance with U.S. GAAP.
  You
should read the following selected financial data in conjunction with the
information included under the heading “Management’s
Discussion and Analysis of Financial Condition and Results of Operations”,
and the consolidated financial statements and related notes included elsewhere
in this Form 10-K.
 Year
      ended
                December31,
      2007
              
              
              Year
      ended
                December31,
      2006
              
              
              Period October 4,
      2005 through
                December 31,
      2005($ in thousands,
      except share amounts, per share amounts and
      percentages)Summary Statement
      of Operation Data:Gross premiums
    written
              
              $
              577,150
              
              
              $
              302,489
              
              
              $
              -Reinsurance premiums
      ceded
              
              
              (50,119
              )
              
              
              (19,991
              )
              
              
              -Net premiums written
              
              
              527,031
              
              
              
              282,498
              
              
              
              -Net premiums earned
              
              
              477,137
              
              
              
              192,063
              
              
              
              -Net investment income
              
              
              73,808
              
              
              
              34,212
              
              
              
              629Net realized and unrealized gains
      (losses) - investments
              
              
              17,174
              
              
              
              10,304
              
              
              
              -Net realized and unrealized gains
      (losses) - other
              
              
              (9,821
              )
              
              
              1,943
              
              
              
              -Other income
              
              
              5,811
              
              
              
              6,099
              
              
              
              -Loss and loss adjustment
      expenses
              
              
              (192,859
              )
              
              
              (26,660
              )
              
              
              -Acquisition costs
              
              
              (82,292
              )
              
              
              (29,939
              )
              
              
              -General and administrative
      expenses
              
              
              (72,461
              )
              
              
              (34,741
              )
              
              
              (13,013
              )Interest expense
              
              
              (18,677
              )
              
              
              (4,648
              )
              
              
              -Net foreign exchange
      gains
              
              
              5,289
              
              
              
              2,079
              
              
              
              -Provision for income
      tax
              
              
              (783
              )
              
              
              (128
              )
              
              
              -Minority interest
              
              
              (35,794
              )
              
              
              -
              
              
              
              -Interest in earnings of equity
      investments
              
              
              1,390
              
              
              
              1,754
              
              
              
              -NET INCOME
      (LOSS)
              
              $
              167,922
              
              
              $
              152,338
              
              
              $
              (12,384
              )Earnings (loss)
      per common share(1)Weighted average common shares
      outstanding—Basic
              
              
              81,975,384
              
              
              
              70,054,087
              
              
              
              55,239,491Weighted average common shares
      outstanding—Diluted
              
              
              82,111,590
              
              
              
              70,393,821
              
              
              
              55,239,491Net income (loss) per common share
      outstanding—Basic
              
              $
              2.05
              
              
              $
              2.17
              
              
              $
              (0.22
              )Net income (loss) per common share
      outstanding—Diluted
              
              $
              2.05
              
              
              $
              2.16
              
              
              $
              (0.22
              )Dividends declared per common
      share
              
              $
              0.08
              
              
              $
              -
              
              
              $
              -Selected ratios
      (based on U.S. GAAP statement of operations data)Loss ratio(2)
              
              
              40.4%
              
              
              
              13.9%
              
              
              
              0.0%Acquisition cost ratio(3)
              
              
              17.2%
              
              
              
              15.6%
              
              
              
              0.0%General and administration expense
      ratio(4)
              
              
              15.2%
              
              
              
              18.1%
              
              
              
              0.0%Combined ratio(5)
              
              
              72.8%
              
              
              
              47.6%
              
              
              
              0.0%
  24
 Table of Contents
  As at December 31,
      2007
              
              As at December 31,
      2006
              
              As at December 31,
      2005($ in thousands,
      except per share amounts)Summary Balance Sheet
      Data:AssetsTotal
      investments and cash and cash equivalents
              
              $
              1,862,924
              
              $
              1,018,126
              
              $
              548,255Premiums
      receivable
              
              
              136,555
              
              
              68,940
              
              
              -Other
      assets
              
              
              104,294
              
              
              57,436
              
              
              101Total assets
              
              $
              2,103,773
              
              $
              1,144,502
              
              $
              548,356LiabilitiesLoss and
      loss adjustment expense reserves
              
              $
              180,978
              
              $
              22,516
              
              $
              -Unearned
      premiums
              
              
              175,607
              
              
              98,659
              
              
              -Long term
      debt
              
              
              264,889
              
              
              137,159
              
              
              -Other
      liabilities
              
              
              87,036
              
              
              21,649
              
              
              688Total
    liabilities
              
              $
              708,510
              
              $
              279,983
              
              $
              688Temporary
      equity
              
              
              -
              
              
              -
              
              
              34Minority
      interest
              
              
              184,778
              
              
              -
              
              
              -Total
      shareholders’ equity
              
              
              1,210,485
              
              
              864,519
              
              
              547,634Total liabilities,
      temporary equity, minority interest and shareholders’
    equity
              
              $
              2,103,773
              
              $
              1,144,502
              
              $
              548,356Per share
      dataBook value per common
      share(6)
              
              
              14.17
              
              
              12.08
              
              
              9.91Diluted book value per
      common share(7)
              
              
              13.87
              
              
              11.94
              
              
              9.86


(1)  Earnings
(loss) per common share is a measure based on our net income (loss) divided by
our weighted average common shares outstanding. Basic earnings (loss) per common
share is defined as net income (loss) divided by the weighted average common
shares outstanding and weighted average vested RSUs for the period, giving no
effect to dilutive securities. Diluted earnings (loss) per common share is
defined as net income (loss) divided by the weighted average common shares and
common share equivalents outstanding calculated using the treasury stock method
for all potentially dilutive securities, including the Warrant, PSUs, and
RSUs.  The issuance of shares with respect to the PSUs is contingent
upon the attainment of certain levels of diluted return-on-equity (“DROE”).
Because the number of common 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 share until the end of the performance
period, when the number of shares issuable under the PSU Plan will be
known.  When the effect of securities would be anti-dilutive, these
securities are excluded from the calculation of diluted earnings (loss) per
common share.  The warrant was anti-dilutive and was excluded from the
calculation of diluted earnings per common share for the years ended December
31, 2007 and 2006 and the period from October 4, 2005 through December 31,
2005.


(2)  The
loss ratio is calculated by dividing loss and loss adjustment expenses by net
premiums earned.


(3)  The
acquisition cost ratio is calculated by dividing acquisition costs by net
premiums earned.


(4)  The
general and administrative expense ratio is calculated by dividing general and
administrative expenses by net premiums earned.


(5)  The
combined ratio is the sum of the loss ratio, the acquisition cost ratio and the
general administrative expense ratio.


(6)  Book
value per common share is defined as total shareholders’ equity divided by the
number of common shares outstanding and vested RSUs at the end of the period,
giving no effect to dilutive securities.


(7)  Diluted
book value per common share is defined as total shareholders’ equity divided by
the number of common shares and common share equivalents outstanding at the end
of the period, including the Warrant, PSUs, and RSUs.  When the
effect of securities would be anti-dilutive, these securities are excluded from
the calculation of diluted book value per common share.  The warrant
was anti-dilutive and was excluded from the calculation of diluted book value
per common share for the years ended December 31, 2007 and 2006 and for the
period ended December 31, 2005.




As of January 1, 2007, we adopted SFAS
157 and SFAS 159. As a result, substantially all of our investments are now
carried at fair value with changes in fair value being reported as net realized
and unrealized gains (losses) in our statement of operations. Prior to the
adoption of SFAS 157 and SFAS 159, our available for sale investments were
carried at fair value with changes in fair value with changes therein reported
as a component of other comprehensive income





On January 12, 2007 we began to
consolidate the operations of Mont Fort in accordance with FIN
46(R).





On July 1, 2007 we began to consolidate
the operations of Island Heritage in accordance with Accounting Research
Bulletin No. 51 - Consolidated Financial Statements.




ITEM
7.         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 December 31, 2007 and 2006 and
our results of operations for the years ended December 31, 2007 and 2006
and the period from October 4, 2005 through December 31, 2005. This
discussion should be read in conjunction with our audited consolidated financial
statements and related notes included in Item 8 of this Form 10-K. 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” 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.


25
 Table of Contents




Executive
Overview




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





We were formed by Haverford, a company
controlled and capitalized by Mark Byrne, the Executive Chairman of our Board of
Directors, and David Brown, our Chief Executive Officer, and we commenced
operations in December 2005. On March 30, 2007, the Company’s common shares
began trading on the New York Stock Exchange. The Company completed the initial
public offering (“IPO”) of 13.0 million of its common shares on April 4, 2007
resulting in gross proceeds to the Company of $175.5 million ($159.3 million net
of expenses).  In connection with this IPO, the Company filed a
Registration Statement on Form S-1 (Registration No. 333-138182) with the
Securities and Exchange Commission (the “SEC”) on March 30, 2007.  On
April 30, 2007, the underwriters of the IPO exercised their option to purchase
an additional 750,000 common shares of the Company at the public offering price
less underwriting discounts and commissions resulting in gross proceeds of $10.1
million ($9.4 million net of expenses).





The various components of our operating
model are unified through our centralized management in Hamilton, Bermuda, and
integrated through our use of advanced technology. Our Bermuda-based
underwriters are complemented with a separately licensed and staffed European
underwriting platform, Flagstone Suisse, based in Martigny, Switzerland. We
recently established a Middle East and North Africa presence with the
establishment of an office in Dubai in addition to an office in Puerto Rico
focused on sourcing Caribbean and Latin American risks. Our research and
development efforts and part of our catastrophe modeling and risk analysis team
is based in Hyderabad, India, and our international reinsurance marketing
operations are conducted from London, England. Our computer data center is in
our Halifax, Canada office, where we also run support services such as
accounting, claims, application support administration and software development.
The result is an operating platform which provides significant efficiencies in
our operations and access to a large and highly qualified staff at a relatively
low cost.





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.





Management views the operations and
management of the Company as one operating segment and does not differentiate
its lines of business into separate reporting segments. We regularly review our
financial results and assess our performance on the basis of our single
operating segment.





We measure our financial success
through long term growth in diluted book value per share plus accumulated
dividends, 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.





Revenues





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





Income from our investment portfolio is
primarily comprised of interest on fixed maturity, short term investments and
cash and cash equivalents, dividends and proportionate share of net income for
those investments accounted for on an equity basis, net realized and unrealized
gains on our investment portfolio including our derivative positions, net of
investment expenses.





Other income includes earned revenue
relating to upfront commitment fees on reinsurance contracts and ceding
commissions earned by Island Heritage.





Expenses





Our expenses consist primarily of the
following types: loss and loss adjustment expenses, acquisition costs, general
and administrative expenses, interest expense and minority
interest.





Loss and loss adjustment expenses are a
function of the amount and type of reinsurance contracts we write and of the
loss experience of the underlying risks. We estimate loss and loss adjustment
expenses based on an actuarial analysis of the estimated losses we expect to be
reported on contracts written. As described below, we will reserve for
catastrophic losses that we anticipate will accrue to us as soon as a loss event
is known to have occurred. The ultimate loss and loss adjustment expenses will
depend on our actual costs to settle claims. We will increase or decrease our
initial loss and loss adjustment estimates as actual claims are reported and
settled.





Acquisition costs are primarily
comprised of ceding commissions, brokerage, premium taxes, profit commissions
and other expenses that relate directly to the writing of reinsurance contracts.
Deferred acquisition costs are amortized over the related contract term, which
is ordinarily twelve months.





General and administrative expenses
consist primarily of salaries, benefits and related costs, including costs
associated with awards under our PSU and RSU Plans, compensation expense based
on the fair value of the Warrant and other general operating
expenses.





Interest expense consists primarily of
the interest expense related to the Deferrable Interest Debentures and the
Junior Subordinated Deferrable Interest Notes that were issued by the
Company in 2006 and 2007.





Minority interest consists of the
minority interest relating to Mont Fort and Island Heritage.  The
portions of Mont Fort’s net income and shareholders’ equity attributable to
holders of the preferred shares for the year ended December 31, 2007 and the
portions of Island Heritage’s net income and shareholders’ equity attributable
to minority shareholders’ for the year ended December 31, 2007 are recorded in
the consolidated financial statements of the Company as minority
interest.





Critical
Accounting Policies





It is important to understand our
accounting policies in order to understand our financial position and results of
operations. Our 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,”
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.




26
 Table of Contents




The following are the accounting
policies that, in management’s judgment, are critical due to the judgments,
assumptions and uncertainties underlying the application of those policies and
the potential for results to differ from management’s assumptions.





Loss
and Loss Adjustment Expense Reserves





Because a significant amount of time
can lapse between the assumption of a risk, the occurrence of a loss event, the
reporting of the event to an insurance company (the primary company or the
cedent), the subsequent reporting to the reinsurance company (the reinsurer) and
the ultimate payment of the claim by the reinsurer, our liability for loss
reserves is based largely upon estimates. We believe that the most significant
accounting judgment we make is our estimate of loss reserves.





Under U.S. GAAP, we are not permitted
to establish loss reserves, which include case reserves and IBNR, until the
occurrence of an event which may give rise to a claim. As a result, only loss
reserves applicable to losses incurred up to the reporting date are established,
with no allowance for the establishment of loss reserves to account for expected
future losses. Claims arising from future catastrophic events can be expected to
require the establishment of substantial loss reserves from time to
time.





Our loss reserve estimates do not
represent an exact calculation of liability. Rather, they represent estimates of
our expectations of the ultimate settlement and administration costs of claims
incurred. These estimates are based upon actuarial and statistical projections
and on our assessment of currently available data, predictions of future
developments and estimates of future trends in claims severity and frequency and
other variable factors such as inflation. Establishing an appropriate level of
our loss reserve estimates is an inherently uncertain process. It is likely that
the ultimate liability will be greater or less than these estimates and that, at
times, this variance will be material.





Reserves for losses and loss adjustment
expenses as at December 31, 2007 and 2006 were comprised of the
following:




Year ended December 31,
      2007
                
                
                Year ended December 31,
      2006Case
                
                
                IBNR
                
                
                Total
                
                
                Case
                
                
                IBNR
                
                
                Total($ in
      thousands)Property
      catastrophe
                
                $
                66,758
                
                
                $
                51,700
                
                
                $
                118,458
                
                
                $
                510
                
                
                $
                6,572
                
                
                $
                7,082Property
                
                
                5,653
                
                
                
                22,623
                
                
                
                28,276
                
                
                
                923
                
                
                
                9,215
                
                
                
                10,138Short-tail specialty and
      casualty
                
                
                2,282
                
                
                
                31,962
                
                
                
                34,244
                
                
                
                1,889
                
                
                
                3,407
                
                
                
                5,296Loss and loss adjustment expense
      reserves
                
                $
                74,693
                
                
                $
                106,285
                
                
                $
                180,978
                
                
                $
                3,322
                
                
                $
                19,194
                
                
                $
                22,516


As we are a broker market reinsurer,
reserving for our business can involve added uncertainty because we depend on
information from ceding companies. There is a time lag inherent in reporting
information from the primary insurer to us and ceding companies have differing
reserving practices. The information we receive varies by cedent and broker and
may include paid losses and estimated case reserves. We may also receive an
estimated provision for IBNR reserves, especially when the cedent is providing
data in support of a request for collateral for loss reserves ceded. The
information received from ceding companies is typically in the form of
bordereaux, which are reports providing premium or loss data with respect to
identified risks, broker notifications of loss and/or discussions with ceding
companies or their brokers. This information can be received on a monthly,
quarterly or transactional basis. As we are a reinsurer, our reserve estimates
may be inherently less reliable than the reserve estimates of our primary
insurer cedents.





Because our business is generally
characterized by loss events of low frequency and high severity, reporting of
claims in general tends to be prompt (as compared to reporting of claims for
casualty or other “long-tail” lines of business).
However, the timing of claims reporting can vary depending on various factors,
including: the nature of the event (e.g., hurricane, earthquake and hail); the
quality of the cedent’s claims management and reserving practices; the
geographic area involved; and whether the claims arise under reinsurance
contracts for primary companies, or reinsurance of other reinsurance companies.
Because the events from which catastrophe claims arise are typically prominent,
public occurrences, we are often able to use independent reports of such events
to augment our loss reserve estimation process. Because of the degree of
reliance that we place on ceding companies for claims reporting, the associated
time lag, the low frequency and high severity nature of the business we
underwrite and the varying reserving practices among ceding companies, our
reserve estimates are highly dependent on management's judgment and are
therefore subject to significant variability from one quarter to another. During
the loss settlement period, additional facts regarding individual claims and
trends may become known, and current laws and case law may change.





For reinsurance written on an excess of
loss basis, which represents approximately 68.0% and 80.1% of the premiums we
wrote for the years ended December 31, 2007 and 2006, respectively,
our exposure is limited by the fact that most treaties have a defined limit of
liability arising from a single loss event. Once the limit has been reached, we
have no further exposure to additional losses from that treaty for the same loss
event. For reinsurance on a pro rata basis, we typically have event caps so
these liabilities are contained.





The Company’s actuarial group performs
a quarterly loss reserve analysis on a contract by contract basis. This analysis
incorporates specific exposures, loss payment and reporting patterns and other
relevant factors. This process involves the segregation of risks between
catastrophic and non-catastrophic risks to ensure appropriate
treatment.





For our property catastrophe policies
which comprise 71.3% and 72.4% of our gross premiums written for the years ended
December 31, 2007 and 2006, respectively, and other catastrophe policies,
we initially establish our loss reserves based on loss payments and case
reserves reported by ceding companies. We then add to these case reserves our
estimates for IBNR. To establish our IBNR estimates, in addition to the loss
information and estimates communicated by cedents, we use industry information,
knowledge of the business written by us, management’s judgment and general
market trends observed from our underwriting activities.





When a catastrophic event occurs, we
first determine which treaties may be affected using our zonal monitoring of
exposures. We contact the respective brokers and ceding companies involved
with those treaties, to determine their estimate of involvement and the extent
to which the reinsurance program is affected. We may also use our computer-based
vendor and proprietary modeling systems to measure and estimate loss exposure
under the actual event scenario, if available. Although the loss modeling
systems assist with the analysis of the underlying loss, and provide us with
information and the ability to perform an enhanced analysis, the estimation of
claims resulting from catastrophic events is inherently difficult because of the
variability and uncertainty of property and other catastrophe claims and the
unique characteristics of each loss.





For non-catastrophe business, we
utilize a variety of standard actuarial methods in our analysis. The selections
from these various methods are based on the loss development characteristics of
the specific line of business and specific contracts. The actuarial methods we
use to perform our quarterly contract by contract loss reserve analysis
include:




27
 Table of Contents






●
            Paid Loss Development
      Method.    We estimate ultimate losses by
      calculating past paid loss development factors and applying them to
      exposure periods with further expected paid loss development. The paid
      loss development method assumes that losses are paid at a consistent rate.
      It provides an objective test of reported loss projections because paid
      losses contain no reserve estimates. For many coverages, claim payments
      are made very slowly and it may take years for claims to be fully reported
      and settled. This method is a key input into the Bornheutter-Ferguson paid
      loss method discussed below. ●
              Reported Loss Development
      Method.    We estimate ultimate losses by
      calculating past reported loss development factors and applying them to
      exposure periods with further expected reported loss development. Since
      reported losses include payments and case reserves, changes in both of
      these amounts are incorporated in this method. This approach provides a
      larger volume of data to estimate ultimate losses than paid loss methods.
      Thus, reported loss patterns may be less varied than paid loss patterns,
      especially for coverages that have historically been paid out over a long
      period of time but for which claims are reported relatively early and case
      loss reserve estimates established. This method is a key input into the
      Bornheutter-Ferguson reported loss method discussed
  below.
 ●
              Expected Loss Ratio
      Method.    To estimate ultimate losses under
      the expected loss ratio method, we multiply earned premiums by an expected
      loss ratio. The expected loss ratio is selected utilizing industry data,
      historical company data and professional judgment. The Company uses this
      method for lines of business and contracts where there are no historical
      losses or where past loss experience is not
  credible.●
              Bornheutter-Ferguson Paid Loss
      Method.    The Bornheutter-Ferguson paid loss
      method is a combination of the paid loss development method and the
      expected loss ratio method. The amount of losses yet to be paid is based
      upon the expected loss ratios. These expected loss ratios are modified to
      the extent paid losses to date differ from what would have been expected
      to have been paid based upon the selected paid loss development pattern.
      This method avoids some of the distortions that could result from a large
      development factor being applied to a small base of paid losses to
      calculate ultimate losses. This method will react slowly if actual loss
      ratios develop differently because of major changes in rate levels,
      retentions or deductibles, the forms and conditions of reinsurance
      coverage, the types of risks covered or a variety of other changes. The
      Company uses this method for lines of business and contracts where there
      are limited historical paid losses.●
              Bornheutter-Ferguson Reported
      Loss Method.    The Bornheutter-Ferguson
      reported loss method is similar to the Bornheutter-Ferguson paid loss
      method with the exception that it uses reported losses and reported loss
      development factors. The Company uses this method for lines of business
      and contracts where there are limited historical paid and reported
      losses.


Initially
selected expected loss ratios are used while the exposure is earning. We assign
payment and reporting patterns for attritional business to use with paid
development, incurred development, and paid and incurred Bornheutter-Ferguson
methods. We maintain an expected loss ratio through the exposure
earning period followed by selections of Bornheutter-Ferguson paid and
reported during intermediate reporting periods. Later, through the development,
we revert from Bornheutter-Ferguson paid and reported to paid and reported
development methods to fully reflect account exeperience. This entails a
reasonable evolution from initial expected loss ratios to full account
experience through a tempering phase of Bornheutter-Ferguson weightings. We
maintain a conservative bias toward the selection of Bornheutter-Ferguson paid
and reported methods on accounts with losses paid or reported earlier while
holding expected loss ratios on loss free accounts where no paid or reported
losses have yet occurred early in the account's maturation.





We reaffirm the validity of the
assumptions we use in the reserving process on a quarterly basis during our
internal review process. During this process, the Company’s actuaries verify
that the assumptions continue to form a sound basis for projection of
future liabilities.





Our critical underlying assumptions
are:





(i)
            the
      cedent’s business practices will proceed as in the past with no material
      changes either in submission of accounts or cash flow
      receipts;


(ii)
            case
      reserve reporting practices, particularly the methodologies used to
      establish and report case reserves, are unchanged from historical
      practices;


(iii)
            for
      the expected loss ratio method, ultimate losses vary proportionately with
      premiums;


(iv)
            historical
      levels of claim inflation can be projected into the
  future;


(v)
            in
      cases where benchmarks are used, they are derived from the experience of
      similar business; and


(vi)
            we
      form a credible initial expectation of the ultimate loss ratios
      through a review of pricing information supplemented by qualitative
      information on market events.





All of our critical assumptions can be
thought of as key assumptions in the sense that they can have a material impact
on the adequacy of our reserves. In general, the various actuarial techniques we
use assume that loss reporting and payment patterns in the future can be
estimated from past experience. To the extent that any of the above assumptions
is not valid, future payment and reporting patterns could differ from historical
experience. In practice it is difficult to be precise on the effect of each
assumption. However, due to a greater potential for estimation error, and thus
greater volatility, our reserves may be more sensitive to the effects of
deviations from assumptions (iv), (v) and (vi) than the other
assumptions.





Our reserving methodology, as discussed
above, uses a loss reserving model that calculates a point estimate for the
Company’s ultimate losses, as opposed to a methodology that develops a range of
estimates. The Company then uses this point estimate, deducting cumulative paid
claims and current case reserves, to record its estimate of IBNR. The Company
employs sensitivity analysis in selecting our point estimate, which involves
varying industry loss estimates for catastrophe events and estimated loss ratio
for non-catastrophe business.





Our reserve estimates for reported
catastrophe losses are based upon industry loss estimates and our modeled loss
scenarios. Because any catastrophe event loss reserve estimate is simply an
insurer’s estimate of its ultimate liability, and because there are numerous
factors which affect reserves but cannot be determined with certainty in
advance, our ultimate payments will vary, perhaps materially, from our initial
estimate of reserves. Therefore, because of these inherent uncertainties, we
have developed a reserving philosophy which attempts to incorporate prudent
assumptions and estimates in making our loss selection based on both the
potential for adverse development and historical experience among industry
participants. Our reserving philosophy does not include an explicit adjustment
to our point estimate of ultimate losses. There may be instances in the future
in which it would be beneficial to develop a range of estimates, but at present,
due to our short operating history, we have not found it necessary to do
so.





For
our non-catastrophe business, the key factors used to arrive at our best
estimate of loss and loss adjustment expense reserves are the expected loss
ratios, rate of loss cost inflation, selection of benchmarks and reported and
paid loss emergence patterns. Our reporting patterns and expected loss ratios
were based on either benchmarks or historical reporting patterns. The benchmarks
selected are those that we believe are most similar to our underwriting
business. There were no material changes in any of these key factors during the
year ended December 31, 2007.





Although we believe that we are prudent
in our assumptions and methodologies, we cannot be certain that our ultimate
payments will not vary, perhaps materially, from the estimates we have made. If
we determine that adjustments to an earlier estimate are appropriate, such
adjustments are recorded in the quarter in which they are identified. The
establishment of new reserves, or the adjustment of reserves for reported
claims, could result in significant upward or downward changes to our financial
condition or results of operations in any particular period. We regularly review
and update these estimates using the most current information available to
us.





During the year ended December 31,
2007, the significant losses on our catastrophe business were as follows; United
Kingdom floods in June and July of $38.0 million; European Windstorm
Kyrill of $32.4 million; New South Wales (Australia) floods of $18.5
million; $13.8 million for three satellite losses during 2007; and the Sydney
Hailstorm of $11.4 million.  Given the benign catastrophe activity
during the year ended December 31, 2006, the losses incurred on catastrophe
business were approximately $12.4 million. Because we expect a small volume
of large claims, we believe the variance of our catastrophe related loss ratio
could be relatively wide. Claims from catastrophic events could reduce our
earnings and cause substantial volatility in our results of operations for any
fiscal quarter or year which could adversely affect our financial condition and
liquidity position.




28
 Table of Contents




A significant component of our loss
ratio relates to non-catastrophe business for the years ended December 31,
2007 and 2006. As we commonly write net lines of non-catastrophe business
exceeding $10.0 million, we expect that the ultimate loss ratio for
non-catastrophe business can vary significantly from our initial loss ratios.
Thus, a 10% increase or decrease in loss ratios for non-catastrophe business is
likely to occur and, for the years ended December 31, 2007 and 2006, this
would have resulted in an approximate increase or decrease in our net income or
shareholders’ equity of approximately $6.3 million and $1.4 million,
respectively.





Our estimates are reviewed annually by
an independent actuary in order to provide additional insight into the
reasonableness of our loss reserves.





Premiums
and Acquisition Costs





We recognize premiums as revenue
ratably over the terms of the related contracts and policies. Our gross premiums
written are based on policy and contract terms and include estimates based on
information received from both insured and ceding companies. The information
received is typically in the form of bordereaux, broker notifications and/or
discussions with ceding companies or their brokers. This information can be
received on a monthly, quarterly or transactional basis and normally includes
estimates of gross premiums written (including adjustment premiums and
reinstatement premiums), net premiums earned, acquisition costs and ceding
commissions. Adjustment premiums are premiums due to either party when the
contract's subject premium is adjusted at expiration and is recorded
in subsequent periods.  Reinstatement premiums are premiums charged for the
restoration of a reinsurance limit of an excess of loss contract to its full
amount after payment of losses as a result of an occurrence.





We write treaty and facultative
reinsurance on either a non-proportional (also referred to as excess of loss)
basis or a proportional (also referred to as pro rata) basis.





We book premiums on excess of loss
contracts in accordance with the contract terms and earn them over the contract
period. Since premiums for our excess of loss contracts are usually established
with some certainty at the outset of the contract and the reporting lag for such
premiums is minimal, estimates for premiums written for these contracts are
usually not significant. The minimum and deposit premiums on excess of loss
contracts are usually set forth in the language of the contract and are used to
record premiums on these contracts. Actual premiums are determined in subsequent
periods based on actual exposures and any adjustments are recorded in the period
in which they are identified.





For pro rata contracts, gross premiums
written and related acquisition costs are normally estimated on a quarterly
basis based on discussions with ceding companies, together with historical
experience and management’s judgment. Premiums written on pro rata contracts are
earned over the risk periods of the underlying policies issued and renewed. As a
result, the earning pattern of pro rata contracts may extend up to
24 months. This is generally twice the contract period due to the fact that
some of the underlying exposures may attach towards the end of our contracts
(i.e., risks attaching basis), and such underlying exposures generally have a
one year coverage period. Total premiums written and earned on our pro rata
business for the year ended December 31, 2007 were $152.0 million
(26.3%), and $101.5 million (21.3%), respectively and were
$60.3 million (19.9%), and $36.9 million (19.2%), respectively for the
year ended December 31, 2006.  Total earned acquisition costs
estimated on pro rata contracts for the year ended December 31, 2007 and
2006 were $35.1 million (42.6%) and $11.2 million (37.4%),
respectively. On a quarterly basis, we track the actual premium received and
acquisition costs incurred and compare this to the estimates previously booked.
Such estimates are subject to adjustment in subsequent periods when actual
figures are recorded.





Acquisition costs, which are primarily
comprised of ceding commissions, brokerage, premium taxes, profit commissions
and other expenses that relate directly to the writing of reinsurance contracts
are expensed over the underlying risk period of the related contracts.
Acquisition costs relating to the unearned portion of premiums written are
deferred and carried on the balance sheet as deferred acquisition costs.
Deferred acquisition costs are amortized over the period of the related contract
and are limited to their estimated realizable value based on the related
unearned premiums, anticipated claims expenses and investment
income.





Reinstatement premiums are estimated
after the occurrence of a significant loss and are recorded in accordance with
the contract terms based upon the amount of loss reserves expected to be paid,
including IBNR. Reinstatement premiums are earned when written.





Investments





Prior to January 1, 2007,
investments were considered available-for-sale in accordance with SFAS No.
115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS
115”), and were carried at fair value with unrealized gains and losses recorded
in accumulated other comprehensive income. 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 early 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 commencing
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 has elected the fair value
option to simplify the accounting, as this election will reduce the burden of
monitoring differences between the cost and fair value of our investments,
including the assessment as to whether declines in value are temporary in nature
and, therefore, further removes an element of management judgment.





The election of SFAS 159 will not
change the carrying value of our fixed maturity investments, equity investments,
REITs, investment funds, catastrophe bonds, fixed income funds and derivative
instruments as they were previously carried at fair value.  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.




29
 Table of Contents




The difference as a result of the
election of the fair value option is in respect of the treatment of unrealized
gains and losses. Prior to January 1, 2007, unrealized gains and losses on
fixed maturity investments and equities were included within accumulated other
comprehensive income as a separate component of shareholders’ equity. On
January 1, 2007, a cumulative-effect adjustment was made to reclassify the
net unrealized losses from accumulated other comprehensive loss as at
December 31, 2006 into retained earnings in the amount of $4.0
million.  This adjustment represented the difference between the cost
or amortized cost of our investments and the fair value of those investments at
December 31, 2006.  Subsequent to January 1, 2007, any
movement in unrealized gains and losses is now recorded within net realized and
unrealized gains (losses) on investments within the consolidated statements
of operations and comprehensive income (loss). Investments are recorded on a
trade date basis and realized gains and losses on sales of investments continue
to be determined on a first-in, first-out basis. Net investment income includes
interest income on fixed maturity investments, recorded when earned, dividend
income on equity investments, recorded when declared, and the amortization of
premiums and discounts on investments.





The Company’s investments are
allocated between the levels as follows:




Fair Value Measurement at December 31, 2007,
  using:Quoted Prices
      in
              
              Significant
      Other
              
              Significant
      OtherFair
    Value
              
              Active
      Markets
              
              Observable
      Inputs
              
              Unobservable
      InputsMeasurements
              
              (Level
1)
              
              (Level
2)
              
              (Level
      3)($ in
      thousands)DescriptionFixed 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
      InvestmentsReal estate investment
      trusts
              
              
              12,204
              
              
              -
              
              
              12,204
              
              
              -Investment
funds
              
              
              31,249
              
              
              -
              
              
              20,041
              
              
              11,208Catastrophe
    bonds
              
              
              36,619
              
              
              -
              
              
              -
              
              
              36,619Fixed income
    fund
              
              
              212,982
              
              
              212,982
              
              
              -
              
              
              -293,054
              
              
              212,982
              
              
              32,245
              
              
              47,827Totals
              
              $
              1,500,132
              
              $
              764,064
              
              $
              688,241
              
              $
              47,827


The table above does not include an
equity investment of $0.1 million 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 at fair value under SFAS 159.


Fair
      Value Measurement at December 31, 2007,
  using:
 Quoted
      Prices in
                
                
                Significant
      Other
                
                
                Significant
      OtherFair
      Value
                
                
                Active
      Markets
                
                
                Observable
      Inputs
                
                
                Unobservable
      InputsMeasurements
                
                
                (Level
      1)
                
                
                (Level
      2)
                
                
                (Level
      3)($
      in thousands)DerivativesFuture
      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
                )


Share
Based Compensation





The Company accounts for share based
compensation in accordance with SFAS No. 123(R), “Share-Based Payment”
(“SFAS 123(R)”).  SFAS 123(R) requires entities to measure
the cost of services received from employees and directors in exchange for an
award of equity instruments based on the grant date fair value of the award. The
cost of such services will be recognized as compensation expense over the period
during which an employee or director is required to provide service in exchange
for the award.





The 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, PSUs may be granted to executive officers and
certain other key employees. The current series of PSUs vests over a period of
approximately three years and vesting is contingent upon the Company meeting
certain diluted return-on-equity goals. Future series of PSUs may be granted
with different terms and measures of performance.





Upon vesting, the existing PSU holders
will be entitled to receive a number of common shares of the Company (or the
cash equivalent, at the election of the Company) equal to the product of the
number of PSUs granted multiplied by a factor. The factor will range between
zero and 200%, depending on the diluted return-on-equity achieved during the
vesting period.







30
 Table of Contents




The grant date fair value of the common
shares underlying the PSUs was based on the following:
  ●
                369,000
      PSUs granted between December 20, 2005 and February 20, 2006
      valued at $10.00 on the grant date. The $10.00 valuation was based on the
      subscription price paid by investors in the private placement on
      December 20, 2005 and additional closings on February 1, 2006
      and February 23, 2006. The valuation was selected as the equity
      securities in the private placement are the same securities as those for
      which the fair value determination is being made and the transaction is a
      current transaction between willing
parties.
 ●
                344,000
      PSUs granted between April 1, 2006 and May 22, 2006 valued at
      $10.07. The fair value was determined by using the price to book value
      multiple of a group of comparable publicly traded reinsurers and adjusting
      it downward. In adjusting the price to book value multiple, we took into
      account that our common shares were relatively illiquid at the time of
      these PSU grants and the fact that these comparable reinsurers have longer
      track records, more mature infrastructures and more established franchises
      than us.
 ●
                672,000
      PSUs granted between January 1, 2007 and March 31, 2007 valued at
      $13.50. The fair value was determined by using the stock price of the IPO
      that occurred on March 30, 2007.●
                PSUs
      granted subsequent to our initial public offering were valued on the
      closing price of our common shares on the grant
  date.


We estimate the fair value of PSUs
granted under the PSU Plan on the date of grant using the grant date fair value
and the most probable diluted return-on-equity outcome and record the
compensation expense in our consolidated statement of operations over the course
of each three-year performance period. At the end of each quarter, we reassess
the projected results for each three-year performance period as our financial
results evolve. If we determine that a change in estimate is required, we
recalculate the compensation expense under the PSU Plan and reflect any
adjustments in the consolidated statements of operations in the period in which
they are determined.





The total number of PSUs outstanding
under the PSU Plan at December 31, 2007 and 2006 were 1,658,700 and
713,000, respectively (or up to 3,317,400 common shares at December 31, 2007,
should the maximum factor for each of the performance periods apply). Taking
into account the results to date and the expected results for the remainder of
the performance periods, we have established the most probable factor at 100%
and as such the expected number of common shares to be issued under the plan is
1,658,700 at December 31, 2007.  As at December 31, 2007 and
2006, there was a total of $11.9 million and $5.0 million, respectively, of
unrecognized compensation cost related to non-vested PSUs, the cost of which is
expected to be recognized over a period of approximately 2.1 years and 2.0
years, respectively.





The RSU Plan is the Company’s incentive
scheme for officers, employees and non-management directors. The Compensation
Committee has the authority to grant RSUs. Upon vesting, the value of an RSU
grant may be paid in common shares, in cash, or partly in cash and partly in
common shares at the discretion of the Compensation Committee. RSUs granted to
employees generally vest two years after the date of grant and RSUs granted to
directors vest on the date of grant. The Company estimates the fair value of
RSUs on the date of grant and records the compensation expense in its
consolidated statements of operations over the vesting period.





The grant date fair value of the common
shares underlying the RSUs granted during 2007 was determined by reference to
the closing share price effective at the date of grant.  The grant
date fair value of the common shares underlying the RSUs granted during 2006 was
determined by reference to the price to book value multiple of a group of
comparable publicly traded reinsurers with a longer track record, more mature
infrastructure and a more established franchise.





The total number
of RSUs outstanding under the RSU Plan as at December 31, 2007 and 2006
were 326,610 and 117,727, respectively. As at December 31, 2007 and 2006,
there was a total of $1.3 million and $0.5 million, respectively, of
unrecognized compensation cost related to non-vested RSUs, the cost of which is
expected to be recognized over a period of approximately 0.9 years and 1.5
years, respectively.





New
Accounting Pronouncements




In December 2007, the FASB issued SFAS
No. 141 (revised 2007) “Business Combinations” (“SFAS 141(R)”).  SFAS
141(R) improves reporting by creating greater consistency in the accounting and
financial reporting of business combinations, resulting in more complete,
comparable, and relevant information for investors and other users of financial
statements. To achieve this goal, the new standard requires the acquiring entity
in a business combination to recognize all (and only) the assets acquired and
liabilities assumed in the transaction; establishes the acquisition-date fair
value as the measurement objective for all assets acquired and liabilities
assumed; and requires the acquirer to disclose to investors and other users all
of the information needed to evaluate and understand the nature and financial
effect of the business combination.  SFAS 141(R) applies
prospectively to business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008. An entity may not apply it before that date. The effective
date of this Statement is the same as that of the related FASB SFAS No. 160
“Non-controlling Interests in Consolidated Financial Statements - an amendment
of ARB No. 51” (“SFAS 160”). We are currently assessing the impact of the
adoption of this Statement on our results and financial position.




In December 2007, the FASB issued
SFAS 160 which improves the relevance, comparability, and transparency of
financial information provided to investors by requiring all entities to report
non-controlling (minority) interests in subsidiaries as equity in the
consolidated financial statements. Moreover, SFAS 160 eliminates the diversity
that currently exists in accounting for transactions between an entity and
non-controlling interests by requiring they all be treated as equity
transactions. SFAS 160 is effective for financial statements issued for
fiscal years beginning after December 15, 2008 and interim periods within
those fiscal years, and early adoption is prohibited.  If SFAS 160 was
adopted as of December 31, 2007, the $184.8 million of minority interest would
be reclassified as a separate component of shareholders’ equity.




Recent
Developments




Imperial
Reinsurance Company Limited




On March 6, 2008, the Company signed an agreement to subscribe to a majority
stake (65%) in Imperial Reinsurance Company Limited (“Imperial
Re”).
The transaction is subject to regulatory approvals and closing conditions and is
expected to close in the second quarter of 2008. The subscription amount, to be
determined upon completion of Imperial Re’s
audited financial statements, will be approximately $20.8 million.




Imperial Re is domiciled in South Africa and writes multiple lines of
reinsurance in sub-Saharan Africa. The Company believes that its capital
and technical support will enhance Imperial Re’s
services, increase its market penetration and broaden its product distribution
within Africa.




Results
of Operations





The following is a discussion and
analysis of our financial condition as at December 31, 2007 and 2006 and our
results of operations for the years ended December 31, 2007 and 2006 and the
period October 4, 2005 through December 31, 2005. All amounts in the following
tables are expressed in thousands of U.S. dollars.





We generated $167.9 million of net
income in 2007, compared to net income of $152.3 million and a net loss of $12.4
million in 2006 and 2005, respectively. As a result of our net income in 2007,
our diluted book value per share plus accumulated dividends increased to $13.95,
an increase of 16.8% from the amount at December 31, 2006. As a result of our
net income in 2006, our diluted book value per share increased to $11.94, a
21.1% increase from the amount at December 31, 2005.





As highlighted in the table below, the
three most significant items impacting our 2007 financial performance compared
to 2006 and 2005 include: (1) an increase in our net premiums earned,
principally resulting from the growth in business by increased participation on
programs from our existing clients and the addition of new clients due to our
increased capital base and growth in our franchise; (2) an increase in loss and
loss adjustment expenses in 2007 impacted by Windstorm Kyrill, U.K. floods and
New South Wales storms versus light catastrophe activity in 2006;
and  (3) a significant increase in investment income due to higher
average invested assets from the generation of cash flows from operations and
financing activities.




31
 Table of Contents




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
Item 8, Note 2 to the consolidated financial statements in the
Company’s financial statements for a discussion on translation of foreign
currencies.




2007
                
                2006
                
                2005($
      in thousands, except per share amounts and percentages)Highlights:Gross
      premiums written
                
                $
                577,150
                
                
                $
                302,489
                
                
                $
                -Net
      premiums written
                
                
                527,031
                
                
                
                282,498
                
                
                
                -Net
      premiums earned
                
                
                477,137
                
                
                
                192,063
                
                
                
                -Loss
      and loss adjustment expenses
                
                
                (192,859
                )
                
                
                (26,660
                )
                
                
                -Acquisition
      costs
                
                
                (82,292
                )
                
                
                (29,939
                )
                
                
                -General
      and administrative expenses
                
                
                (72,461
                )
                
                
                (34,741
                )
                
                
                (13,013
                )Net
      investment income
                
                
                73,808
                
                
                
                34,212
                
                
                
                629Net
      realized and unrealized gains - investments
                
                
                17,174
                
                
                
                10,304
                
                
                
                -Net
      realized and unrealized gains - other
                
                
                (9,821
                )
                
                
                1,943
                
                
                
                -Other
      income
                
                
                5,811
                
                
                
                6,099
                
                
                
                -Interest
      expense
                
                
                (18,677
                )
                
                
                (4,648
                )
                
                
                -Net
      foreign exchange gains
                
                
                5,289
                
                
                
                2,079
                
                
                
                -Provision
      for income tax
                
                
                (783
                )
                
                
                (128
                )
                
                
                -Minority
      interest
                
                
                (35,794
                )
                
                
                -
                
                
                
                -Net
      income (loss)
                
                
                167,922
                
                
                
                152,338
                
                
                
                (12,384
                )Comprehensive
      income (loss)
                
                
                175,867
                
                
                
                147,810
                
                
                
                (12,384
                )Total
      Assets
                
                
                2,103,773
                
                
                
                1,144,502
                
                
                
                548,356Total
      Shareholders’ Equity
                
                
                1,210,485
                
                
                
                864,519
                
                
                
                547,634Per
      share dataNet
      income (loss) per common share outstanding—Basic
                
                
                2.05
                
                
                
                2.17
                
                
                
                (0.22
                )Net
      income (loss) per common share outstanding—Diluted
                
                
                2.05
                
                
                
                2.16
                
                
                
                (0.22
                )Dividends
      declared per common share
                
                
                0.08
                
                
                
                -
                
                
                
                -Basic
      book value per common share
                
                
                14.17
                
                
                
                12.08
                
                
                
                9.91Basic
      book value per common share adjusted for dividends (1)
                
                
                14.25
                
                
                
                12.08
                
                
                
                9.91Diluted
      book value per common share
                
                
                13.87
                
                
                
                11.94
                
                
                
                9.86Diluted
      book value per common share adjusted for dividends (1)
                
                
                13.95
                
                
                
                11.94
                
                
                
                9.86Key
      RatiosLoss
      ratio(2)
                
                
                40.4
                %
                
                
                13.9
                %
                
                
                0.0
                %Acquisition
      cost ratio(3)
                
                
                17.2
                %
                
                
                15.6
                %
                
                
                0.0
                %General
      and administrative expense ratio(4)
                
                
                15.2
                %
                
                
                18.1
                %
                
                
                0.0
                %Combined
      ratio(5)
                
                
                72.8
                %
                
                
                47.6
                %
                
                
                0.0
                %(1)
      Basic book value per common share is calculated by dividing common
      shareholders’ equity by the sum of common shares outstanding plus vested
      RSUs outstanding. Diluted book value per common share is calculated
      by dividing common shareholders’ equity by the sum of common shares
      outstanding, RSUs outstanding and PSUs outstanding.(2)
      The loss ratio is calculated by dividing loss and loss adjustment expenses
      (including estimates for IBNR losses) by net premiums
    earned.(3)
      The acquisition cost ratio is calculated by dividing acquisition costs by
      net premiums earned.(4)
      The general and administrative expense ratio is calculated by dividing
      general and administrative expenses by net premiums
earned.(5)
      The combined ratio is the sum of the loss, acquisition cost and
      general and administrative expense ratios.




32
 Table of Contents




Comparison
of Years Ended December 31, 2007 and 2006
  Gross
Premiums Written
 
 Details of gross premiums written by
line of business and by geographic area of risk insured are provided
below:
 Year
      Ended December 31, 2007
                
                
                Year
      Ended December 31, 2006Gross
      premiums written
                
                Percentage
      of total
                
                Gross
      premiums written
                
                Percentage
      of total($ in thousands)Line of
      businessProperty
      catastrophe
                
                $
                411,566
                
                
                
                71.3
                %
                
                $
                219,102
                
                
                
                72.4
                %Property
                
                
                94,503
                
                
                
                16.4
                %
                
                
                56,417
                
                
                
                18.7
                %Short-tail
      specialty and casualty
                
                
                71,081
                
                
                
                12.3
                %
                
                
                26,970
                
                
                
                8.9
                %Total
                
                $
                577,150
                
                
                
                100.0
                %
                
                $
                302,489
                
                
                
                100.0
                %Year
      Ended December 31, 2007
                
                
                Year
      Ended December 31, 2006Gross
      premiums written
                
                Percentage
      of total
                
                Gross
      premiums written
                
                Percentage
      of total($ in thousands)Geographic area of risk
      insured(1)North
      America
                
                $
                297,928
                
                
                
                51.6
                %
                
                $
                160,384
                
                
                
                53.0
                %Worldwide
      risks(2)
                
                
                99,365
                
                
                
                17.2
                %
                
                
                37,815
                
                
                
                12.5
                %Europe
                
                
                79,894
                
                
                
                13.8
                %
                
                
                45,737
                
                
                
                15.1
                %Caribbean
                
                
                48,103
                
                
                
                8.3
                %
                
                
                10,291
                
                
                
                3.4
                %Japan
      and Australasia
                
                
                39,547
                
                
                
                6.9
                %
                
                
                31,690
                
                
                
                10.5
                %Other
                
                
                12,313
                
                
                
                2.2
                %
                
                
                16,572
                
                
                
                5.5
                %Total
                
                $
                577,150
                
                
                
                100.0
                %
                
                $
                302,489
                
                
                
                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.





Gross premiums written were primarily
driven by excess of loss reinsurance contracts, generally with a twelve-month
term, which for the years ended December 31, 2007 and 2006 accounted for $392.3
million (68.0% of gross premiums written) and $242.2 million (80.1% of
gross premiums written), respectively. Gross premiums written relating to Island
Heritage primarily relate to a select property insurance portfolio in the
Caribbean region.  For the year ended December 31, 2007, gross premiums
written from Island Heritage were $32.9 million and were classified as property
catastrophe premiums in the line of business table above.  Renewal
dates for reinsurance business tend to be concentrated at the beginning of
quarters, and the timing of premiums written varies by line of business. Most
property catastrophe business is written in the January 1, April 1,
June 1 and July 1 renewal periods, while the property lines and the
short-tail specialty and casualty lines are written throughout the
year.





Our property catastrophe business is
primarily on an excess of loss basis. Our property business and our short-tail
specialty and casualty business are on both an excess of loss and a pro rata
basis. See Item 1, “Business—Reinsurance Products and Operations—Reinsurance
Products”.





Property
Catastrophe Reinsurance





Our property catastrophe reinsurance
contracts provide protection for most catastrophic losses that are covered in
the underlying insurance policies written by our ceding company clients.
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, 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.





For the years ended December 31,
2007 and 2006, gross property catastrophe premiums written were $411.6
million and $219.1 million, respectively, comprising business written on
the key renewal dates of January 1, April 1, June 1 and
July 1.  The $192.5 million (87.8%) increase in property
catastrophe premiums written during 2007 was primarily due to the increased
participation on programs from our existing clients, the addition of new clients
due to our increased capital base, growth in our franchise and the acquisition
of the controlling interest in Island Heritage in July 2007 which resulted in
the inclusion of $32.9 million in gross premiums for the year ended December 31,
2007.





For the year ended December 31, 2006,
premiums included $10.1 million of assumed premiums written specifically
for Mont Fort.  With effect from January 12, 2007, the results of Mont
Fort are consolidated in the Company’s consolidated financial statements, and
therefore, assumed premiums relating to Mont Fort during the year ended December
31, 2007 have been eliminated with the consolidation of Mont Fort’s results into
the Company’s consolidated financial statements. Premiums ceded to Mont Fort
which have been eliminated with the consolidation for the year ended December
31, 2007 were $37.0 million.





During the years ended
December 31, 2007 and 2006, the Company recorded $10.4 million and
$0.7 million of gross reinstatement premiums.  In 2007, the
reinstatement premiums were primarily attributable to European Windstorm Kyrill
and the U.K. floods.  In 2006, the lack of gross reinstatement
premiums was due to low catastrophe activity during the period.





Property
Reinsurance





Property reinsurance contracts are
written on a pro rata basis and a 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.





Premiums written during the years ended
December 31, 2007 and 2006 were $94.5 million and $56.4 million,
respectively, which was primarily driven by pro rata contracts in the amount of
$83.8 million and $41.9 million, respectively.  This increase of
$38.1 million during 2007, or 67.5%, was primarily driven by an increased
participation on existing accounts as well as new proportional
accounts.




33
 Table of Contents




During the year ended December 31,
2007, the Company recorded $0.9 million of gross reinstatement premiums
compared to $nil recorded for the year ended December 31, 2006.  In 2006,
the lack of gross reinstatement premiums was due to low catastrophe activity
during the period.





Short-tail
Specialty and Casualty Reinsurance





Short-tail specialty and casualty
reinsurance is comprised of reinsurance programs such as aviation, energy,
accident and health, workers compensation catastrophe, satellite and marine.
Most short-tail specialty and casualty reinsurance is written with loss
limitation provisions.





Premiums written during the years ended
December 31, 2007 and 2006 were $71.1 million and $27.0 million,
respectively.  The increase of $44.1 million during 2007,
or 163.6%, was primarily driven by increased participation on existing
accounts and expansion of our client base, mainly in the marine and aviation
programs.





During the year ended December 31,
2007, we recorded $2.6 million of gross reinstatement premiums compared to $nil
recorded for the year ended December 31, 2006.  The reinstatement premiums
in the year ended December 31, 2007 were primarily attributable to aviation and
marine contracts.





Premiums
Ceded





Due to the potential volatility of our
reinsurance contracts, especially our property catastrophe reinsurance contracts
which we sell, we purchase reinsurance to reduce our exposure to large losses
and as part of our overall risk management process.  To the extent
that appropriately priced coverage is available, we anticipate use of
reinsurance to reduce the financial impact of large losses on our results and to
optimize our overall risk profile. We segment our reinsurance purchases into the
following areas – common account reinsurance purchased mutually on behalf of our
needs and the client’s needs on specific treaties, business written with the
intent to cede directly to our sidecar facility, and opportunistic and core
purchases.





Reinsurance premiums ceded for the
years ended December 31, 2007 and 2006 were $50.1 million (8.7% of gross written
premiums) and $20.0 million (6.6% of gross written premiums),
respectively.





For the year ended December 31, 2007,
the Company purchased common account reinsurance of $3.5 million and purchased
$27.1 million of opportunistic and core reinsurance protection to optimize our
overall risk profile. In addition, the acquisition of the controlling interest
in Island Heritage resulted in the inclusion of $19.5 million in our ceded
premiums for the year.





In 2006, the primary component was
attributable to premiums ceded to our sidecar facility, Mont Fort, of
$15.1 million. Through Mont Fort, we participated in reinsurance
opportunities that otherwise would be outside or in excess of our own
exposure limits, which provides additional capacity typically in times of market
dislocations where capacity for a given risk is in short supply.  With
effect from January 12, 2007, the results of Mont Fort are consolidated in the
Company’s consolidated financial statements, and therefore, premiums ceded to
Mont Fort during the year ended December 31, 2007 have been eliminated with the
consolidation of Mont Fort’s results into the Company’s consolidated financial
statements.





As the Company grows its book of
business, the need for additional retrocessional coverage will also
grow.  We will continue to assess the need for retrocessional coverage
and may purchase additional coverage in future periods.





Net
Premiums Earned





We write the majority of our business
on a losses occurring basis. A “losses occurring” contract covers claims
arising from loss events that occur during the term of the reinsurance contract,
although not necessarily reported during the term of the contract. The premium
from a losses occurring contract is earned over the term of the contract,
usually twelve months. In contrast, a “risks attaching” contract covers claims
arising on underlying insurance policies that incept during the term of the
reinsurance contract. The premium from a risks attaching contract generally is
earned over a period longer than twelve months.





Net premiums earned for the years ended
December 31, 2007 and 2006 were $477.1 million and $192.1 million,
respectively. The increase of $285.0 million, during 2007, or 148.4%, is
primarily due to the increased levels of net premiums written over the last
twelve months, and the acquisition of the controlling interest in Island
Heritage in July 2007 which resulted in the inclusion of $12.9 million in net
premiums earned for the year ended December 31, 2007.  The large
difference between net premiums written and net premiums earned during the years
ended December 31, 2007 and 2006 reflects the fact that most of our
contracts are written on an annual basis, with the premiums earned over the
course of the contract period. The majority of our business is written at the
January 1, April 1, June 1 and July 1 renewal periods and
therefore it is reasonable to anticipate that the earned premiums would
generally increase over the course of the fiscal year as premiums written in
earlier months are increasingly earned.





Underwriting
Results





The underwriting results of a
reinsurance company are often measured by reference to its loss ratio and
expense ratios. The loss ratio is calculated by dividing loss and loss
adjustment expenses (including estimates for IBNR losses) by net premiums
earned. The two components of the expense ratio may be expressed as separate
ratios, the acquisition cost ratio and the general and administrative expense
ratio.  The acquisition cost ratio is calculated by dividing acquisition
costs by net premiums earned.  The general and administrative expense
ratio is calculated by dividing general and administrative expenses by net
premiums earned.  The combined ratio is the sum of these three
ratios.





Our combined ratio and components
thereof are set out below for the years ended December 31, 2007 and
2006:




Year
      Ended
                
                Year
      EndedDecember
      31, 2007
                
                December
      31, 2006Loss
      ratio
                
                
                40.4
                %
                
                
                13.9
                %Acquisition
      cost ratio
                
                
                17.2
                %
                
                
                15.6
                %General
      and administrative expense ratio
                
                
                15.2
                %
                
                
                18.1
                %Combined
      ratio
                
                
                72.8
                %
                
                
                47.6
                %


See the discussion below for an
explanation of the fluctuations in these ratios.




34
 Table of Contents




a.
            Loss
      and loss adjustment expenses





Loss and loss adjustment expenses are
comprised of three main components:





●
            losses
      paid, which are actual cash payments to insureds, net of recoveries, if
      any, from our own reinsurers;


●
            movement
      in outstanding loss or case reserves, which represent the change in
      management’s best estimate of the likely settlement amount for reported
      claims, less the portion that can be recovered from reinsurers;
      and


●
            movement
      in IBNR reserves, which are reserves established by us for claims that are
      not yet reported but can reasonably be expected to have occurred based on
      industry information, management’s experience and actuarial evaluation,
      less expected recoveries from reinsurers, if
  any.





The portion recoverable from our
reinsurers is deducted from the gross estimated loss and loss adjustment
expenses in the statement of operations.





The increase in the loss ratio of 26.5%
in 2007 is as a result of the catastrophe events that occurred in 2007
(described below) compared to the light insured catastrophe activity experienced
in 2006.





Loss and loss adjustment expenses for
the years ended December 31, 2007 and 2006 were $192.9 million and
$26.7 million, respectively. The components of loss and loss adjustment
expenses of $192.9 million for the year ended December 31, 2007
include $39.6 million paid losses and our actuaries’ estimate of case
reserves and IBNR on premiums earned to date of $153.3 million. The change
in the case reserves and IBNR of $153.3 million includes the following key
loss events: $32.4 million for losses from Windstorm Kyrill in January
2007; $38.0 million for United Kingdom flood losses in June and July 2007; $18.5
million for New South Wales (Australia) flood losses in June 2007; $13.8 million
for three satellite losses during 2007; and $11.4 million for the Sydney
(Australia) hailstorm in December 2007.





The components of loss and loss
adjustment expenses of $26.7 million for the year ended December 31,
2006 include $4.2 million paid losses and our actuaries’ estimate of case
reserves and IBNR on premiums earned to date of $22.5 million reflecting
the low insured catastrophe activity for the period.





Because of our short operating history,
our loss experience is limited and reliable evidence of changes in trends of
numbers of claims incurred, average settlement amounts, numbers of claims
outstanding and average losses per claim will necessarily take years to develop.
A significant portion of our business is property catastrophe reinsurance and
other classes of reinsurance with high attachment points of coverage. Attachment
points refer to the dollar amount of loss above which excess of loss reinsurance
becomes operative. Reserving for losses in such programs is inherently
complicated in that losses in excess of the attachment level of our policies are
characterized by high severity and low frequency. In addition, as a broker
market reinsurer, we must rely on loss information reported to such brokers by
primary insurers who must estimate their own losses at the policy level, often
based on incomplete and changing information. See “—Critical
Accounting Policies—Loss and Loss Adjustment Expense Reserves” and Item 1A, “Risk Factors—Risks Related
to the Company.”If we underestimate our loss reserves, so that they are inadequate to
cover our ultimate liability for losses, the underestimation could materially
adversely affect our financial condition and results of operations.





b.
            Acquisition
      costs





For the years ended December 31, 2007
and 2006, acquisition costs were $82.3 million and $29.9 million, respectively,
representing an increase of 174.9%.  Acquisition costs consist
principally of ceding commissions, brokerage, premium taxes, profit commissions
and other expenses that relate directly to the writing of reinsurance
contracts.  Acquisition costs are driven by contract terms and are
generally determined based upon a set percentage of premiums. Acquisition costs
are expensed over the period of their related contracts.  The
acquisition cost ratio has increased 1.6% from 2006 due to increased levels of
proportional contracts written in 2007 which typically have higher levels of
acquisition costs.





The acquisition of the controlling
interest in Island Heritage in July 2007 resulted in the inclusion of $6.4
million in acquisition costs for the year ended December 31, 2007.





c.
            General
      and administrative expenses





General and administrative expenses
consist primarily of salaries, benefits, and related costs, including costs
associated with our PSU and RSU Plans and other general operating expenses.
General and administrative expenses for the years ended December 31, 2007
and 2006 were $72.5 million (15.2% general and administrative expense ratio) and
$34.7 million (18.1% general and administrative expense ratio),
respectively.  The increase of $37.8 million during 2007,
or 108.6%, is principally due to expenses related to the increase in
staffing levels as we continue to build our global platform and associated
general operating expenses. In addition, $3.5 million of expenses for 2007
resulted from the inclusion of Island Heritage from July 1, 2007
onwards.  Because the growth in our net premiums earned has outpaced
the growth in our general and administrative expenses, the general and
administrative expense ratio has decreased 2.9% from 2006.





Interest
Expense





Interest expense was $18.7 million for
the year ended December 31, 2007 compared to $4.6 million for the year
ended December 31, 2006. Interest expense primarily consists of interest due on
our subordinated debt securities and the amortization of debt offering
expenses.  The primary reason for the increase is that the first
debt issuances of $120.0 million and €13.0 million occurred in August 2006,
resulting in only five months of interest expense in 2006.  During
2007, the Company incurred twelve months of interest expense on the debt
contracted in 2006 and interest expense on the additional debt offerings of
$100.0 million and $25.0 million which occurred in June and September 2007,
respectively.





Foreign
Exchange





For the year ended December 31, 2007,
we experienced net foreign exchange gains of $5.3 million compared to net
foreign exchange gains of $2.1 million for the year ended December 31, 2006. For
both years,  the net gains were principally a result of gains on net
monetary assets denominated in foreign currencies which generally appreciated
against the Company’s functional currency. The Company’s policy is to hedge the
majority of its foreign currency exposures with derivative instruments such as
foreign currency swaps and forward contracts.





The Company has entered into certain
foreign currency forward contracts that are 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 were recorded in other comprehensive income as part of the
cumulative translation adjustment, to the extent that it is effective as a
hedge.  The Company designated $264.4 million of foreign currency
forwards contractual value as hedges, which had a fair value of $(3.4) million
as of December 31, 2007.  All other derivatives are not designated as
hedges, and accordingly, the realized and unrealized gains and losses are
included in “Net realized gains
and losses —investments” and “—other” in the
consolidated financial statements.  There were no derivatives
designated as hedges as of December 31, 2006.




35
 Table of Contents




Investment
Results





The total return on our investment
portfolio comprises investment income and realized and unrealized gains and
losses on investments. For the year ended December 31, 2007, the total return
was $91.0 million, compared to $44.5 million for the year ended December 31,
2006.  The increase of 104.4% during 2007 is primarily due to
increased investment income resulting from our higher average invested assets in
our portfolio, net positive performance of the relevant markets (such as fixed
income and equitites) during 2007, offset by our net realized and unrealized
losses on our foreign currency forward positions.





The Company’s overall fixed maturities
strategy, established by the Finance Committee of the Board of Directors and
executed by a combination of internal investment professionals and external
investment managers, is to match appropriate indices after fees and trading
costs, including taxes. Our investment managers generally manage the interest
rate risk associated with holding fixed maturity investments by actively
managing the average duration of the portfolio to achieve an adequate total
return without subjecting the portfolio to an unreasonable level of interest
rate risk. Our principal fixed maturity measurement index is the Lehman
Aggregate Index. Our principal index for inflation-protected securities is the
Treasury Inflation-Protected Securities (“TIPS”) Index and our principal
short-term portfolio index is 3-month LIBOR. We continue to refine and develop
our investment strategy. Substantially all of our fixed maturity securities
consisted of investment grade securities. As at December 31, 2007, the
average credit rating, provided by a recognized national rating agency, of our
fixed maturity portfolio is AA+ with an average duration of
3.2 years.




a.
            Net
      investment income




Net investment income for the year
ended December 31, 2007 was $73.8 million, compared to $34.2 million for the
year ended December 31, 2006, an increase of 115.7% from the prior
year.  Investment income is principally derived from interest and
dividends earned on investments, partially offset by investment management fees
and fees paid to our custodian bank.  The components of net investment
income are set forth below:




Year
      Ended
                
                Year
      EndedDecember
      31, 2007
                
                December
      31, 2006($
      in thousands)Interest
      and dividend incomeCash
      and cash equivalents
                
                $
                12,911
                
                
                $
                18,176Fixed
      maturities
                
                
                45,830
                
                
                
                13,380Short
      term
                
                
                150
                
                
                
                3,440Equity
      investments
                
                
                308
                
                
                
                381Other
      investments
                
                
                7,456
                
                
                
                -Amortization
      incomeCash
      and cash equivalents
                
                
                -
                
                
                
                11Fixed
      maturities
                
                
                8,128
                
                
                
                (155
                )Short
      term
                
                
                102
                
                
                
                -Other
      investments
                
                
                -
                
                
                
                27Investment
      expenses
                
                
                (1,077
                )
                
                
                (1,048
                )Net
      investment income
                
                $
                73,808
                
                
                $
                34,212


Net investment income increased by
$39.6 million in 2007 compared to 2006 principally due to an increase in
interest and dividend income due to the growth on our cash and fixed maturities
portfolio, dividends from other investments and the increase in amortization
income on our TIPS due to the significant increase in the inflation index during
the year. The increase in invested assets is due to positive cash flows from our
operating and financing activities (receipt of net proceeds in April 2007 of
$168.7 million from our IPO and $123.6 million of net debenture proceeds) which
we deployed into our invested assets.





b.
            Net
      realized and unrealized gains and losses –
  investments





Our investment portfolio is structured
to preserve capital and provide us with a high level of liquidity and is managed
to produce a total return. In assessing returns under this approach, we include
investment income and realized and unrealized gains and losses generated by the
investment portfolio. As a result, there can be significant changes in the
levels of our net realized and unrealized gains and losses from year to
year.




Effective January 1, 2007, we early
adopted SFAS 159 with respect to our investment portfolio. The impact is that
all subsequent changes in the fair value of our investment portfolio have been
recorded as net realized and unrealized gains and losses in our statement of
operations.




Net realized and unrealized gains and
losses on our investment portfolio amounted to a $17.2 million gain for the year
ended December 31, 2007 compared to a $10.3 million gain for the year ended
December 31, 2006. These amounts comprise net realized and unrealized gains and
losses on our fixed maturities and equities portfolios, on our investment
portfolio of derivatives including global equity, global bond, commodity and
real estate futures, TBA securities, interest rate swaps and total return
swaps.




36
 Table of Contents


The following table is the breakdown of
net realized and unrealized gains and losses - investments in the consolidated
statements of operations into its various components:


Year
      Ended
                
                Year
      EndedDecember
      31, 2007
                
                December
      31, 2006($
      in thousands)Net
      realized losses on fixed maturities
                
                $
                (7,252
                )
                
                $
                (1,274
                )Net
      unrealized gains on fixed maturities
                
                
                15,069
                
                
                
                -Net
      realized gains on equities
                
                
                9,362
                
                
                
                2,207Net
      unrealized gains on equities
                
                
                346
                
                
                
                -Net
      realized and unrealized (losses) gains on derivative
      instruments
                
                
                (983
                )
                
                
                8,382Net
      realized and unrealized gains on other investments
                
                
                632
                
                
                
                989Total
      net realized and unrealized gains - investments
                
                $
                17,174
                
                
                $
                10,304


Net realized and unrealized gains on
fixed maturities of $7.8 million for the year ended December 31, 2007 were
primarily due to the positive impact of declining interest rates over
the year on our portfolio offset by realized losses on disposals of fixed
maturities.




Net realized and unrealized gains on
equities of $9.7 million for the year ended December 31, 2007 were due primarily
to an $8.7 million gain on the disposal of an exchange traded fund during the
year.





The following table is a breakdown of
the realized and unrealized gains and losses on derivatives:




Year
      Ended
                
                Year
      EndedDecember
      31, 2007
                
                December
      31, 2006($
      in thousands)Futures
      contracts
                
                $
                4,416
                
                
                $
                8,516Swap
      contracts
                
                
                (4,590
                )
                
                
                -Mortgage-backed
      securities TBA
                
                
                (809
                )
                
                
                (134
                )Realized
      and unrealized (losses) gains on derivatives
                
                $
                (983
                )
                
                $
                8,382


The Company enters into investment
portfolio derivatives including global equity, global bond, commodity and real
estate futures, TBAs, total return swaps and interest rate swaps. The Company
enters into index futures contracts and total return swaps to gain or reduce its
exposure to an underlying asset or index. The Company also purchases TBAs as
part of its investing activities. The Company enters into interest rate swaps in
order to manage portfolio duration and interest rate risk. The Company manages
the exposure to these instruments based on guidelines established by management
and approved by the Board of Directors. The decrease in net realized and
unrealized losses and gains on derivatives in 2007 was due to the poor
performance of our swap contracts which had exposure to the real estate market
and to the lower performance in 2007 of equity markets compared to 2006 which
affected our net gains on futures contracts.





c.
            Net
      realized and unrealized gains and losses –
other





The Company also enters into derivative
instruments such as foreign currency forward contracts, interest rate
and  currency swaps on our subordinated debt in order to manage its
foreign currency exposure and interest rate risk.  In addition, the
Company enters into reinsurance transactions that are structured as
derivatives.





Net realized and unrealized gains and
losses-other amounted to a $9.8 million loss for the year ended December 31,
2007 compared to a $1.9 million gain for the year ended December 31, 2006. These
amounts comprise net gains and losses on foreign currency forward contracts,
interest rate and currency swaps on our subordinated debt and on reinsurance
derivatives.





The following table is the breakdown of
net realized and unrealized gains and losses—other in the
consolidated statements of operations into its various components:




Year
      Ended
                
                Year
      EndedDecember
      31, 2007
                
                December
      31, 2006($
      in thousands)Swap
      contracts
                
                $
                2,446
                
                
                $
                1,035Foreign
      currency forward contracts
                
                
                (14,016
                )
                
                
                543Reinsurance
      derivatives
                
                
                1,749
                
                
                
                365Realized
      and unrealized (losses) gains on derivatives
                
                $
                (9,821
                )
                
                $
                1,943


We use currency swaps and foreign
currency forwards to economically hedge the currency exposure of the Company’s
investment in foreign subsidiaries, primarily our Swiss subsidiary, and to hedge
operational balances such as premiums receivable, loss reserves and the portion
of our long term debt issued in Euros. The losses on foreign currency forwards
were due to the continued weakening of the U.S. dollar against other major
currencies.





We
entered into interest rate swaps during 2007 to convert the interest on our long
term debt from floating to fixed.  Reinsurance derivatives relate to
reinsurance arrangements that are structured as derivative transactions and the
movement for the year ended December 31, 2007 is due to new contracts being
entered into during 2007 offset by the earning of the 2006
contracts.




37
 Table of Contents




Other
Income





During the year ended December 31,
2007, other income was $5.8 million, compared to $6.1 million during the year
ended December 31, 2006.  Other income for 2007 includes earned
revenue relating to upfront commitment fees on reinsurance contracts, ceding
commissions earned by Island Heritage, which was consolidated from July 1, 2007
onwards, and other fee income.  Other income for 2006 primarily
consisted of fees from Mont Fort (management, performance fees and ceding
commissions).  With effect from January 12, 2007, the results of Mont
Fort were consolidated in the Company’s consolidated financial statements, and
therefore fee income of $8.5 million relating to Mont Fort during 2007 has
been eliminated with the consolidation of Mont Fort’s results into the Company’s
consolidated financial statements.





Minority
Interest





From January 12, 2007, the Company
consolidated Mont Fort, in accordance with the provisions of FIN 46(R). As such,
the results of Mont Fort are included in the Company’s consolidated
financial statements and the portions of Mont Fort’s net income and
shareholders’ equity attributable to the preferred shareholders are recorded in
the consolidated financial statements of the Company as minority
interest.  In relation to Mont Fort, the Company recorded a minority
interest expense of $33.6 million for the year ended December 31,
2007.





On July 3, 2007, the Company purchased
73,110 shares (representing a 21.4% interest) in Island Heritage for a purchase
price of $12.6 million. Island Heritage is 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.   With
this acquisition, the Company took a controlling interest in Island Heritage by
increasing its interest to 54.6% of the voting shares.   The
Company’s share of Island Heritage’s results from operations was recorded in the
Company’s consolidated financial statements under the equity method of
accounting through June 30, 2007. As a result of the acquisition of this
controlling interest, the results of operations of Island Heritage have been
included in the Company’s consolidated financial statements from July 1, 2007,
with the portions of Island Heritage’s net income and shareholders’ equity
attributable to minority shareholders recorded as minority interest in the
Company’s consolidated financial statements.  In relation to Island
Heritage, the Company recorded a minority interest expense of $2.2 million for
the year ended December 31, 2007.





Income
Tax Expense





The Company has subsidiaries that
operate in various other jurisdictions around the world that are subject to tax
in the jurisdictions in which they operate. The significant jurisdictions in
which the Company’s subsidiaries are subject to tax are Canada, India,
Switzerland, USVI and the United Kingdom.  However since the majority
of our income is currently earned in Bermuda where we are exempt from income
tax, the tax impact to date has been minimal.  During the year ended
December 31, 2007, income tax expense was $0.8 million compared to $0.1 million
for the year ended December 31, 2006.  The increase of $0.7 million is
primarily attributable to higher taxable income in jurisdictions around the
world that are subject to tax as well as the acquisition of Island Heritage in
July 2007, which resulted in taxable income being earned in the
USVI.





Comprehensive
Income





Comprehensive income for the years
ended December 31, 2007 and 2006 was $175.9 million and
$147.8 million, respectively.  In 2007, comprehensive income
included $167.9 million of net income and $8.0 million for the change in the
currency translation adjustment as a result of the translation of our foreign
subsidiaries into U.S. dollars, the Company’s reporting currency.  In
2006, comprehensive income included $152.3 million of net income,
$4.0 million of net unrealized losses for the period on our investment
portfolio and $0.5 million of loss for the change in the currency translation
adjustment.





Comparison
of the Year Ended December 31, 2006 and the Period October 4, 2005 through
December 31, 2005





Because the Company began
operations on December 20, 2005, and as the principal renewal periods for our
ceding company clients commenced January 1, 2006, the Company did not write any
policies in the period from October 4, 2005 through December 31,
2005.  Net investment income resulting from the investment of the
proceeds of our private placement contributed $0.6 million to our net
income.  This was offset, however by general and administrative
expenses of $0.8 million and the compensation expense based on the fair value of
the Warrant of $12.2 million.  As a result we do not believe a
comparison of the results of operations for the year ended December 31, 2006
with the period from October 4, 2005 through December 31, 2005 is
meaningful.





Financial
Condition, Liquidity and Capital Resources




Investments





The total
of investments and cash and cash equivalents was $1.9 billion at
December 31, 2007, compared to $1.0 billion at December 31,
2006.





The major
factors influencing the increase in 2007 were:





●
            net
      cash provided by operating activities of $326.9
  million;


●
            the
      addition of $167.3 million of invested assets and cash equivalents
      resulting from the consolidation of Mont Fort in
  2007;


●
            net
      proceeds of $168.7 million from the issuance of our common shares through
      our IPO in April 2007;


●
            net
      proceeds of $98.9 million, through a private placement of Junior
      Subordinated Deferrable Interest Notes in June
  2007;


●
            the
      addition of $38.5 million of invested assets and cash equivalents
      resulting from the consolidation of Island Heritage in
    2007;


●
            net
      proceeds through a private sale of subordinated debt of $24.7 million in
      September 2007;


●
            net
      realized and unrealized gains on invested assets during the year of $17.2
      million; and


●
            increase
      in net payable for securities purchased during the year of $26.0
      million.





The investment management guidelines of
the Company are set by the Finance Committee of our Board of Directors. The
Finance Committee establishes investment policies and guidelines for both
internal and external investment managers. The Company employs a prudent
investment philosophy. It maintains a high-quality, well-balanced and liquid
portfolio having the dual objectives of optimizing current investment income and
achieving capital appreciation.





When the Company was formed, the
Finance Committee decided to invest initially in a conventional portfolio
consisting of mainly high grade bonds and a 10% component of passive U.S.
equities. Subsequently, the Finance Committee conducted a comprehensive asset
allocation study, consistent with modern practice in portfolio optimization, and
developed a sophisticated optimization model using asset classes the Company is
allowed to invest in from fiscal, regulatory, and liquidity aspects. The model
aims at achieving higher expected total returns while maintaining adequate
liquidity to pay potential claims and preserving our financial strength rating.
The asset class composition of the model output includes a significant
allocation to high grade fixed maturity securities, with the balance invested
between other asset classes, such as U.S. equities, developed and emerging
market equities, commodities, and cash equivalents.  A smaller portion
of our investments is allocated to private equity, real estate (see “—Sub-prime
Exposure”)
and hedge funds. The Company has a strong bias against active management in
favor of indexing and passive securities that are generally the most liquid. A
number of our equity and other exposure implementations use futures contracts
and swaps, whereas the assets in a short term portfolio, managed by external
managers, support the futures contracts as if those assets were pledged and not
available for liquidity purposes. The portfolio managers are required to adhere
to investment guidelines as to minimum ratings and issuer and sector
concentration limitations. This implementation strategy gives us a low cost and
efficient way, using a mixture of passive assets and outside managers, to complement our in-house capability for
overall portfolio management, liquidity management and hedging. The Company
believes that an allocation of a portion of its investments to asset classes
other than high grade fixed income is both prudent and desirable, as it helps to
achieve broader asset diversification (lower risk) and maximizes the portfolio’s
total return over time.




38
 Table of Contents





As noted above, the Company’s
investment strategy allows the use of derivative instruments such as futures
contracts, total return swaps, foreign exchange forward contracts, and currency
swaps, subject to strict limitations. Derivative instruments may be used to
replicate investment positions or to manage currency and market exposures and
duration risk that would be allowed under the Company’s investment policy if
implemented in other ways.





Our investment portfolio on a risk
basis, at December 31, 2007 comprised 66.6% fixed maturities and short-term
investments, 22.9% equities and the balance in other investments.  Our
desired portfolio mix will comprise 50% high grade short term fixed maturities
and the balance a highly diversified global asset mix. We believe our fixed
maturity securities, short term investments, equity investments, fixed income
fund, REITs and derivatives held for investments can be liquidated and
converted into cash within a very short period of time. However, our investments
in investment funds and catastrophe bonds, which represent 3.6% of our
total investments and cash and cash equivalents at December 31, 2007, do not
trade on liquid markets or are subject to redemption provisions that prevent us
from converting them into cash immediately.




At December 31, 2007 and 2006,
100% of our fixed maturity securities were rated investment-grade (BBB- or
higher) by Standard & Poor’s (or estimated equivalent).





At December 31, 2007, the average
duration of the Company’s investment portfolio was 3.2 years, compared
to 2.5 years at December 31, 2006.  The duration increased due to
the higher weighting of TIPs in our December 31, 2007 portfolio compared to
December 31, 2006.





The cost or amortized cost, gross
unrealized gains and losses and carrying values of the Company’s fixed maturity,
short term and equity investments as at December 31, 2007 and 2006, were as
follows:




As
      at December 31, 2007Gross
                
                GrossAmortized
                
                unrealized
                
                unrealizedcost
      or cost
                
                losses
                
                gains
                
                Fair
      value($
      in thousands)Fixed
      maturitiesU.S.
      government and government agency
                
                $
                479,462
                
                
                $
                (1
                )
                
                $
                14,508
                
                
                $
                493,969Other
      foreign governments
                
                
                545
                
                
                
                (2
                )
                
                
                15
                
                
                
                558Corporates
                
                
                265,569
                
                
                
                (5,786
                )
                
                
                909
                
                
                
                260,692Mortgage-backed
      securities
                
                
                198,242
                
                
                
                (2,315
                )
                
                
                2,807
                
                
                
                198,734Asset-backed
      securities
                
                
                155,331
                
                
                
                (468
                )
                
                
                289
                
                
                
                155,152Total
      fixed maturities
                
                $
                1,099,149
                
                
                $
                (8,572
                )
                
                $
                18,528
                
                
                $
                1,109,105Short
      term investments
                
                $
                23,660
                
                
                $
                (49
                )
                
                $
                5
                
                
                $
                23,616Equity
      investments
                
                $
                73,603
                
                
                $
                -
                
                
                $
                754
                
                
                $
                74,357
   As
      at December 31, 2006Gross
                
                GrossAmortized
                
                unrealized
                
                unrealizedcost
      or cost
                
                losses
                
                gains
                
                Fair
      value($
      in thousands)Fixed
      maturitiesU.S.
      government and government agency
                
                $
                252,775
                
                
                $
                (4,319
                )
                
                $
                9
                
                
                $
                248,465Corporates
                
                
                188,080
                
                
                
                -
                
                
                
                28
                
                
                
                188,108Mortgage-backed
      securities
                
                
                97,112
                
                
                
                -
                
                
                
                263
                
                
                
                97,375Asset-backed
      securities
                
                
                136,575
                
                
                
                -
                
                
                
                5
                
                
                
                136,580Other
      debt securities
                
                
                11,746
                
                
                
                -
                
                
                
                4
                
                
                
                11,750Total
      fixed maturities
                
                $
                686,288
                
                
                $
                (4,319
                )
                
                $
                309
                
                
                $
                682,278


Prior to January 1, 2007, investments
were considered available-for-sale in accordance with SFAS 115 and
were carried at fair value with unrealized gains and losses recorded in
accumulated other comprehensive income. Following the issuance by the FASB of
SFAS 159, the Company elected to early adopt the fair value option for all fixed
maturity investments, equity investments (excluding investments accounted for
under the equity method of accounting), REITs, investment funds, catastrophe
bonds, and fixed income funds commencing January 1, 2007. This election
requires the Company to adopt 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.




39
 Table of Contents




The Company has elected the fair value
option to simplify the accounting, as this election will reduce the burden of
the monitoring of differences between the cost and fair value of our
investments, including the assessment as to whether declines in value are
temporary in nature and, therefore, further removes an element of management's
judgment.





The difference as a result of the
election of the fair value option is in respect to the treatment of unrealized
gains and losses. Prior to January 1, 2007, unrealized gains and losses on
fixed maturity investments and equities were included within accumulated other
comprehensive income as a separate component of shareholders’ equity. On
January 1, 2007, a cumulative-effect adjustment was made to reclassify the
net unrealized losses from accumulated other comprehensive loss as at
December 31, 2006 into retained earnings in the amount of $4.0 million.
This adjustment represented the difference between the cost or amortized cost of
our investments and the fair value of these investments at December 31,
2006.  Subsequent to January 1, 2007, any movement in unrealized gains
and losses has been recorded within net realized and unrealized gains and
losses on investments within the consolidated statements of operations.
Investments are recorded on a trade date basis and realized gains and losses on
sales of investments continue to be determined on a first-in, first-out basis.
Net investment income includes interest income on fixed maturity investments,
recorded when earned, dividend income on equity investments, recorded when
declared, and the amortization of premiums and discounts on
investments.





Rating
Distribution





The following table provides a
breakdown of the credit quality of the Company’s fixed maturity investments at
December 31, 2007 and 2006:




As
      at December 31, 2007
                
                
                As
      at December 31, 2006%
      of Total Fixed
                
                
                
                
                %
      of Total FixedRating
      Category
                
                
                Maturity
      Investments
                
                Fair
      Value
                
                Maturity
      Investments
                
                Fair
      Value($
      in thousands)AAA
                
                
                
                75.4
                %
                
                $
                836,122
                
                
                
                71.8
                %
                
                $
                489,800AA
                
                
                
                9.5
                %
                
                
                105,769
                
                
                
                12.1
                %
                
                
                82,563A
                
                
                
                13.0
                %
                
                
                144,416
                
                
                
                14.9
                %
                
                
                101,755BBB
                
                
                
                2.1
                %
                
                
                22,798
                
                
                
                1.2
                %
                
                
                8,160Total
                
                
                
                100.0
                %
                
                $
                1,109,105
                
                
                
                100.0
                %
                
                $
                682,278


Maturity
Distribution





The contractual maturity dates of
fixed maturity and short term investments as at December 31, 2007 and 2006
is shown below. Actual maturities may differ from contractual maturities because
certain borrowers have the right to call or prepay certain obligations with or
without call or prepayment penalties.




As
      at December 31, 2007Amortized
      Cost
                
                
                Fair
      Value($
      in thousands)Due
      within one year
                
                $
                57,039
                
                
                $
                57,032Due
      after 1 through 5 years
                
                
                373,643
                
                
                
                372,338Due
      after 5 through 10 years
                
                
                202,990
                
                
                
                209,821Due
      after 10 years
                
                
                135,564
                
                
                
                139,643Mortgage
      and asset-backed securities
                
                
                353,573
                
                
                
                353,887Total
                
                $
                1,122,809
                
                
                $
                1,132,721As
      at December 31, 2006Amortized
      Cost
                
                
                Fair
      Value($
      in thousands)Due
      within one year
                
                $
                5,496
                
                
                $
                5,496Due
      after 1 through 5 years
                
                
                257,328
                
                
                
                256,965Due
      after 5 through 10 years
                
                
                88,447
                
                
                
                86,748Due
      after 10 years
                
                
                101,330
                
                
                
                99,114Mortgage
      and asset-backed securities
                
                
                233,687
                
                
                
                233,955Total
                
                $
                686,288
                
                
                $
                682,278




40
 Table of Contents




Other
Investments
 
 The Company’s other investments
include:


As
      at
              
              As
      atDecember
      31, 2007
              
              December
      31,
                2006($
      in thosuands)Island
      Heritage
              
              $
              -
              
              
              $
              8,826Mont
      Fort
              
              
              -
              
              
              
              1,445Investment
      funds
              
              
              31,249
              
              
              
              28,378Catastrophe
      bonds
              
              
              36,619
              
              
              
              35,847Real
      estate investment trusts
              
              
              12,204
              
              
              
              -Fixed
      income fund
              
              
              212,982
              
              
              
              -Other
      investments
              
              
              112
              
              
              
              -Total
      other investments
              
              $
              293,166
              
              
              $
              74,496


The
investment funds consist of investments in a hedge fund and private equity
funds.  The catastrophe bonds held pay a variable interest coupon and
their return, from interest and return of principal, is contingent upon
climatological and geological events.  REITs are an investment in a
corporation investing in real estate.  The fixed income fund is a
Swiss franc money market fund.





Sub-prime
Exposure





Global financial markets experienced
significant stress during the third and fourth quarters of 2007 and early 2008,
primarily driven by challenging conditions in the markets related to
U.S. sub-prime mortgages (including collateralized debt obligations
(“CDOs”) based on sub-prime collateral), and in the markets for loans and bonds
related to leveraged finance transactions (collectively referred to as
“sub-prime”). This adverse market environment began to intensify toward the end
of July 2007 and was characterized by significant credit spread widening,
prolonged illiquidity, reduced price transparency and increased volatility. As
conditions in these markets deteriorated, other areas such as the asset-backed
commercial paper market also experienced decreased liquidity and the equity
markets experienced short-term weakness and increased volatility. In addition, a
number of participants in the financial guaranty market, have reported
significant mark-to-market losses on their portfolio of financial guaranty
contracts accounted for as derivatives under GAAP. Certain of these market
participants have had their financial strength ratings put on review for
possible downgrade by various rating agencies, or such ratings were downgraded
and the market capitalization of such participants decreased significantly. In
response and in an effort to stabilize market conditions generally, the Federal
Reserve and other central banks injected significant liquidity into the markets
and lowered benchmark interest rates.





Based in part on published news and
research reports, further deterioration in the performance of the sub-prime
mortgage sector appears to be generally expected; however, the extent and
duration of the current deterioration in the credit markets more broadly is
unknown. It is possible that the continued deterioration in the credit markets
noted above would significantly adversely impact the overall economy, which
could directly or indirectly give rise to adverse effects on us, potentially
including effects we can not currently reasonably foresee. In addition, there
can be no assurance that any of the governmental or private sector initiatives
designed to address such credit deterioration in the markets will be
implemented, or that if implemented would be successful.





With reference to sub-prime, at
December 31, 2007, we had no exposure to sub-prime backed investments or CDOs of
sub-prime backed investments. At December 31, 2007, our holdings of Alt –A
securities was $14.7 million with an average rating of AAA.  Alt – A
securities are defined as a classification of mortgages where the risk
profile falls between prime and sub-prime. The borrowers behind these
mortgages will typically have clean credit histories, but the mortgage itself
will generally have some features that increase its risk profile. These
features include higher loan-to-value and debt-to-income ratios or
inadequate documentation of the borrower’s income.  Our exposure
to traditional monoline insurers emanates from our non subprime asset-backed
holdings. We have securities with credit enhancement from the traditional
monoline insurers that amount to $9.9 million at December 31, 2007. We do not
have any collateralized loan obligations or CDO exposures in our
portfolio.





Loss
and Loss Adjustment Expense Reserves





The Company establishes loss reserves
to estimate the liability for the payment of all loss and loss adjustment
expenses incurred with respect to premiums earned on the contracts that the
Company writes. Loss reserves do not represent an exact calculation of the
liability. Loss reserves represent estimates, including actuarial and
statistical projections at a given point in time to reflect the Company’s
expectations of the ultimate settlement and administration costs of claims
incurred. Estimates of ultimate liabilities are contingent on many future events
and the eventual outcome of these events may be different from the assumptions
underlying the reserve estimates. The Company believes that the recorded unpaid
loss and loss adjustment expenses represent management’s best estimate of the
cost to settle the ultimate liabilities based on information available at
December 31, 2007. See “—Critical
Accounting Policies—Loss and Loss Adjustment Expense Reserves” for additional
information concerning loss and loss adjustment expenses.




41
 Table of Contents




The following table represents an
analysis of paid and incurred losses and a reconciliation of the beginning and
ending loss and loss adjustment expense reserves for the years ended
December 31, 2007 and 2006:




Year
      EndedDecember
      31, 2007
              
              Year
      EndedDecember
      31,  2006($
      in thousands)Gross
      liability at beginning of year
              
              $
              22,516
              
              
              $
              -Reinsurance
      recoverable at beginning of year
              
              
              -
              
              
              
              -Net
      liability at beginning of year
              
              
              22,516
              
              
              
              -Net
      incurred losses related to:Current
      year
              
              
              196,734
              
              
              
              26,660Prior
      year
              
              
              (3,875
              )
              
              
              -192,859
              
              
              
              26,660Net
      paid losses related to:Current
      year
              
              
              32,664
              
              
              
              4,144Prior
      year
              
              
              6,948
              
              
              
              -39,612
              
              
              
              4,144Effects
      of foreign exchange rate changes
              
              
              2,726
              
              
              
              -Loss
      reserve on acquisition of Island Heritage
              
              
              2,489
              
              
              
              -Net
      liability at end of year
              
              
              180,978
              
              
              
              22,516Reinsurance
      recoverable at end of year
              
              
              -
              
              
              
              -Gross
      liability at end of year
              
              $
              180,978
              
              
              $
              22,516


The $3.9 million prior year reduction
in the net incurred losses arose from the revision of our loss estimates upon
receipt of updated information from our clients and brokers.





The significant increase in the
reserves in 2007 is primarily attributable to light insured catastrophe
activity in 2006 coupled with significant losses in 2007 from Windstorm Kyrill
($32.4 million), June and July U.K. Floods ($38.0 million), New South Wales
Floods ($18.5 million), three satellite losses ($13.8
million) and the Sydney Hailstorm ($11.4 million).




Shareholders’
Equity and Capital Resources Management





As at December 31, 2007, total
shareholders’ equity was $1.2 billion, a 40.0% increase compared to
$864.5 million at December 31, 2006. The increase in shareholders’
equity is principally due to the completion of our IPO and the exercise
of the underwriters’ overallotment option in the amount of
$168.7 million, net income for the year ended December 31, 2007 of
$167.9 million, share based compensation of $8.3 million, accumulated other
comprehensive income of $7.9 million offset by dividends declared of $7.0
million. Other comprehensive income consists of the change in currency
translation adjustment arising from the translation of the Company’s foreign
subsidiaries into U.S. dollars.





The Company actively manages its
capital to support its underwriting operations and for the benefit of its
shareholders, subject to the ability to maintain strong ratings from the
agencies and maintain its ability to pay claims as they arise. Generally, the
Company will seek to raise additional capital when its current capital position
is not sufficient to support attractive business opportunities available.
Conversely, the Company will seek to reduce its capital, through dividends or
stock repurchases when the opportunity set is insufficient to utilize our
capital to earn our long term return targets.





Management uses growth in diluted
book value per share as a prime measure of the value the Company is generating
for its common shareholders. Diluted book value per share is calculated using
the common shareholders’ equity divided by the number of common share and share
equivalents outstanding. In 2007, the Company’s diluted book value per share
plus accumulated dividends increased by 16.8% from $11.94 at December 31,
2006 to $13.95 at December 31, 2007.





Long
Term Debt





On August 23, 2006, the Company
raised gross and net proceeds of $136.7 million and $132.8 million
through a private placement of Deferrable Interest Debentures. The Deferrable
Interest Debentures have a floating rate of interest equal to (i) London
Interbank Offering Rate (“LIBOR”) plus 354 basis points per annum, reset
quarterly for the dollar-denominated principal amount and (ii) Euro
Interbank Offered Rated (“Euribor”) plus 354 basis points per annum, reset
quarterly for the Euro-denominated principal amount. The Deferrable Interest
Debentures mature on September 15, 2036, and may be called at par by the
Company at any time after September 15, 2011. The Company may defer payment
of the interest for up to 20 consecutive quarterly periods, but no later than
September 15, 2011. Any deferred interest payments would accrue interest
quarterly on a compounded basis.





In June 2007, the Company, through its
wholly-owned subsidiary Flagstone Finance SA, raised gross and net proceeds of
$100.0 million and $98.9 million, respectively, through a private placement of
Junior Subordinated Deferrable Interest Notes.  These notes have a
floating rate of interest equal to LIBOR plus 300 basis points per annum, reset
quarterly. These Notes mature on July 30, 2037, and may be called at par by the
Company at any time after July 30, 2012. The Company may defer interest payment
for up to 20 consecutive quarterly periods, but no later than July 30, 2012. Any
deferred interest payments would accrue interest quarterly on a compounded
basis.





In September 2007, the Company raised
gross and net proceeds of $25.0 million and $24.7 million, respectively, through
a private placement of Junior Subordinated Deferrable Interest
Notes.  These Notes have a floating rate of interest equal to LIBOR
plus 310 basis points per annum, reset quarterly. These Notes mature on
September 15, 2037, and may be called at par by the Company at any time after
September 15, 2012.  The Company may defer interest payment for up to
20 consecutive quarterly periods, but no later than September 15, 2012. Any
deferred interest payments would accrue interest quarterly on a compounded
basis.





The
indenture governing our Deferrable Interest Debentures would restrict us from
declaring or paying dividends on our common shares if the Company:




42
 Table of Contents




●
            is
      downgraded by A.M. Best to a financial strength rating below A- and
      fails to renew more than 51% of its net premiums written during any
      twelve-month period;


●
            is
      downgraded by A.M. Best to a financial strength rating below A- and sells
      more than 51% of its rights to renew net premiums written over the course
      of a twelve-month period;


●
            is
      downgraded by A.M. Best to a financial strength rating below B++;
      or


●
            withdraws
      its financial strength rating by A.M.
Best.





Through the acquisition of IAL King Air
on July 22, 2007, the company acquired debt of $0.9 million. The loan has a
floating rate of interest equal to 30-day LIBOR plus 195 basis points per annum,
reset monthly.  The debt matures March 15, 2009.





At December 31, 2007 and 2006, the
Company was in compliance with all required covenants, and no conditions of
default existed related to the Company’s long term debt. We may incur additional
indebtedness in the future if we determine that it would be an efficient part of
our capital structure.





Our capital management strategy is to
preserve sufficient capital to support the Company’s financial strength ratings
and our future growth while maintaining conservative financial leverage and
earnings coverage ratios.





The table below sets forth the capital
structure of the Company at December 31, 2007 and 2006:





December
      31, 2007
              
              
              December
      31, 2006($
      in thousands)Capital
      structure:Long
      term debt
              
              $
              264,889
              
              
              
              18.0
              %
              
              $
              137,159
              
              
              
              13.7
              %Shareholders’
      equity
              
              
              1,210,485
              
              
              
              82.0
              %
              
              
              864,519
              
              
              
              86.3
              %Total
      Capital
              
              $
              1,475,374
              
              
              
              100.0
              %
              
              $
              1,001,678
              
              
              
              100.0
              %


Liquidity





Liquidity is a measure of the Company’s
ability to access sufficient cash flows to meet the short-term and long-term
cash requirements of its business operations. Management believes that its
significant cash flows from operations and high quality liquid investment
portfolio will provide sufficient liquidity for the foreseeable future. For the
period from inception until December 31, 2007, we have had sufficient cash
flow from operations to meet our liquidity requirements. We expect that our
operational needs for liquidity for at least the next twelve months will be met
by our balance of cash, funds generated from underwriting activities, investment
income and proceeds from sales and maturities of our investment portfolio. Cash
and cash equivalents were $362.7 million at December 31, 2007.





We are a holding company that conducts
no operations of our own. We rely primarily on cash dividends and return of
capital from our subsidiaries to pay our operating expenses and make principal
and interest payments on our long term debt. There are restrictions on the
payment of dividends from Flagstone and Flagstone Suisse to the Company, which
are described in more detail below. Following the completion of our IPO, we
have paid a quarterly cash dividend of $0.04 per common share in both the third
and fourth quarters of 2007. Our subsidiaries’ sources of funds primarily
consist of premium receipts net of commissions, investment income, capital
raising activities including the issuance of common shares, long term debt and
proceeds from sales and maturities of investments. Cash is used primarily to pay
losses and loss adjustment expenses, reinsurance purchased, brokerage, general
and administrative expenses and dividends, with the remainder made available to
our investment manager for investment in accordance with our investment policy.
In the future, we may use cash to fund any authorized share repurchases and
acquisitions.





Cash flows from operations in 2007
increased to $326.9 million, from $172.4 million in 2006. This increase in cash
flows from operations was primarily attributable to higher underwriting cash
flows due to higher premium writings in 2007 compared to
2006.  Because a large portion of the coverages we provide typically
can produce losses of high severity and low frequency, it is not possible to
accurately predict our future cash flows from operating activities. As a
consequence, cash flows from operating activities may fluctuate, perhaps
significantly, between individual quarters and years.





Cash flows relating to financing
activities include the payment of dividends, share related transactions and the
issue or repayment of debt.  During 2007, we generated $336.2 million
from financing activities compared to $296.4 million in 2006. During 2007
we received net proceeds of $168.7 million from the issuance of our common
shares through our IPO in April 2007 and net proceeds of $123.7 million
from the issuance of junior subordinated deferrable interest notes, offset by a
$17.1 million repayment of a loan under a sale lease-back
transaction.  In 2006 we raised $162.8 million from the issuance of
common shares and net proceeds of $132.8 million from the issuance of deferrable
interest debentures.





Generally, positive cash flows from our
operating and financing activities are invested in the Company’s investment
portfolio. For further discussion of our investment activities, including our
strategy and current durations, refer to “Business” and also Note 5
to our Consolidated Financial Statements included in Item 8 of this
report.





We monitor our long term liquidity
needs with regard to our annual aggregate PML. Our annual aggregate PML for a
given number of years is our estimate of the maximum aggregate loss and loss
adjustment expenses that we are likely to incur in any one year during that
number of years.





Financial strength ratings and senior
unsecured debt ratings represent the opinions of rating agencies on the
Company’s capacity to meet its obligations. In the event of a significant
downgrade in ratings, the Company’s ability to write business and to access the
capital markets could be impacted. Some of the Company’s reinsurance treaties
contain special funding and termination clauses that are triggered in the event
the Company or one of its subsidiaries is downgraded by one of the major rating
agencies to levels specified in the treaties, or the Company’s capital is
significantly reduced. If such an event were to occur, the Company would be
required, in certain instances, to post collateral in the form of letters of
credit and/or trust accounts against existing outstanding losses, if any,
related to the treaty.





In 2008, we anticipate expenditures of
approximately $5.0 million for our information technology infrastructure
and systems enhancements, including proprietary software expenditures and
$6.0 million primarily for the building costs associated with the
completion of our office building in Hyderabad. We expect our operating cash
flows, together with our existing capital base, to be sufficient to meet these
requirements and to operate our business.





Letter
of Credit Facilities





In the normal course of its
operations, the Company enters into agreements with financial institutions to
obtain secured credit facilities. Under the terms of certain reinsurance
agreements, irrevocable letters of credit are issued on a secured basis in
respect of cedents’ reported loss and unearned premium reserves.




43
 Table of Contents





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 17, 2008, $73.7 million has
been drawn under this facility and the drawn amount of the facility is secured
by $82.0 million of fixed maturity securities from our 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 December 31, 2007, if drawn upon, the utilized portion of the
facility will be secured by an appropriate portion of securities from the
Company’s investment portfolio.





Restrictions
and Specific Requirements





The cash generated from the three
closings of our private placement, the issuance of our Deferrable Interest
Debentures, the completion of our IPO and operating cash flows has provided
us with sufficient liquidity to enable Flagstone to meet its Bermuda statutory
requirements under the Insurance Act, as described below.





The Insurance Act requires Flagstone to
maintain a minimum solvency margin (being the minimum amount that the statutory
assets must exceed the statutory liabilities as required by the Insurance Act)
equal to the greatest of (i) $100 million, (ii) 50% of net
premiums written or (iii) 15% of the reserve for losses and loss adjustment
expenses. To satisfy these requirements, Flagstone was required to maintain a
minimum level of statutory capital and surplus of $228.0 million as at
December 31, 2007. In addition, Flagstone is required to maintain a minimum
liquidity ratio. As at December 31, 2007, 2006 and 2005, Flagstone was in
compliance with all of the requirements of the Insurance Act.





Bermuda law limits the maximum amount
of annual dividends or distributions payable by Flagstone to the Company and in
certain cases requires the prior notification to, or the approval of, the BMA.
As a Bermuda Class 4 reinsurer, Flagstone may not pay dividends in any
financial year which would exceed 25% of its total statutory capital and surplus
unless at least seven days before payment of those dividends it files an
affidavit with the BMA signed by at least two directors and Flagstone’s
principal representative, which states that in their opinion, declaration of
those dividends will not cause Flagstone to fail to meet its prescribed solvency
margin and liquidity ratio. Further, Flagstone may not reduce by 15% or more its
total statutory capital as set out in its previous year’s statements, without
the prior approval of the BMA. Flagstone must also maintain, as a Class 4
Bermuda reinsurer, paid-up share capital of $1 million.





Flagstone is not licensed or admitted
as an insurer or reinsurer in any jurisdiction other than Bermuda. Because many
jurisdictions do not permit insurance companies to take credit for reinsurance
obtained from unlicensed or non-admitted insurers on their statutory financial
statements unless appropriate security mechanisms are in place, we anticipate
that our reinsurance clients will typically require Flagstone to post a letter
of credit or other collateral.





Flagstone Suisse is licensed to operate
as a reinsurer in Switzerland. Swiss law permits dividends to be declared only
after profits have been allocated to the reserves required by law and to any
reserves required by the articles of incorporation. The articles of
incorporation of Flagstone Suisse do not require any specific reserves.
Therefore, Flagstone Suisse must allocate any profits first to the reserve
required by Swiss law generally, and may pay as dividends only the balance of
the profits remaining after that allocation. In the case of Flagstone Suisse,
Swiss law requires that 5% of the company’s profits be allocated to a “general reserve”until the reserve reaches
20% of its paid-in share capital.  In addition, a Swiss reinsurance company
may pay a dividend only if, after payment of the dividend, it will continue to
comply with regulatory requirements regarding minimum capital, special reserves
and solvency margin requirements. See Item 1, “Business—Regulation—Other
Jurisdictions—Switzerland.”





Island Heritage is currently licensed
to transact domestic insurance business in sixteen Caribbean
countries.





Off
Balance Sheet Arrangements





We have no obligations, assets or
liabilities other than those disclosed in the financial statements; no trading
activities involving non-exchange traded contracts accounted for at fair value;
and except as disclosed in this document no relationships and transactions with
persons or entities that derive benefits from their non-independent relationship
with us or our related parties.





Contractual
Obligations and Commitments





The following table shows our aggregate
contractual obligations by time period remaining to due date as at
December 31, 2007:





Less
      than
              
              
              1-3
              
              
              3-5
              
              
              More
      than1
      year
              
              
              years
              
              
              years
              
              
              5
      years
              
              
              Total($
      in thousands)Long
      term debt - Interest(1)
              
              $
              21,161
              
              
              $
              42,222
              
              
              $
              42,214
              
              
              $
              509,025
              
              
              $
              614,622Long
      term debt - Principal
              
              
              128
              
              
              
              755
              
              
              
              -
              
              
              
              264,006
              
              
              
              264,889Lease
      obligations
              
              
              3,731
              
              
              
              6,672
              
              
              
              5,839
              
              
              
              10,906
              
              
              
              27,148Loss
      and loss adjustment expense reserves(2)
              
              
              50,476
              
              
              
              111,711
              
              
              
              14,740
              
              
              
              4,051
              
              
              
              180,978Island
      Heritage share repurchase(3)
              
              
              3,502
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              3,502Investment
      commitments(4)
              
              
              6,356
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              6,356Total
      contractual obligations
              
              $
              85,354
              
              
              $
              161,360
              
              
              $
              62,793
              
              
              $
              787,988
              
              
              $
              1,097,495


(1)The interest on the
long term debt is based on a spread above LIBOR and Euribor. We have reflected
interest due in the table based on the current interest rates on the facility.
See “Long
Term Debt”
above for further details.


(2) The
Company has based its estimate of future claim payments upon benchmark payment
patterns constructed internally, drawing upon available relevant industry
sources of loss and allocated loss adjustment expense development data which may
include both internal and external data sources. We also supplement these
benchmark payment patterns with information received from treaty submissions and
periodically update them. We believe that it is likely that this benchmark data
will not be predictive of our future claim payments and that material
fluctuations can occur due to the nature of the losses which we insure and the
coverages which we provide. Because of the nature of the coverages that we
provide, the amount and timing of the cash flows associated with our policy
liabilities will fluctuate, perhaps significantly, and therefore are highly
uncertain. See “—Critical
Accounting Policies—Loss and Loss Adjustment Expense Reserves.”


(3)Effective November 20,
2007, Island Heritage entered into a share repurchase agreement with one of its
minority shareholders. Under this agreement, Island Heritage will buy back
16,919 shares (representing 5% of its common shares) on June 30, 2008 at a price
of 1.78 times the fully diluted book value as at December 31, 2007.  The
amount will be settled with fifty percent cash on or before June 30, 2008 and
fifty percent cash on or before December 31, 2008.


(4)The Company has made
certain commitments with respect to an investment in a private equity fund and
may receive capital call requests in 2008.




44
 Table of Contents


Currency





The Company’s reporting currency is the
U.S. dollar. The Company has exposure to foreign currency risk due to the
following: its investments in foreign subsidiaries whose functional currencies
are typically their national currencies; Flagstone Suisse’s underwriting
reinsurance exposures; the collection of premiums and payment of claims and
other general operating expenses denominated in currencies other than the U.S.
dollar; and, holding certain net assets in foreign currencies. The Company’s
most significant foreign currency exposure is to the Swiss franc.





Prior to December 2007, gains and
losses on foreign currency forward contracts and on foreign currency swaps used
to hedge the foreign currency exposure of the Company’s debt, investments in and
loan to various subsidiaries, and operational balances (premiums and reserves)
of our investments in foreign subsidiaries were recorded with realized gains and
losses - other on the income statement, while gains and losses on the
translation of foreign subsidiaries’ assets and liabilities were recorded in
accordance with SFAS No. 52 “Foreign Currency
Translation”
(“SFAS 52”) as a change in currency translation adjustment, a component of
comprehensive income. Since the change in currency translation adjustment is not
a component of net income, there was volatility created in our reported earnings
from the translation of our foreign subsidiaries. Prior to renewing our forward
contracts in December 2007, we considered the guidance under SFAS No. 133
“Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”)
which outlines the designated hedge accounting method, which permits the offset
of gains and losses on the hedged instruments (i.e. the forward contracts)
against the gains and losses recorded for the hedged items (i.e. foreign
subsidiaries). As a result, $3.5 million of unrealized losses on forward
contracts was accounted for as an offset against the currency translation
adjustment gain in the fourth quarter 2007, thus reducing the income statement
volatility.  The losses on forward contracts resulted from the
continued weakening of the U.S. dollar against other major currencies, mainly
the Swiss franc.





At December 31, 2007, the value of
the U.S. dollar weakened approximately 1.6% against the British pound, 10.8%
against the Euro, 15.1% against the Canadian dollar, and 7.1% against the Swiss
franc, compared to December 31, 2006. Since a large proportion of the
Company’s assets and liabilities are expressed in these currencies, there was a
net increase in the U.S. dollar value of the assets and liabilities denominated
in these currencies in 2007.





Net foreign exchange gains amounted to
a gain of $5.3 million, a gain of $2.1 million and a gain of $nil for the years
ended December 31, 2007 and 2006 and the period from October 4, 2005
through December 31, 2005, respectively (See “—Results of
Operations”
above).





Effects
of Inflation





The effects of inflation are considered
implicitly in pricing and estimating reserves for unpaid losses and loss
expenses. The actual effects of inflation on the results of operations of the
Company cannot be accurately known until claims are ultimately
settled.





We do not believe that inflation has
had a material effect on our consolidated results of operations, except insofar
as inflation may affect interest rates. The potential exists, after a
catastrophe loss, for the development of inflationary pressures in a local
economy. The effects of inflation are considered implicitly in pricing through
the modeled components such as demand surge. Loss reserves are established to
recognize likely loss settlements at the date payment is made. Those reserves
inherently recognize the effects of inflation. The actual effects of inflation
on our results cannot be accurately known, however, until claims are ultimately
resolved.




45
 Table of Contents




ITEM 7A. QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





We measure and manage market risks and
other risks as part of an enterprise-wide risk management process. The market
risks described in this section relate to financial instruments, primarily in
our investment portfolio, that are sensitive to changes in interest rates,
credit risk premiums or spreads, foreign exchange rates and equity
prices.





We believe that we are currently
principally exposed to four types of market risk: interest rate risk, equity
market risk, credit risk and foreign currency risk.





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 an
underlying asset or index. The Company also purchases 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.





During 2007 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 gains and
losses in the consolidated financial statements.  There were no
derivatives designated as hedges as of December 31, 2006.





The following comments address those
areas where the Company believes it has exposure to material market risk in its
operations.





Interest
Rate Risk





Our primary market risk exposure is to
changes in interest rates. Our fixed maturity portfolio is exposed to interest
rate risk. Fluctuations in interest rates have a direct impact on the market
valuation of these investments. As interest rates rise, the market value of our
fixed maturity portfolio falls and we have the risk that cash outflows will have
to be funded by selling assets, which will be trading at depreciated values. As
interest rates decline, the market value of our fixed income portfolio increases
and we have reinvestment risk, as funds reinvested will earn less than is
necessary to match anticipated liabilities. We expect to manage interest rate
risk by selecting investments with characteristics such as duration, yield,
currency and liquidity tailored to the anticipated cash outflow characteristics
of the reinsurance liabilities of the Company. In addition, from time to time
the Company enters into interest rate swap contracts as protection against
unexpected shifts in interest rates, which would affect the fair value of the
fixed maturity portfolio. By using swaps in the portfolio, the overall duration
or interest rate sensitivity of the portfolio can be altered.





As at December 31, 2007, the
impact on our fixed maturity securities, cash and cash equivalents, from an
immediate 100 basis point increase in market interest rates would have resulted
in an estimated decrease in market value of 3.0%, or approximately
$48.6 million. As at December 31, 2007, the impact on our fixed
maturity securities, cash and cash equivalents, from an immediate 100 basis
point decrease in market interest rates would have resulted in an estimated
increase in market value of 3.4%, or approximately
$55.0 million.  As at December 31, 2006, the impact on our
fixed maturity from an immediate 100 basis point increase in market interest
rates would have resulted in an estimated decrease in market value of 3.0%, or
approximately $20.2 million. As at December 31, 2006, the impact on
our fixed maturity portfolio from an immediate 100 basis point decrease in
market interest rates would have resulted in an estimated increase in market
value of 3.1%, or approximately $20.9 million.





As at December 31, 2007, we held
$353.9 million, or 31.9%, of our fixed maturity portfolio in asset-backed and
mortgage-backed securities. We did not hold any sub-prime securities at December
31, 2007 and held $14.7 million of Alt -A securities with an average rating of
AAA. As at December 31, 2006, we held $234.0 million, or 34.3%, of our
fixed maturity portfolio in asset-backed and mortgage-backed securities. These
assets are exposed to prepayment risk, which occurs when holders of underlying
loans increase the frequency with which they prepay the outstanding principal
before the maturity date and refinance at a lower interest rate cost. The
adverse impact of prepayment is more evident in a declining interest rate
environment. As a result, the Company will be exposed to reinvestment risk, as
cash flows received by the Company will be accelerated and will be reinvested at
the prevailing interest rates.





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. 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 year ended
December 31, 2007, the Company recorded $0.5 million of realized and
unrealized gains on interest rate swaps.  As at December 31,
2006, there were no interest rate swaps in the portfolio.





The Company also uses interest rate
swaps to manage its borrowing costs on long term debt.  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, and will receive
interest at three month London Interbank Offered Rate (“LIBOR”) and pay 3.962% and 4.096%
interest, respectively. The agreements 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
pay 4.095% interest.  The agreement will terminate on July 30,
2012.  As of December 31, 2007, the fair value of these swaps was $0.4
million and the Company recorded $0.4 million of unrealized gains on those
swaps.





Equity
Price Risk





We gain exposure to the equity markets
through the use of various index-linked futures, exchange traded funds, total
return swaps and global REIT equities.  This risk is defined as
the potential loss in fair value resulting from adverse changes in the
respective stock prices. The fair value of equity positions as at December 31,
2007 amounted to $80.9 million and was recorded in both equities and other
investments and the net realized and unrealized gains of $8.0 million for the
year ended December 31, 2007 are recorded in the consolidated statements of
operations.  The total exposure of the index-linked futures and total
return swaps was $346.1 million as at December 31, 2007.  The fair
value of our future positions as at December 31, 2006 amounted to
$1.9 million and was recorded in other assets and the net realized and
unrealized gains for the year ended December 31, 2006 of $8.5 million was
recorded in the consolidated statements of operations.





Credit
Risk





The Company has exposure to credit risk
primarily as a holder of fixed maturity securities. Our risk management strategy
and investment guidelines have been defined to ensure we invest in debt
instruments of high credit quality issuers and to limit the amount of credit
exposure with respect to particular ratings categories and any one issuer. As at
December 31, 2007, all of our fixed maturity investments consisted of
investment grade securities. The Company believes this high-quality portfolio
reduces its exposure to credit risk on fixed income investments to an acceptable
level.




46
 Table of Contents




The Company does not have any exposure
to credit risk as a holder of sub-prime backed investments.  The
Company does not have a specific sub-prime limit with any investment
manager.   At December 31, 2007, all sub-prime assets within the
investment portfolio had been liquidated.





To a lesser extent, the Company also
has credit risk exposure as a party to over-the-counter derivative instruments.
To mitigate this risk, we monitor our exposure by counterparty and ensure that
counterparties to these contracts are high-credit-quality international banks or
counterparties. In addition, we generally request our counterparties to
collateralize their loss positions. These derivative instruments include foreign
currency forwards contracts, currency swaps, interest rate swaps and total
return swaps.





In addition, the Company has exposure
to credit risk as it relates to its trade balances receivable, namely
reinsurance balances receivable. Reinsurance balances receivable from the
Company’s clients at December 31, 2007 and December 31, 2006, were
$136.6 million and $68.9 million, respectively, including balances
both currently due and accrued. The Company believes that credit risk exposure
related to these balances is mitigated by several factors, including but not
limited to credit checks performed as part of the underwriting process,
monitoring of aged receivable balances our rights to cancel the cover for
non-payment of premiums and right to offset premiums yet to be paid against
losses due to the cedent. Since our inception, we have recorded $1.1 million in
bad debt expenses.





While the Company does not rely heavily
on retrocessional reinsurance, we do require our reinsurers to have adequate
financial strength. The Company evaluates the financial condition of its
reinsurers and monitors its concentration of credit risk on an ongoing
basis.





In addition, consistent with industry
practice, we assume a degree of credit risk associated with reinsurance brokers.
We frequently pay amounts owed on claims under our policies to reinsurance
brokers, and these brokers, in turn, pay these amounts to the ceding insurers
that have reinsured a portion of their liabilities with us. In some
jurisdictions, if a broker fails to make such a payment, we may remain liable to
the ceding insurer for the deficiency. Conversely, in certain jurisdictions,
when the ceding insurer pays premiums to reinsurance brokers for payment to us,
these premiums are considered to have been paid and the ceding insurer will no
longer be liable to us for those amounts, regardless of whether we have received
the premiums.





Foreign
Currency Risk




Premiums,
Reserves, and Claims





The U.S. dollar is our principal
reporting currency and the functional currencies of our operating subsidiaries
are generally their national currencies, except for Bermuda subsidiaries, whose
functional currency is the U.S. dollar. We enter into reinsurance contracts
where the premiums receivable and losses payable are denominated in currencies
other than the U.S. dollar. Premiums in non-U.S. currencies are generally
converted into U.S. dollars at the time of receipt, except in our Swiss
subsidiary where they are generally converted into Swiss francs. When we incur a
loss in a non-U.S. currency, we carry the liability on our books in the original
currency. As a result, we have an exposure to foreign currency risk resulting
from fluctuations in exchange rates between the time premiums are collected and
converted to the functional currency (either U.S. dollars or Swiss francs), and
the time claims are paid.





With respect to loss reserves, our
policy is to hedge the expected losses with forward foreign exchange purchases.
Expected losses means incurred and reported losses and IBNR.  We do not
hedge expected catastrophe events. However, upon the occurrence of a catastrophe
loss and when the actuarial department has estimated the loss to the Company, we
purchase foreign currency promptly on a forward basis. When we pay claims in a
non-base currency, we either use the proceeds of a foreign currency forward
contract to do so, or buy spot foreign exchange to pay the claim and
simultaneously adjust the hedge balance to the new lower exposure.





Investments




The majority of the securities held in
our investment portfolios are held by Flagstone, where they are measured in U.S.
dollars, and in Flagstone Suisse, where they are measured in Swiss francs. At
the time of purchase, each investment is identified as either a hedged
investment, to be maintained with an appropriate currency hedge to U.S. dollars
or Swiss francs as the case may be, or an unhedged investment, one not to be
maintained with a hedge. Generally, fixed income investments will be hedged,
listed equity investments may or may not be hedged, and other investments such
as real estate and commodities will not be hedged.





Financing




When the Company or its subsidiaries
issues a debt or equity financing in a currency other than the functional
currency of that company, our practice is to hedge that exposure. The
contractual amount of foreign currency forward contracts as at
December 31, 2007 and 2006 was $311.1 million and $84.9 million, and
had a fair value of $(7.1) million and $0.5 million, respectively. The
Company designated $264.4 million of foreign currency forwards contractual value
as hedges, which had a fair value of ($3.5) million as of December 31,
2007.  During the years ended December 31, 2007 and 2006, the
Company recorded $14.0 million and $1.0 million respectively of realized
and unrealized losses on foreign currency forward contracts.  The
Company recorded $3.5 million of unrealized losses directly into comprehensive
income as part of the cumulative translation adjustment for the effective
portion of the hedge.  There were no foreign currency forwards
designated as hedges as of December 31, 2006.





The Company entered into a foreign
currency swap in relation to the Euro-denominated Deferrable Interest
Debentures. Under the terms of the foreign currency swap the Company exchanged
€13.0 million for $16.7 million, will receive Euribor plus
354 basis points and pay LIBOR plus 371 basis points. The swap expires
on September 15, 2011 and had a fair value of $2.5 million and $0.4
million, respectively, as at December 31, 2007 and December 31,
2006.





Foreign currency exchange contracts
will not eliminate fluctuations in the value of our assets and liabilities
denominated in foreign currencies but rather allow us to establish a rate of
exchange for a future point in time. Of our business written in the year ended
December 31, 2007, approximately 21.8% was written in currencies other than the
U.S. dollar (excluding Island Heritage). For the year ended December 31, 2007
and December 31, 2006, we had net realized and unrealized foreign exchange gains
of $5.3 million and $2.1 million, respectively.





The Company does not hedge currencies
for which its asset or liability exposures are not material or where it is
unable or impractical to do so. In such cases, the Company is exposed to foreign
currency risk. However, the Company does not believe that the foreign currency
risks corresponding to these unhedged positions are material.





Effects
of Inflation




We do not believe that inflation has
had a material effect on our combined results of operations, except insofar as
inflation may affect interest rates.




47
 Table of Contents




ITEM 8. FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA





INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS




PAGEReport
      of Independent Registered Public Accounting Firm
              49Consolidated
      Balance Sheets as at December 31, 2007 and 2006
              50Consolidated
      Statements of Operations and Comprehensive Income (Loss) for the Years
      Ended December 31, 2007, 2006, and the Period from October 4, 2005
      through December 31, 2005
              51Consolidated
      Statements of Changes in Shareholders’ Equity for the years ended
      December 31, 2007, 2006 and the Period from October 4, 2005 through
      December 31, 2005
              52Consolidated
      Statements of Cash Flows for the years ended December 31, 2007, 2006,
      and the Period from October 4, 2005 through December 31,
    2005
              53Notes
      to the Consolidated Financial Statements
              54







48
 Table of Contents







REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and Shareholders of
 Flagstone
Reinsurance Holdings Limited
 
 
 We have
audited the accompanying consolidated balance sheets of Flagstone Reinsurance
Holdings Limited and subsidiaries (the “Company”) as of
December 31, 2007 and 2006, and the related consolidated statements of
operations and comprehensive income (loss), shareholders' equity, and cash flows
for the years ended December 31, 2007 and 2006, and the period from October 4,
2005 (date of incorporation) to December 31, 2005. Our audits also included the
financial statement schedules listed in the Index at Item 15. These financial
statements and financial statement schedules are the responsibility of the
Company's management.  Our responsibility is to express an opinion on
the financial statements and financial statement schedules based on our
audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
Company is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting.  Our audits included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company's
internal control over financial reporting.  Accordingly, we express no
such opinion.  An audit also includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.
 
 In our
opinion, such consolidated financial statements present fairly, in all material
respects, the financial position of Flagstone Reinsurance Holdings Limited and
subsidiaries at December 31, 2007 and 2006, and the results of their operations
and their cash flows for the years ended December 31, 2007 and 2006, and the
period from October 4, 2005 (date of incorporation) to December 31, 2005 in
conformity with accounting principles generally accepted in the United States of
America.  Also, in our opinion, such financial statement schedules,
when considered in relation to the basic consolidated financial statements taken
as a whole, present fairly in all material respects the information set forth
therein.
 
 
 
 
 /s/
Deloitte & Touche
 Hamilton,
Bermuda
 March 18,
2008










49
 Table of Contents







FLAGSTONE
REINSURANCE HOLDINGS LIMITED


CONSOLIDATED BALANCE SHEETS


As
at December 31, 2007 and 2006


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






2007
              
              2006ASSETSInvestments:Fixed
      maturities, at fair value (Amortized cost: 2007 - $1,099,149; 2006 -
      $686,288)
              
              $
              1,109,105
              
              
              $
              682,278Short
      term investments, at fair value (Cost: 2007 - $23,660; 2006 - $nil)
              
              
              23,616
              
              
              
              -Equity
      investments, at fair value (Cost: 2007 - $73,603; 2006 -
    $nil)
              
              
              74,357
              
              
              
              -Other
      investments
              
              
              293,166
              
              
              
              74,496Total Investments
              
              
              1,500,244
              
              
              
              756,774Cash
      and cash equivalents
              
              
              362,680
              
              
              
              261,352Reinsurance
      premium balances receivable, net
              
              
              136,555
              
              
              
              68,940Unearned
      premiums ceded
              
              
              14,608
              
              
              
              8,224Accrued
      interest receivable
              
              
              9,915
              
              
              
              6,331Receivable
      for investments sold
              
              
              -
              
              
              
              3,599Deferred
      acquisition costs
              
              
              30,607
              
              
              
              11,909Funds
      withheld
              
              
              6,666
              
              
              
              -Goodwill
              
              
              10,781
              
              
              
              5,624Other
      assets
              
              
              31,717
              
              
              
              18,659Due
      from related parties
              
              
              -
              
              
              
              3,090Total
      Assets
              
              $
              2,103,773
              
              
              $
              1,144,502LIABILITIESLoss
      and loss adjustment expense reserves
              
              $
              180,978
              
              
              $
              22,516Unearned
      premiums
              
              
              175,607
              
              
              
              98,659Insurance
      and reinsurance balances payable
              
              
              12,088
              
              
              
              -Payable
      for investments purchased
              
              
              41,750
              
              
              
              9,531Long
      term debt
              
              
              264,889
              
              
              
              137,159Other
      liabilities
              
              
              33,198
              
              
              
              11,866Due
      to related parties
              
              
              -
              
              
              
              252Total
      Liabilities
              
              
              708,510
              
              
              
              279,983Minority
      Interest
              
              
              184,778
              
              
              
              -SHAREHOLDERS’
      EQUITYCommon
      voting shares, 150,000,000 authorized, $0.01 par value, issued and
      outstanding (2007 - 85,309,107; 2006 - 71,547,891)
              
              
              853
              
              
              
              715Additional
      paid-in capital
              
              
              905,316
              
              
              
              728,378Accumulated
      other comprehensive income (loss)
              
              
              7,426
              
              
              
              (4,528
              )Retained
      earnings
              
              
              296,890
              
              
              
              139,954Total Shareholders’
      Equity
              
              
              1,210,485
              
              
              
              864,519Total
      Liabilities, Minority Interest and Shareholders’ Equity
              
              $
              2,103,773
              
              
              $
              1,144,502














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








50
 Table of Contents







FLAGSTONE
REINSURANCE HOLDINGS LIMITED


CONSOLIDATED STATEMENTS OF OPERATIONS AND
COMPREHENSIVE INCOME (LOSS)


For
the Years Ended December 31, 2007, 2006, and the Period from October 4, 2005
through December 31, 2005


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




2007
              
              2006
              
              2005REVENUESGross
      premiums written
              
              $
              577,150
              
              
              $
              302,489
              
              
              $
              -Reinsurance
      premiums ceded (related party:  2007 - $nil; 2006 - $15,095;
      2005 - $nil)
              
              
              (50,119
              )
              
              
              (19,991
              )
              
              
              -Net
      premiums written
              
              
              527,031
              
              
              
              282,498
              
              
              
              -Change
      in net unearned premiums
              
              
              (49,894
              )
              
              
              (90,435
              )
              
              
              -Net
      premiums earned
              
              
              477,137
              
              
              
              192,063
              
              
              
              -Net
      investment income
              
              
              73,808
              
              
              
              34,212
              
              
              
              629Net
      realized and unrealized gains - investments
              
              
              17,174
              
              
              
              10,304
              
              
              
              -Net
      realized and unrealized (losses) gains - other
              
              
              (9,821
              )
              
              
              1,943
              
              
              
              -Other
      income (related party:  2007 - $nil; 2006 - $5,143; 2005 -
      $nil)
              
              
              5,811
              
              
              
              6,099
              
              
              
              -Total
      revenues
              
              
              564,109
              
              
              
              244,621
              
              
              
              629EXPENSESLoss
      and loss adjustment expenses
              
              
              192,859
              
              
              
              26,660
              
              
              
              -Acquisition
      costs
              
              
              82,292
              
              
              
              29,939
              
              
              
              -General
      and administrative expenses
              
              
              72,461
              
              
              
              34,741
              
              
              
              13,013Interest
      expense
              
              
              18,677
              
              
              
              4,648
              
              
              
              -Net
      foreign exchange gains
              
              
              (5,289
              )
              
              
              (2,079
              )
              
              
              -Total
      expenses
              
              
              361,000
              
              
              
              93,909
              
              
              
              13,013Income
      (loss) before income taxes, minority interest and interest in earnings of
      equity investments
              
              
              203,109
              
              
              
              150,712
              
              
              
              (12,384
              )Provision
      for income tax
              
              
              (783
              )
              
              
              (128
              )
              
              
              -Minority
      interest
              
              
              (35,794
              )
              
              
              -
              
              
              
              -Interest
      in earnings of equity investments
              
              
              1,390
              
              
              
              1,754
              
              
              
              -NET
      INCOME (LOSS)
              
              $
              167,922
              
              
              $
              152,338
              
              
              $
              (12,384
              )Change
      in net unrealized losses
              
              
              -
              
              
              
              (4,008
              )
              
              
              -Change
      in currency translation adjustment
              
              
              7,945
              
              
              
              (520
              )
              
              
              -COMPREHENSIVE
      INCOME (LOSS)
              
              $
              175,867
              
              
              $
              147,810
              
              
              $
              (12,384
              )Weighted
      average common shares outstanding—Basic
              
              
              81,975,384
              
              
              
              70,054,087
              
              
              
              55,239,491Weighted
      average common shares outstanding—Diluted
              
              
              82,111,590
              
              
              
              70,393,821
              
              
              
              55,239,491Net
      income (loss) per common share outstanding—Basic
              
              $
              2.05
              
              
              $
              2.17
              
              
              $
              (0.22
              )Net
      income (loss) per common share outstanding—Diluted
              
              $
              2.05
              
              
              $
              2.16
              
              
              $
              (0.22
              )Dividends
      declared per common share
              
              $
              0.08
              
              
              $
              -
              
              
              $
              -

















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








51
 Table of Contents







FLAGSTONE
REINSURANCE HOLDINGS LIMITED


CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’
EQUITY


For
the Years Ended December 31, 2007, 2006, and the Period from October 4, 2005
through December 31, 2005


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





2007
              
              2006
              
              2005Common voting
      shares:Balance
      at beginning of period
              
              
              71,547,891
              
              
              
              55,239,491
              
              
              
              -Issued
      during the period
              
              
              13,761,216
              
              
              
              16,308,400
              
              
              
              55,239,491Balance
      at end of period
              
              
              85,309,107
              
              
              
              71,547,891
              
              
              
              55,239,491Share
      capital:Common voting
      sharesBalance
      at beginning of period
              
              $
              715
              
              
              $
              552
              
              
              $
              -Issued
      during period
              
              
              138
              
              
              
              163
              
              
              
              552Balance
      at end of period
              
              
              853
              
              
              
              715
              
              
              
              552Additional paid-in
      capitalBalance
      at beginning of period
              
              
              728,378
              
              
              
              559,466
              
              
              
              -Issue
      of shares
              
              
              185,488
              
              
              
              162,921
              
              
              
              551,843Issuance
      costs (related party: 2007 - $3,430; 2006 - $nil; 2005 -
      $2,972)
              
              
              (16,839
              )
              
              
              (251
              )
              
              
              (4,590
              )Fair
      value of issue warrant
              
              
              -
              
              
              
              3,372
              
              
              
              12,213Share
      based compensation expense
              
              
              8,289
              
              
              
              2,870
              
              
              
              -Balance
      at end of period
              
              
              905,316
              
              
              
              728,378
              
              
              
              559,466Accumulated other comprehensive
      (income) lossBalance
      at beginning of period
              
              
              (4,528
              )
              
              
              -
              
              
              
              -Change
      in net unrealized losses
              
              
              -
              
              
              
              (4,008
              )
              
              
              -Change
      in currency translation adjustment
              
              
              7,945
              
              
              
              (520
              )
              
              
              -Cumulative
      effect adjustment from adoption of new accounting
principle
              
              
              4,009
              
              
              
              -
              
              
              
              -Balance
      at end of period
              
              
              7,426
              
              
              
              (4,528
              )
              
              
              -Retained earnings (accumulated
      deficit)Balance
      at beginning of period
              
              
              139,954
              
              
              
              (12,384
              )
              
              
              -Cumulative
      effect adjustment from adoption of new accounting
principle
              
              
              (4,009
              )
              
              
              -
              
              
              
              -Dividend
      declared
              
              
              (6,977
              )
              
              
              -
              
              
              
              -Net
      income (loss) for the period
              
              
              167,922
              
              
              
              152,338
              
              
              
              (12,384
              )Balance
      at end of period
              
              
              296,890
              
              
              
              139,954
              
              
              
              (12,384
              )Total
      Shareholders’ Equity
              
              $
              1,210,485
              
              
              $
              864,519
              
              
              $
              547,634




















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








52
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FLAGSTONE
REINSURANCE HOLDINGS LIMITED


CONSOLIDATED STATEMENTS OF CASH
FLOWS


For
the Years Ended December 31, 2007, 2006, and the Period from October 4, 2005
through December 31, 2005


(Expressed
in thousands of U.S. dollars)





2007
              
              2006
              
              2005Cash flows provided by (used
      in) operating activities:Net
      income
              
              $
              167,922
              
              
              $
              152,338
              
              
              $
              (12,384
              )Adjustments to reconcile net
      income to net cash provided by
                operating
      activities:Net
      realized and unrealized gains
              
              
              (7,353
              )
              
              
              (12,247
              )
              
              
              -Minority
      interest
              
              
              35,794
              
              
              
              -
              
              
              
              -Depreciation
      expense
              
              
              2,647
              
              
              
              1,018
              
              
              
              -Share
      based compensation expense
              
              
              8,136
              
              
              
              6,208
              
              
              
              12,247Interest
      in earnings of equity investments
              
              
              (1,390
              )
              
              
              (1,754
              )
              
              
              -Accretion/amortization
      on fixed maturities
              
              
              (8,196
              )
              
              
              156
              
              
              
              -Changes
      in assets and liabilities, excluding net assets acquired:Reinsurance
      premium receivable
              
              
              (53,278
              )
              
              
              (68,940
              )
              
              
              -Unearned
      premiums ceded
              
              
              (9,619
              )
              
              
              (8,224
              )
              
              
              -Deferred
      acquisition costs
              
              
              (13,549
              )
              
              
              (11,909
              )
              
              
              -Funds
      withheld
              
              
              (6,666
              )
              
              
              -
              
              
              
              -Loss
      and loss adjustment expense reserves
              
              
              158,078
              
              
              
              22,516
              
              
              
              -Unearned
      premiums
              
              
              57,942
              
              
              
              98,659
              
              
              
              -Insurance
      and reinsurance balances payable
              
              
              (8,474
              )
              
              
              -
              
              
              
              -Other
      changes in assets and liabilities, net
              
              
              4,952
              
              
              
              (5,431
              )
              
              
              587Net
      cash provided by operating activities
              
              
              326,946
              
              
              
              172,390
              
              
              
              450Cash flows provided by (used
      in) investing activities:Net
      cash received (paid) in acquisitions of subsidiaries
              
              
              2,643
              
              
              
              (12,702
              )
              
              
              -Purchases
      of fixed income securities
              
              
              (1,699,537
              )
              
              
              (1,712,280
              )
              
              
              -Sales
      and maturities of fixed income securities
              
              
              1,391,198
              
              
              
              1,030,738
              
              
              
              -Purchases
      of equity securities
              
              
              (98,774
              )
              
              
              (99,682
              )
              
              
              -Sales
      of equity securities
              
              
              34,533
              
              
              
              101,889
              
              
              
              -Purchases
      of other investments
              
              
              (225,156
              )
              
              
              (57,117
              )
              
              
              -Sales
      of other investments
              
              
              13,872
              
              
              
              -
              
              
              
              -Purchases
      of fixed assets
              
              
              (9,668
              )
              
              
              (6,023
              )
              
              
              -Sale
      of fixed asset under a sale lease-back transaction
              
              
              18,500
              
              
              
              -
              
              
              
              -Net
      cash used in investing activities
              
              
              (572,389
              )
              
              
              (755,177
              )
              
              
              -Cash flows provided by (used
      in) financing activities:Issue
      of common shares, net of issuance costs paid
              
              
              171,644
              
              
              
              162,833
              
              
              
              547,805Issue
      of notes, net of issuance costs paid
              
              
              123,673
              
              
              
              132,810
              
              
              
              -Contribution
      of minority interest
              
              
              84,322
              
              
              
              -
              
              
              
              -Repurchase
      of minority interest
              
              
              (14,353
              )
              
              
              -
              
              
              
              -Dividend
      paid on common shares
              
              
              (6,823
              )
              
              
              -
              
              
              
              -Repayment
      of loan under a sale lease-back transaction
              
              
              (17,063
              )
              
              
              -
              
              
              
              -Other
              
              
              (5,166
              )
              
              
              725
              
              
              
              -Net
      cash provided by financing activities
              
              
              336,234
              
              
              
              296,368
              
              
              
              547,805Effect
      of foreign exchange rate on cash and cash equivalents
              
              
              10,537
              
              
              
              (484
              )
              
              
              -Increase
      (decrease) in cash and cash equivalents
              
              
              101,328
              
              
              
              (286,903
              )
              
              
              548,255Cash
      and cash equivalents - beginning of period
              
              
              261,352
              
              
              
              548,255
              
              
              
              -Cash
      and cash equivalents - end of period
              
              $
              362,680
              
              
              $
              261,352
              
              
              $
              548,255Supplemental cash flow
      information:Payable
      for investments purchased
              
              $
              41,750
              
              
              $
              9,531
              
              
              $
              -Receivable
      for investments sold
              
              $
              -
              
              
              $
              3,599
              
              
              $
              -Interest
      paid
              
              $
              16,271
              
              
              $
              3,861
              
              
              $
              -







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








53
 Table of Contents


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





1.    ORGANIZATION





Flagstone Reinsurance Holdings Limited
(“the Company”) is a holding company
incorporated on October 4, 2005 under the laws of Bermuda. The Company, through
its principal operating, wholly owned subsidiaries, Flagstone Reinsurance
Limited (“Flagstone”) and Flagstone Réassurance
Suisse SA (“Flagstone Suisse”), is a provider of global property, property
catastrophe, and short-tail specialty and casualty reinsurance. Flagstone was
incorporated in Bermuda on November 10, 2005 and licensed as a Class 4
insurer under The Insurance Act 1978, as amended and related Regulations (the
“Insurance Act”).  Flagstone
Suisse was formed in Switzerland on September 7, 2006 and is an indirect
wholly owned subsidiary of Flagstone. Flagstone Suisse was formed to serve as
the Company’s European underwriting platform and was licensed by the Federal
Office of Private Insurance in Switzerland on December 20,
2006.





On March 31, 2006, Flagstone
acquired an equity interest in Island Heritage Holdings Limited (“Island Heritage”), a Caribbean
property insurer based in the Cayman Islands.  With subsequent
purchases in October 2006 and May 2007, Flagstone increased its equity interest
in Island Heritage to 33.2%.  On July 3, 2007, Flagstone took a
controlling interest in Island Heritage by increasing its ownership to 54.6% of
Island Heritage’s voting shares.





On March 31, 2006, the Company
acquired Flagstone Capital Management (Bermuda) Limited and its subsidiaries
(formerly known as West End Capital Management
(Bermuda) Limited and referred to herein as “West End”), a company engaged in the
business of investment and insurance management in Bermuda. West End
subsidiaries include (a) Flagstone Management Services (Halifax) Limited
which provides accounting, claims, information technology support, risk
modeling, actuarial and legal services and (b) West End Capital Management
BPO Services (India) Private Limited which provides back office information
technology support services.





On March 6, 2006, the Company
entered into a share purchase agreement to purchase 370,000 common shares,
representing 100% of the outstanding common shares of Mont Fort Re Limited
(“Mont Fort”), a segregated accounts or “cell” company registered under
the Bermuda Segregated Accounts Companies Act 2000 (as amended). In
May 2006, the Company invested an additional $1.3 million in Mont
Fort.   Mont Fort raises capital from investors through offerings
of its preferred shares, and uses the proceeds of those offerings to underwrite
reinsurance, which will be ceded to Mont Fort solely by Flagstone pursuant to a
reinsurance agreement. On June 6, 2006, Mont Fort closed an offering of
preferred shares relating to its first cell, Mont Fort ILW, which yielded gross
proceeds of $60.0 million including investments by Flagstone of
$5.0 million (8.3%) and LB I Group Inc. (“LB I”) of $50.0 million
(83.3%).  LB I is a related party due to its investment in common
shares of the Company.  On August 28, 2006, Mont Fort repurchased
the preferred shares held by Flagstone for $5.1 million. As at December 31,
2006, and for the year ended December 31, 2006, 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)”) the Company had
determined that Mont Fort was a Variable Interest Entity (“VIE”). The Company
was not considered to be the primary beneficiary and, therefore, was not
required to consolidate Mont Fort into its financial statements. On January 2,
2007, Mont Fort closed an offering of preferred shares relating to its second
cell, Mont Fort ILW 2 Cell (“Mont Fort ILW 2”) which yielded gross proceeds
of $55.0 million from LB I.  On January 12, 2007, Mont Fort
closed an offering of preferred shares, with an unrelated party, relating to a
third cell, Mont Fort High Layer (“Mont Fort HL”), which yielded gross proceeds
of $28.1 million. The Company determined that the establishment of these
cells was a reconsideration event under the provisions of paragraph 7 and
paragraph 15 of FIN 46(R). The Company assessed the impact of these
reconsideration events on its results and financial position, and concluded that
the establishment of the Mont Fort HL cell on January 12, 2007 was the
reconsideration event that resulted in the Company being the primary beneficiary
of Mont Fort. As such, the results of Mont Fort are included in the Company’s
consolidated financial statements with effect from January 12,
2007.





2.    SIGNIFICANT
ACCOUNTING POLICIES





Basis
of Presentation





The consolidated financial statements
have been prepared in conformity with accounting principles generally accepted
in the United States of America (“U.S. GAAP”). All inter-company
accounts and transactions have been eliminated on consolidation.




The
accompanying financial statements as at December 31, 2007 include all
adjustments (consisting of normal recurring accruals) considered necessary to
present fairly the financial position as at December 31, 2007 and 2006 and
the results of operations and cash flows for the years ended December 31,
2007 and 2006 and the period October 4, 2005 through December 31,
2005.





These consolidated financial statements
include the accounts of the Company and its wholly owned subsidiaries. The
Company’s policy is to consolidate all entities in which it has a controlling
financial interest. In accordance with FIN 46(R), entities that are deemed
to be VIEs are consolidated by the Company if it is determined that the
Company is the primary beneficiary. Under FIN 46(R) the primary beneficiary
of a VIE is the party that absorbs a majority of the entity’s expected losses,
receives a majority of its expected returns, or both, as a result of holding
variable interests. For entities that are not deemed to be VIEs under
FIN 46(R), the Company consolidates those in which it owns more than 50% of
the outstanding voting stock unless it does not control the entity. Investments
in preferred or voting common shares relating to unconsolidated entities that
provide the Company with significant influence over the operating and financial
policies of the investee are accounted for under the equity method of
accounting.





As at December 31, 2006, and for the
year ended December 31, 2006, in accordance with FIN 46(R) the Company had
determined that Mont Fort was a variable interest entity. The Company was not
considered to be the primary beneficiary and, therefore, was not required
to consolidate Mont Fort into its financial statements. The Company was deemed
to have significant influence over the operating and financial policies of Mont
Fort due to its board representation and 100% voting interests and accordingly,
Mont Fort was accounted for under the equity method of accounting. Under this
method, the Company recorded all of the income or loss from the general account
of Mont Fort but no income or losses arising from the activities of the
segregated account of Mont Fort and the Company’s investment in Mont Fort was
included in other investments on the Consolidated Balance Sheet for December 31,
2006 as discussed in Note 1 above.





As discussed in Note 1 above, the
results of Mont Fort are included in the Company’s consolidated financial
statements with effect from January 12, 2007. The portions of Mont Fort’s net
income and shareholder’s equity attributable to holders of the preferred shares
for the year ended December 31, 2007 are recorded in the consolidated financial
statements of the Company as minority interest.  (See Note 4 for
further details)




Use
of Estimates in Financial Statements





The preparation of these 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 consolidated 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.




54
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)




Loss
and Loss Adjustment Expense Reserves





Loss and loss adjustment expense
reserves, including losses incurred but not reported (“IBNR”) and provisions for
settlement expenses, include amounts determined from loss reports on individual
cases, independent actuarial determinations and based on the Company’s own
historical experience. To the extent that the Company’s own historical
experience is inadequate for estimating reserves, such estimates may be
determined based upon industry data and management estimates.





A significant portion of the Company’s
business is property catastrophe and programs with high attachment points of
coverage. Reserving for losses in such programs is inherently judgmental in that
losses in excess of the attachment level on those programs are characterized as
high severity and low frequency and other factors which could vary significantly
as claims are settled. This limits the volume of relevant industry claims
experience available from which to reliably predict ultimate losses following a
loss event. In addition, the Company has limited past loss experience due to its
relatively short operating history, which increases the inherent uncertainty in
estimating ultimate loss levels.





Loss and loss adjustment expense
reserves include a component for outstanding case reserves for which claims have
been reported and a component for IBNR. Case reserve estimates are initially set
on the basis of loss reports received from ceding companies. Estimated IBNR
reserves consist of a provision for additional development in excess of the case
reserves reported by ceding companies as well as a provision for claims which
have occurred but which have not yet been reported to the Company by ceding
companies. IBNR reserves are estimated by management using various actuarial
methods as well as a combination of the Company’s loss experience, insurance
industry loss experience, underwriters’ experience, general market trends, and
management’s judgment. The Company’s internal actuaries review the reserving
assumptions and methodologies on a quarterly basis.





The uncertainties inherent in the
reserving process, delays in ceding companies reporting losses to the Company
together with the potential for unforeseen adverse developments, may result in
loss and loss adjustment expense reserves significantly greater or less than the
reserve provided at the time of the loss event. Loss and loss adjustment expense
reserve estimates are regularly reviewed and updated as new information becomes
known. Any resulting adjustments are reflected in the period in which they
become known.





Premiums
and Acquisition Costs





Premiums are first recognized as
written as at the date that the contract is bound. The Company writes both
excess of loss and pro rata reinsurance contracts, and also writes a select
property insurance portfolio in the Caribbean region through its subsidiary
Island Heritage.





For excess of loss contracts, premiums
written are based on the deposit premium as defined in the contract, which is
generally based on an estimate at the inception of the contract of the
underlying exposure (e.g., values of properties insured) during the contract
period. At the end of the policy term, a final premium is calculated based on
the actual underlying exposure during the contract period and an adjustment to
the deposit premium, if any, is recognized in the period in which it is
determined. For pro rata contracts where no deposit premium is specified in the
contract, premiums written are based on estimates of ultimate premiums provided
by the ceding companies. Initial estimates of premiums written are reflected
quarterly from the period in which the underlying risks incept. Subsequent
adjustments, based on reports of actual premiums written by the ceding
companies, or revisions in estimates, are recorded in the period in which they
are determined.





The Company has entered into industry
loss warranty transactions that are structured as reinsurance or derivatives.
The Company evaluates each contract in accordance with Derivatives
Implementation Group B26, “Dual Trigger Property and
Casualty Contracts,” to
determine if the amounts received from these contracts should be recorded as
reinsurance transactions or as derivatives. When the transactions are determined
to be reinsurance, the consideration received is recorded as premiums written
and earned over the contract period.





In the normal course of its operations,
the Company has received commitment fees to provide future reinsurance capacity.
These contracts are accounted for as deferred revenue as they relate to upfront
commitment fees and are included in other liabilities. The commitment fees are
recognized ratably over the commitment period and are non-refundable in the
event that the counterparty does not utilize the reinsurance
capacity.





Premiums receivable are recorded as
amounts due less any required provision for doubtful accounts.




Premiums are earned over a period that
is consistent with the risks covered under the terms of the contract, which is
generally one to two years. The portion of the premium related to the unexpired
portion of the risk period is reflected in unearned premiums.  Where
contract terms require the reinstatement of coverage after a ceding company’s
loss, the mandatory reinstatement premiums are recorded as written and are
recognized as premiums earned when the loss event occurs.





Reinsurance premiums ceded are expensed
over the period the reinsurance coverage is provided. Unearned ceded premiums
represent the portion of premiums ceded related to the unexpired portion of the
risk period.





Acquisition costs are comprised of
ceding commissions, brokerage, premium taxes, profit commissions and other
expenses that relate directly to the writing of reinsurance contracts. Deferred
acquisition costs are amortized over the underlying term of the related
contracts and are limited to their estimated realizable value based on the
related unearned premiums, anticipated loss and loss adjustment expenses and
investment income.





Investments,
Cash and Cash Equivalents





Prior to January 1, 2007, investments
were considered available-for-sale in accordance with SFAS No. 115,
“Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”),
and were carried at fair value with unrealized gains and losses recorded in
accumulated other comprehensive income (loss). Following the issuance by the
FASB of SFAS 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 early 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 commencing
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 has elected the fair value
option to simplify the accounting, as this election will reduce the burden of
monitoring differences between the cost and fair value of our investments,
including the assessment as to whether declines in value are temporary in nature
and, therefore, further removes an element of management judgment.




55
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)




The difference as a result of the
election of the fair value option is in respect to the treatment of unrealized
gains and losses. Prior to January 1, 2007, unrealized gains and losses on
fixed maturity investments and equities were included within accumulated other
comprehensive income (loss) as a separate component of shareholders’ equity. On
January 1, 2007, a cumulative-effect adjustment was made to reclassify the
net unrealized losses, which represented the difference between the cost or
amortized cost of investments and the fair value of those investments at
December 31, 2006, from accumulated other comprehensive loss as at
December 31, 2006 into retained earnings in the amount of $4.0 million.
Subsequent to January 1, 2007, any movement in unrealized gains and losses
has been recorded within net realized and unrealized gains (losses) on
investments within the audited consolidated statements of operations and
comprehensive income (loss).  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. Net investment income includes interest income on
fixed maturity investments, recorded when earned, dividend income on equity
investments, recorded when declared, and the amortization of premiums and
discounts on investments.





The election of SFAS 159 will not
change the carrying value of our fixed maturity investments, equity investments,
REITs, investment funds, catastrophe bonds, fixed income fund and derivative
instruments as they were previously carried at fair value.  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.  When the market for a security is considered
active and multiple quotes are obtained with identical prices, the quote is
considered to be binding. 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 administrative
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.  The private equity investments are valued by the
investment funds using the valuations and financial statements provided by the
general partners on a quarterly basis.  These valuations are then
adjusted by the investment funds for the cash flows since the most recent
valuation.  The valuation methodology used for the investment funds
are consistent with the investment industry.





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.





Short term investments, if any,
comprise fixed maturity investments with a maturity greater than three months
but less than one year from the date of purchase. Cash and cash equivalents
include amounts held in banks, money market funds and time deposits with
maturities of less than three months at the date of purchase.





Investments in preferred or voting
common shares in which the Company has significant influence over the operating
and financial policies of the investee are classified as other investments and
are accounted for under the equity method of accounting. Under this method, the
Company records its proportionate share of income or loss from such investments
in interest in earnings of equity investments for the period. Any decline in
value of the equity method investments considered by management to be
other-than-temporary is charged to income in the period in which it is
determined.





Net investment income is stated net of
investment management and custody fees. Investment income is recognized when
earned and includes interest and dividend income together with the amortization
of premiums and the accretion of discounts calculated under the interest method
on fixed maturity investments purchased at amounts different from their par
value.





Share
Based Compensation





The Company accounts for share based
compensation in accordance with SFAS No. 123(R), “Share-Based Payment”,
(“SFAS 123(R)”).  SFAS 123(R) requires entities to measure
the cost of services received from employees and directors in exchange for an
award of equity instruments based on the grant date fair value of the award. The
cost of such services will be recognized as compensation expense over the period
during which an employee or director is required to provide service in exchange
for the award.





The Company’s share based compensation
plans consists of performance share units (“PSUs”) and restricted share units
(“RSUs”). The PSUs are designed to
maximize shareholder value over long periods of time by aligning the financial
interests of the Company’s management with those of its shareholders. The
Company estimates the fair value of PSUs granted under the PSU Plan on the date
of grant using the grant date fair value and the most probable performance
factor for the three-year performance period and records the compensation
expense in its consolidated statements of operations over the course of such
period. At the end of each quarter, the Company reassesses the projected results
for each three-year performance period as its financial results evolve. The
Company recalculates the compensation expense under the PSU Plan and reflects
any adjustments in the consolidated statements of operations in the period in
which they are determined.





The RSUs are granted to employees and
directors of the Company. RSUs granted to employees generally vest two years
after the date of grant and RSUs granted to directors vest on the date of grant.
The company estimates the fair value of RSUs on the date of grant and records
the compensation expense in its consolidated statements of operations over the
vesting period.





Warrant





The Company accounts for the warrant
granted to Haverford (Bermuda) Ltd. (“Haverford”), a related party due to
common ownership, as stock compensation in accordance with SFAS No. 123(R).
Compensation expense for the warrant was measured at fair value at the date of
issuance of the warrant and recorded as compensation expense in the issuance
period as there was no required service period. (See Note 11 for additional
details)





Derivative
Instruments





The Company accounts for its derivative
instruments using SFAS No. 133, “Accounting for Derivative Instruments and
Hedging Activities” (“SFAS 133”). SFAS 133 requires an entity to recognize
all derivative instruments as either assets or liabilities in the balance sheet
and measure those instruments at fair value, with the fair value recorded in
other assets or liabilities.  The accounting for realized and
unrealized gains and losses associated with changes in the fair value of
derivatives depends on its hedge designation and whether the hedge is highly
effective in achieving offsetting changes in the fair value of the asset or
liability being hedged.  The realized and unrealized gains and losses
on derivatives not designated as hedging instruments are included in net
realized and unrealized gains and losses in the consolidated financial
statements. Gains and losses associated with changes in fair value of the
designated hedge instruments are recorded with the gains and losses on the
hedged items, to the extent that the hedge is effective.  Derivative
instruments are stated at fair value in accordance with SFAS 157 based on quoted
market price for futures contracts and based on observable market inputs (such
as currency spot and forward rates, underlying exchange traded securities yield
curves and transactional history) for foreign currency forwards, total return
swaps, currency swaps, interest rates swaps and “to be announced” mortgage-backed 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.




56
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)




Derivatives
used in hedging activities





The Company utilizes foreign currency
forward contracts to manage its foreign currency exposure.  On the
date the Company enters into a forward contract, it designates whether the
derivative is to be used as a hedge of an identified foreign currency exposure
(a designated hedge).  As part of the overall currency risk management
strategy, the Company uses forward contracts to hedge the currency exposure of
their investments and loans to subsidiaries (hedged items).





The Company formally documents all
relationships between designated hedging instruments and hedged items, as well
as its risk management objective and strategy for undertaking various hedge
transactions. In this documentation, the Company specifically identifies the
investments in or loans to subsidiaries that have been designated as a hedged
item and states how the hedging instrument is expected to hedge the risks
related to the hedged item. The Company formally measures effectiveness of its
designated hedging relationships, both at the hedge inception and on an ongoing
basis. The Company assesses the effectiveness of its designated foreign currency
hedges based on the value of the investment in and loans to subsidiaries and the
currency translation adjustment recorded upon consolidation. The time value
component of the designated fair value hedges is excluded from the assessment of
hedge effectiveness.





The Company will discontinue hedge
accounting prospectively if it is determined that the derivative is no longer
effective in offsetting changes in the fair value of a hedged item. To the
extent that the Company in the future chooses to discontinue hedge accounting
related to its foreign currency hedging of its investment in and loans to
subsidiaries because, based on Management’s assessment, the derivative no longer
qualifies as an effective fair value hedge, the derivative will continue to be
carried in the consolidated balance sheets at its fair value, with changes in
its fair value recognized in current period net income.





Other
derivative instruments





The Company generally uses interest
rate swaps, currency swaps and foreign currency forward contracts to manage its
duration and currency exposures. The Company may acquire TBAs and for the period
between the purchase of the TBAs and the issuance of the underlying securities,
the Company’s position is accounted for as a derivative. The Company also uses
futures contracts and total return swaps for the purpose of replicating
investment positions, managing market exposure and enhancing investment
performance.





Reinsurance
derivative contracts





The Company has entered into industry
loss warranty transactions that are structured as reinsurance or derivatives.
When those transactions are determined to be derivatives, they are recorded at
fair value in other assets or liabilities with the changes in fair value
reported in realized gains and losses in the consolidated financial
statements.





Goodwill





In connection with its purchase of West
End, the Company recorded goodwill in the amount of
$2.0 million.  In connection with its interest in Island
Heritage, the Company recorded goodwill in the amount of $3.6 million at
December 31, 2006 and an additional $5.2 million in 2007 for a total of $8.8
million at December 31, 2007.





For acquisitions under the purchase
method, in accordance with SFAS No. 142 “Goodwill and Other Intangible
Assets”, (“SFAS 142”), the Company will perform, at a minimum, an annual
valuation of its goodwill asset to test it for impairment. If, as a result of
the assessment, the Company determines that the value of its goodwill asset is
impaired, the Company will record an impairment charge in the period in which
the determination is made.





Equity method investments will be
reviewed annually, at a minimum, for potential impairment in accordance with
Accounting Policies Board Opinion 18 (“APB 18”), “The Equity Method of
Accounting for Investments in Common Stock”.  If it is
determined the Company would be unable to recover the carrying amount of its
equity investment or if its equity investment would be unable to sustain an
earning capacity to justify its carrying amount, the Company would record an
impairment charge in the period the determination is made by lowering the
goodwill recorded on the equity method investment.





The Company conducted its annual
reviews as at December 31, 2007 and determined that the recorded goodwill was
not impaired.





Funds
Withheld





Funds held by reinsured companies
represent insurance balances retained by ceding companies for a period in
accordance with contractual terms.  The company generally earns
investment income on these balances during the period funds are
held.





Foreign
Currency Translation





The reporting currency of the Company
is the U.S. dollar. The functional currencies of the Company’s subsidiaries are
generally their national currencies, except for the Bermuda subsidiaries, whose
functional currency is the U.S. dollar. In translating the financial statements
of those subsidiaries whose functional currency is other than the U.S. dollar,
assets and liabilities are converted into U.S. dollars using the rates of
exchange in effect at the balance sheet dates, and revenues and expenses are
converted using the weighted average foreign exchange rates for the period. The
cumulative translation adjustment is reported in the consolidated balance sheets
as a separate component of accumulated other comprehensive income
(loss).





In recording foreign currency
transactions, revenues and expense items are converted at the prevailing
exchange rate at the transaction date. Monetary assets and liabilities
denominated in foreign currencies are translated at exchange rates in effect at
the balance sheet date, which may result in the recognition of exchange gains or
losses. The exchange gains and losses are reported in the consolidated
statements of operations as net foreign exchange gains.




Earnings
(Loss) Per Common Share





The calculation of basic earnings
(loss) per common share is based on weighted average common shares and weighted
average vested RSUs outstanding and excludes any dilutive effects of warrants
and share equivalents. Diluted earnings (loss) per common share assume the
exercise of all dilutive warrant and share equivalents.




57
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)




The issuance of shares with respect to
the PSUs is contingent upon the attainment of certain levels of diluted
return-on-equity (“DROE”). Because the number of common 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 share
until the end of the performance period, when the number of shares issuable
under the PSU Plan will be known.





Taxation





Certain subsidiaries of the Company
operate in jurisdictions where they are subject to taxation. Current and
deferred income taxes are charged or credited to net income based upon enacted
tax laws and rates applicable in the relevant jurisdiction in the period in
which the tax becomes realizable. Deferred income taxes are provided for all
temporary differences between the bases of assets and liabilities used in the
consolidated balance sheets and those used in the various jurisdictional tax
returns. When management’s assessment indicates that it is more likely than not
that deferred income tax assets will not be realized, a valuation allowance is
recorded against the deferred tax assets. We adopted the provisions of FASB
Interpretation No. 48, "According for Uncertainty in Income Taxes – An Interpretation
of FASB Statement No. 109" ("FIN 48") on January 1, 2007. Under FIN 48, the
tax benefits of uncertain tax positions may only be recognized when the position
is more-likely-than-not to be sustained upon audit by the relevant taxing
authorities.





New
Accounting Pronouncements





In December 2007, the FASB issued SFAS
141 (revised 2007) “Business Combinations” (“SFAS 141(R)”).  SFAS
141(R) improves reporting by creating greater consistency in the accounting and
financial reporting of business combinations, resulting in more complete,
comparable, and relevant information for investors and other users of financial
statements. To achieve this goal, the new standard requires the acquiring entity
in a business combination to recognize all (and only) the assets acquired and
liabilities assumed in the transaction; establishes the acquisition date fair
value as the measurement objective for all assets acquired and liabilities
assumed; and requires the acquirer to disclose to investors and other users all
of the information needed to evaluate and understand the nature and financial
effect of the business combination.  SFAS 141(R) applies
prospectively to business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008. An entity may not apply it before that date. The effective
date of this Statement is the same as that of the related FASB Statement No. 160
“Noncontrolling Interests in Consolidated Financial Statements- an amendment of
ARB No. 51” (“SFAS 160”).  The Company is currently assessing the
impact of the adoption of this Statement on its results and financial
position.




In December 2007, the FASB issued
SFAS 160 which improves the relevance, comparability, and transparency of
financial information provided to investors by requiring all entities to report
non-controlling (minority) interests in subsidiaries as equity in the
consolidated financial statements. Moreover, SFAS 160 eliminates the diversity
that currently exists in accounting for transactions between an entity and
non-controlling interests by requiring they all be treated as equity
transactions. SFAS 160 is effective for financial statements issued for
fiscal years beginning on or after December 15, 2008 and interim periods
within those fiscal years, and early adoption is prohibited.  If SFAS
160 was adopted as of December 31, 2007, the $184.8 million of minority interest
would be reclassified as a separate component of shareholders’
equity.




3.    BUSINESS
COMBINATIONS





West
End





On March 31, 2006, the Company
purchased all of the common shares of West End for a purchase price of
$16.1 million. The Company purchased 12,000 West End shares (representing a
70.6% interest) from the Company’s Executive Chairman and 2,829 West End shares
(representing a 16.6% interest) from the Company’s Chief Executive Officer. The
results of operations of West End are included in the consolidated statement of
operations from April 1, 2006.





The primary reason for the transaction
was for the Company to be self-supporting and not reliant on outsourcing for its
administrative functions and investment activities.




The Company paid an amount of
$15.4 million on March 31, 2006 and the final settlement was made on
August 16, 2006 in the amount of $0.7 million. Goodwill of
$2.0 million was recognized on the acquisition date. The fair value of the
net assets acquired is summarized as follows:




As
      at
                March
      31, 2006Cash
              
              $
              3,394Investments
      in Rockridge Re Holdings Limited (“Rockridge”)1
              
              
              10,171Fixed
      assets
              
              
              2,236Other
      assets
              
              
              684Assets
      acquired
              
              
              16,485Long
      term liabilities
              
              
              183Accruals
      and other liabilities
              
              
              2,206Liabilities
      acquired
              
              
              2,389Net
      assets acquired
              
              $
              14,096


(1)
            Rockridge,
      a company incorporated under the laws of the Cayman Islands, was
      established to assume high-layer, short-tail risks principally from
      Montpelier Reinsurance Ltd. West End held 11.6% of the common share
      equity interests, which represented 29.6% of the total voting rights of
      all shares. West End was deemed to have significant influence over
      Rockridge due to its 29.6% voting interest and board representation. As
      such, the Rockridge investment was recorded as an equity method
      investment. On December 20, 2006, the board of directors of Rockridge
      decided that it was in the best interest of Rockridge to redeem all its
      common shares. Redemption proceeds of $10.7 million were received by
      West End on December 29, 2006 and the Company recorded an amount of
      $0.2 million as receivable from Rockridge as of December 31,
      2006.  Further proceeds of $0.2 million were received during
      2007 resulting in a $nil receivable at December 31,
  2007.




58
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)




The following unaudited pro-forma
information related to the Company’s acquisition of West End for the year ended
December 31, 2006 and the period from October 4, 2005 through
December 31, 2005 illustrates the effects of the acquisition as if it had
occurred at the beginning of the periods presented. The pro-forma information is
not intended to be indicative of the consolidated results of operations that
would have been reported if the acquisition had occurred on January 1, 2006
and October 4, 2005 nor does it purport to be indicative of combined
results of operations which may be reported in the future.




Year
      EndedDecember
      31, 2006
              
              
              Period
      October 4 throughDecember
      31, 2005(unaudited)
              
              
              (unaudited)Revenue
              
              $
              247,551
              
              
              $
              4,864Net
      income (loss)
              
              
              151,407
              
              
              
              (11,440
              )Net
      income (loss) per common share - Basic
              
              
              2.16
              
              
              
              (0.21
              )Net
      income (loss) per common share - Diluted
              
              
              2.15
              
              
              
              (0.21
              )


Included in the pro-forma revenue and
net income (loss) amounts above for the year ended December 31, 2006 and
the period from October 4, 2005 through December 31, 2005 is revenue
of $4.0 million and $3.4 million and net (loss) income of
$(1.7) million and $0.6 million, respectively, primarily relating to
an investment management agreement that was terminated by West End effective
June 30, 2006.





Island
Heritage





On July 3, 2007, Flagstone purchased
73,110 shares (representing a 21.4% interest) in Island Heritage for a purchase
price of $12.6 million. With this acquisition, Flagstone took a controlling
interest in Island Heritage by increasing its interest to 54.6% of the voting
shares.  Flagstone had previously acquired 33.2% of the shares through
three purchases in March 2006 ($7.3 million, 18.7% interest), October 2006 ($4.2
million, 9.8% interest) and May 2007 ($2.5 million, 4.7%
interest).  At December 31, 2007, the Company had recorded goodwill
and intangible assets not subject to amortization in the amount of $8.8 million
and $0.8 million, respectively, and $3.6 million and $nil, respectively, at
December 31, 2006.  Following the acquisition, the Company’s representation
on Island Heritage’s board and the close working relationship with its
management allows Flagstone to promote and support best practices in the
underwriting of Island Heritage’s underlying business and to consequently
enhance the quality of data available to Flagstone to underwrite the reinsurance
of such business. The Company recorded goodwill in excess of the fair value of
the acquired net assets to increase its participation in Island Heritage’s
reinsurance program and to expand its book of business into the developing
Caribbean markets.





Flagstone’s share of Island Heritage’s
results from operations was recorded in the Company’s consolidated financial
statements under the equity method of accounting through June 30, 2007. As a
result of the acquisition of the controlling interest, the results of operations
of Island Heritage have been included in the Company’s consolidated financial
statements from July 1, 2007, with the portions of Island Heritage’s net income
and shareholders’ equity attributable to minority shareholders recorded as
minority interest in the Company’s consolidated financial
statements.








The fair value of the net assets
acquired is summarized as follows:




As
      at
                July
      1, 2007Cash
      and cash equivalents
              
              $
              17,997Investments
              
              
              20,730Reinsurance
      premium balances receivable
              
              
              15,279Unearned
      premiums ceded
              
              
              3,579Deferred
      acquisition costs
              
              
              4,482Fixed
      assets
              
              
              1,883Other
      assets
              
              
              3,864Assets
      acquired
              
              
              67,814Loss
      and loss adjustment expense reserves
              
              
              2,490Unearned
      premiums
              
              
              18,312Accruals
      and other liabilities
              
              
              11,670Liabilities
      acquired
              
              
              32,472Net
      assets acquired
              
              $
              35,342






59
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)




The following unaudited pro-forma
information related to the Company’s acquisition of Island Heritage for the
years ended December 31, 2007 and 2006 and the period from October 4 through
December 31, 2005 illustrates the effects of the acquisition as if it had
occurred at the beginning of each of the periods presented.  The
pro-forma information is not intended to be indicative of the consolidated
results of operations that would have been reported if the acquisition had
occurred on January 1, 2007, January 1, 2006, or October 4, 2005 nor does it
purport to be indicative of combined results of operations which may be reported
in the future.




Period
      October 4Year
      Ended
              
              
              Year
      Ended
              
              
              throughDecember
      31, 2007
              
              
              December
      31, 2006
              
              
              December
      31, 2005(unaudited)
              
              
              (unaudited)
              
              
              (unaudited)Revenue
              
              $
              579,950
              
              
              $
              267,619
              
              
              $
              4,136Net
      income (loss)
              
              
              169,282
              
              
              
              154,638
              
              
              
              (11,686
              )Net
      income (loss) per common share - Basic
              
              
              2.07
              
              
              
              2.21
              
              
              
              (0.21
              )Net
      income (loss) per common share - Diluted
              
              
              2.06
              
              
              
              2.20
              
              
              
              (0.21
              )
  4.    MONT
FORT RE LIMITED





On March 6, 2006, the Company
entered into a share purchase agreement to purchase 370,000 common shares,
representing 100% of the outstanding common shares of Mont Fort, a segregated
accounts or “cell” company registered under
the Bermuda Segregated Accounts Companies Act 2000 (as amended), for
consideration of $0.1 million. The assets and liabilities acquired at the
date of purchase were $0.1 million and $nil, respectively. In
May 2006, the Company invested an additional $1.3 million in Mont
Fort.





Prior to the acquisition, the purpose
of Mont Fort was to facilitate third-party transactions in credit insurance and
reinsurance through its segregated accounts on a 100% matched, fully offset
basis so that it would bear no net retained insurance risk. Each policy written
by a segregated account would be entirely reinsured at the closing of the
transaction with high-credit quality counterparties.





As at December 31, 2006, and for the
year ended December 31, 2006, in accordance with FIN 46(R) the Company had
determined that Mont Fort was a VIE. The Company was not considered to be the
primary beneficiary and, therefore, was not required to consolidate Mont
Fort into its financial statements. The Company was deemed to have significant
influence over the operating and financial policies of Mont Fort due to its
board representation and 100% voting interests and Mont Fort was accounted for
under the equity method of accounting. Under this method, the Company recorded
all of the income or loss from the general account of Mont Fort but no income or
losses arising from the activities of the segregated account of Mont
Fort.





On January 2, 2007, Mont Fort closed an
offering of preferred shares relating to its second cell, Mont Fort ILW 2 which
yielded gross proceeds of $55.0 million from LB I.  Mont Fort, in
respect of Mont Fort ILW 2, entered into a quota share reinsurance contract with
Flagstone under which Flagstone assumes 8.3% of the business written by Mont
Fort ILW 2.





On January 12, 2007, Mont Fort
closed an offering of preferred shares relating to a third cell, Mont Fort HL
which yielded gross proceeds of $28.1 million. The investor in Mont Fort HL
is Newcastle Special Opportunity Fund V, L.P., an entity with no previous
investments or affiliations with the Company or with Mont Fort. Mont Fort, in
respect of Mont Fort HL, entered into a quota share reinsurance contract with
Flagstone under which Flagstone assumes 9.0% of the business written by Mont
Fort HL.





The Company determined that the
establishment of these cells was a reconsideration event under the provisions of
paragraph 7 and paragraph 15 of FIN 46(R). Consequently, the Company
assessed whether or not Mont Fort continued to be a VIE and, if so, whether the
Company or another party was Mont Fort’s primary beneficiary. The Company
assessed the impact of these reconsideration events on its results and financial
position, and concluded that the establishment of the Mont Fort HL cell on
January 12, 2007 was the reconsideration event that resulted in the Company
being the primary beneficiary of Mont Fort. As such, the results of Mont Fort
are included in the Company’s consolidated financial statements with effect from
January 12, 2007. The portions of Mont Fort’s net income and shareholder’s
equity attributable to holders of the preferred shares for the year ended
December 31, 2007 are recorded in the consolidated financial statements of the
Company as minority interest.





Further, with the addition of any new
contracts that the Company enters into with each of the new cells, the Company
will evaluate whether the contracts with Mont Fort continue to meet the risk
transfer parameters of SFAS No. 113, “Accounting and Reporting for Reinsurance
of Short-Duration and Long-Duration Contracts” ("SFAS 113") considered
individually and, where appropriate, in the aggregate.  In the event
that these cells caused any contract or group of contracts to fail to meet the
risk transfer parameters, the Company’s future financial statements would
account for these reinsurance transactions in accordance with the provisions of
Statement of Position 98-7 “Deposit Accounting: Accounting for Insurance and
Reinsurance Contracts that do not Transfer Insurance Risk.”





In accordance with a reinsurance
agreement entered into between Flagstone and Mont Fort on behalf on its cells,
Flagstone earns a ceding commission from the cells based on the level of
premiums ceded to the cells. During the year ended December 31, 2007,
transactions between Flagstone and Mont Fort were eliminated upon
consolidation.  During the year ended December 31, 2006, when
Mont Fort was not consolidated, Flagstone earned $0.4 million from Mont
Fort ILW under this arrangement.  West End also entered into an
investment management agreement with Mont Fort in respect to each
cell.  Under the agreement, West End earns an investment management
fee based on the current size of the cells and a performance-based fee of 15% of
the increase, if any, in the net asset value of each cell over the course of
each year. During the year ended December 31, 2006, West End earned
$1.3 million from Mont Fort ILW under this arrangement. On August 28,
2006, Mont Fort repurchased the preferred shares held by Flagstone for
$5.1 million, and Mont Fort in respect of Mont Fort ILW entered into a
quota share reinsurance contract with Flagstone under which Flagstone assumes
8.3% of the business written by Mont Fort ILW.





Included in the Company’s assets as at
December 31, 2007 were cash, cash equivalents and fixed maturity investments of
$177.0 million held for the sole benefit of preferred shareholders of each
specific Mont Fort cell and available to settle the specific current and future
liabilities of each cell.




60
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)




5.    INVESTMENTS





Fixed
maturity, short term and equity investments





The cost or amortized cost, gross
unrealized gains and losses, and carrying values of the Company’s fixed
maturity, short term and equity investments as at December 31, 2007 and
2006 are as follows:




As
      at December 31, 2007Gross
              
              
              GrossAmortized
              
              
              unrealized
              
              
              unrealizedcost
      or cost
              
              
              losses
              
              
              gains
              
              
              Fair
      valueFixed
      maturitiesU.S.
      government and government agency
              
              $
              479,462
              
              
              
              $
              (1
              )
              
              
              $
              14,508
              
              
              
              $
              493,969Other
      foreign governments
              
              
              545
              
              
              
              
              (2
              )
              
              
              
              15
              
              
              
              
              558Corporates
              
              
              265,569
              
              
              
              
              (5,786
              )
              
              
              
              909
              
              
              
              
              260,692Mortgage-backed
      securities
              
              
              198,242
              
              
              
              
              (2,315
              )
              
              
              
              2,807
              
              
              
              
              198,734Asset-backed
      securities
              
              
              155,331
              
              
              
              
              (468
              )
              
              
              
              289
              
              
              
              
              155,152Total
      fixed maturities
              
              $
              1,099,149
              
              
              
              $
              (8,572
              )
              
              
              $
              18,528
              
              
              
              $
              1,109,105Short
      term investments
              
              $
              23,660
              
              
              
              $
              (49
              )
              
              
              $
              5
              
              
              
              $
              23,616Equity
      investments
              
              $
              73,603
              
              
              
              $
              -
              
              
              
              $
              754
              
              
              
              $
              74,357
   As
      at December 31,  2006Gross
              
              
              GrossAmortized
              
              
              unrealized
              
              
              unrealizedcost
      or cost
              
              
              losses
              
              
              gains
              
              
              Fair
      valueFixed
      maturitiesU.S.
      government and government agency
              
              $
              252,775
              
              
              
              $
              (4,319
              )
              
              
              $
              9
              
              
              
              $
              248,465Corporates
              
              
              188,080
              
              
              
              
              -
              
              
              
              
              28
              
              
              
              
              188,108Mortgage-backed
      securities
              
              
              97,112
              
              
              
              
              -
              
              
              
              
              263
              
              
              
              
              97,375Asset-backed
      securities
              
              
              136,575
              
              
              
              
              -
              
              
              
              
              5
              
              
              
              
              136,580Other
      debt securities
              
              
              11,746
              
              
              
              
              -
              
              
              
              
              4
              
              
              
              
              11,750Total
      fixed maturities
              
              $
              686,288
              
              
              
              $
              (4,319
              )
              
              
              $
              309
              
              
              
              $
              682,278


Proceeds from the sale of fixed
maturity, short term and equity investments during the year ended
December 31, 2007 and 2006 amounted to $1.4 billion and $1.1 billion,
respectively.





The contractual maturity dates of fixed
maturity and short term investments as at December 31, 2007 and 2006 are as
follows:




As
      at December 31, 2007Amortized
      Cost
              
              
              Fair
      ValueDue
      within one year
              
              $
              57,039
              
              
              
              $
              57,033Due
      after 1 through 5 years
              
              
              373,643
              
              
              
              
              372,338Due
      after 5 through 10 years
              
              
              202,990
              
              
              
              
              209,821Due
      after 10 years
              
              
              135,564
              
              
              
              
              139,643Mortgage
      and asset-backed securities
              
              
              353,573
              
              
              
              
              353,886Total
              
              $
              1,122,809
              
              
              
              $
              1,132,721
   As
      at December 31, 2006Amortized
      Cost
              
              
              Fair
      ValueDue
      within one year
              
              $
              5,496
              
              
              
              $
              5,496Due
      after 1 through 5 years
              
              
              257,328
              
              
              
              
              256,965Due
      after 5 through 10 years
              
              
              88,447
              
              
              
              
              86,748Due
      after 10 years
              
              
              101,330
              
              
              
              
              99,114Mortgage
      and asset-backed securities
              
              
              233,687
              
              
              
              
              233,955Total
              
              $
              686,288
              
              
              
              $
              682,278


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






61
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)




As at December 31, 2007 and 2006,
100% of the Company’s fixed maturity investment portfolio was invested in
securities which were investment grade. As at December 31, 2007, the Company did
not hold any security with direct exposure to the sub-prime
markets.





Other
investments





The Company’s other investments
include:




As
      at
              
              
              As
      atDecember
      31, 2007
              
              
              December
      31,
                2006Island
      Heritage
              
              $
              -
              
              
              
              $
              8,826Mont
      Fort
              
              
              -
              
              
              
              
              1,445Investment
      funds
              
              
              31,249
              
              
              
              
              28,378Catastrophe
      bonds
              
              
              36,619
              
              
              
              
              35,847Real
      estate investment trusts
              
              
              12,204
              
              
              
              
              -Fixed
      income fund
              
              
              212,982
              
              
              
              
              -Other
      investments
              
              
              112
              
              
              
              
              -Total
      other investments
              
              $
              293,166
              
              
              
              $
              74,496


Flagstone’s share of Island Heritage’s
results from operations was recorded in the Company’s consolidated financial
statements under the equity method of accounting from April 1, 2006 (date of
initial investment) through June 30, 2007. As a result of the acquisition of the
controlling interest in July 2007, the results of operations of Island Heritage
have been included in the Company’s consolidated financial statements from July
1, 2007, with the portions of Island Heritage’s net income and shareholders’
equity attributable to minority shareholders recorded as minority interest in
the Company’s consolidated financial statements.  (See Note 3 for
additional discussion on Island Heritage)





See Note 4 for a discussion of Mont
Fort.





Catastrophe bonds held pay a variable
interest coupon and their return, from interest and return of principal, is
contingent upon climatological and geological events.  The catastrophe
bonds are recorded at fair value and as at December 31, 2007 and December 31,
2006 they had net realized gains of $0.8 and $0.9 million for the years then
ended, respectively.





The investment funds consist of
investments in a hedge fund and private equity funds.  The Company
accounts for its other investments at fair value based on the most recent
financial information available from fund managers and third party
administrators.





Fair
value disclosure





Prior to January 1, 2007, investments
were considered available-for-sale in accordance with SFAS 115, and were
carried at fair value with unrealized gains and losses recorded in accumulated
other comprehensive income. Following the issuance by the FASB of SFAS 159, the
Company elected to early adopt the fair value option for all fixed maturity
investments, equity investments (excluding investments accounted for under
the equity method of accounting), REITs, investment funds, catastrophe bonds,
and fixed income funds commencing January 1, 2007. This election requires
the Company to adopt 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 election of SFAS 159 will not
change the carrying value of our fixed maturity investments, equity investments,
REITs, investment funds, catastrophe bonds, fixed income funds and derivative
instruments as they were previously carried at fair value.  In
accordance with 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, asset backed securities and REITs are stated at Level 2 whereas
investment funds that are private placement investments and catastrophe bonds
are stated at Level 3 fair value.


62
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  As at
December 31, 2007, the Company’s investments are allocated between levels as
follows:




Fair
      Value Measurement at December 31, 2007, using:Fair
      Value
              
              Quoted
      Prices in
                Active Markets
              
              
              Significant
      Other
                Observable Inputs
              
              
              Significant
      Other
                Unobservable
                InputsMeasurements
              
              
              (Level
      1)
              
              
              (Level
      2)
              
              
              (Level
      3)DescriptionFixed
      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
      InvestmentsReal
      estate investment trusts
              
              
              12,204
              
              
              
              
              -
              
              
              
              
              12,204
              
              
              
              
              -Investment
      funds
              
              
              31,249
              
              
              
              
              -
              
              
              
              
              20,041
              
              
              
              
              11,208Catastrophe
      bonds
              
              
              36,619
              
              
              
              
              -
              
              
              
              
              -
              
              
              
              
              36,619Fixed
      income fund
              
              
              212,982
              
              
              
              
              212,982
              
              
              
              
              -
              
              
              
              
              -293,054
              
              
              
              
              212,982
              
              
              
              
              32,245
              
              
              
              
              47,827Totals
              
              $
              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
              
              
              Catastrophefunds
              
              
              bondsDescriptionBeginning
      balance
              
              $
              8,378
              
              
              
              $
              35,847Total
      realized and unrealized gains included in earnings
              
              
              1,124
              
              
              
              
              772Net
      purchases and sales
              
              
              1,706
              
              
              
              
              -Closing
      fair value
              
              $
              11,208
              
              
              
              $
              36,619


Net
investment income





Net investment income for the years
ended December 31, 2007 and 2006, and the period from October 4, 2005
through December 31, 2005 was $73.8 million, $34.2 million, and $0.6
million, respectively. The components are set out below:




Year
      Ended
                December
      31,
                2007
              
              
              Year
      Ended
                December
      31,
                2006
              
              
              Period
      October 4,
                2005
      through
                December
      31,
                2005Interest
      and dividend incomeCash
      and cash equivalents
              
              $
              12,911
              
              
              
              $
              18,176
              
              
              
              $
              629Fixed
      maturities
              
              
              45,830
              
              
              
              
              13,380
              
              
              
              
              -Short
      term
              
              
              150
              
              
              
              
              3,440
              
              
              
              
              -Equity
      investments
              
              
              308
              
              
              
              
              381
              
              
              
              
              -Other
      investments
              
              
              7,456
              
              
              
              
              -
              
              
              
              
              -Amortization
      incomeCash
      and cash equivalents
              
              
              -
              
              
              
              
              11
              
              
              
              
              -Fixed
      maturities
              
              
              8,128
              
              
              
              
              (155
              )
              
              
              
              -Short
      term
              
              
              102
              
              
              
              
              -
              
              
              
              
              -Other
      investments
              
              
              -
              
              
              
              
              27
              
              
              
              
              -Investment
      expenses
              
              
              (1,077
              )
              
              
              
              (1,048
              )
              
              
              
              -Net
      investment income
              
              $
              73,808
              
              
              
              $
              34,212
              
              
              
              $
              629




63
 Table of Contents


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






Net
realized and unrealized gains and losses





The analysis of the change in net
unrealized gains (losses) on investments reflected in accumulated other
comprehensive income (loss) for the years ended December 31, 2007 and 2006
and the period from October 4, 2005 through December 31, 2005 is as
follows:




Year
      Ended
                December
      31, 2007
              
              
              Year
      Ended
                December
      31, 2006
              
              
              Period
      October 4,
                2005 through
                December
      31, 2005Fixed
      maturities
              
              $
              -
              
              
              
              $
              (4,008
              )
              
              
              $
              -


Realized
investment gains and losses on the sale of fixed maturity, short term and equity
investments for the years ended December 31, 2007 and 2006 and the period
from October 4, 2005 through December 31, 2005 are as follows:





Net
      Realized Gains (Losses)Year
      Ended
                December
      31, 2007
              
              
              Year
      Ended
                December
      31, 2006
              
              
              Period
      October 4,
                2005 through
                December
      31, 2005Fixed
      maturity and short term investmentsGross
      realized gains
              
              $
              5,854
              
              
              
              $
              2,529
              
              
              
              $
              -Gross
      realized losses
              
              
              (13,106
              )
              
              
              
              (3,803
              )
              
              
              
              -EquitiesGross
      realized gains
              
              
              9,362
              
              
              
              
              2,207
              
              
              
              
              -Net
      realized gains
              
              $
              2,110
              
              
              
              $
              933
              
              
              
              $
              -
  The
following table is a breakdown of the net realized and unrealized
gains recorded in the consolidated statements of
operations:





Net
      Realized and Unrealized Gains (Losses)Period
      October 4,Year
      Ended
              
              
              Year
      Ended
              
              
              2005
      throughDecember
      31, 2007
              
              
              December
      31, 2006
              
              
              December
      31, 2005Net
      realized losses on fixed maturities
              
              $
              (7,252
              )
              
              $
              (1,274
              )
              
              $
              -Net
      unrealized gains on fixed maturities
              
              
              15,069
              
              
              
              -
              
              
              
              -Net
      realized gains on equities
              
              
              9,362
              
              
              
              2,207
              
              
              
              -Net
      unrealized gains on equities
              
              
              346
              
              
              
              -
              
              
              
              -Net
      realized and unrealized (losses) gains on derivative instruments -
      investments
              
              
              (983
              )
              
              
              8,382
              
              
              
              -Net
      realized and unrealized (losses) gains on derivative instruments -
      other
              
              
              (9,821
              )
              
              
              1,943
              
              
              
              -Net
      realized and unrealized gains on other investments
              
              
              632
              
              
              
              989
              
              
              
              -Total
      net realized and unrealized gains
              
              $
              7,353
              
              
              $
              12,247
              
              
              $
              -


The following table presents an
analysis of the available for sale fixed maturity investment positions which
were carried at an unrealized loss as at December 31, 2006:





As
      at December 31, 2006GrossUnrealizedAmortized
      Cost
              
              
              Losses
              
              
              Fair
      ValueFixed
      maturitiesU.S.
      government and government agency
              
              $
              181,665
              
              
              
              $
              (4,319
              )
              
              
              $
              177,346


For the year ended December 31, 2006
(prior to the adoption of SFAS 159), the Company considered several factors and
circumstances in the determination of other-than-temporary impairment, including
the issuer’s overall financial condition, the issuer’s credit and financial
strength ratings, the general market conditions in the industry or geographic
region in which the issuer operates, the length of time the fair value of an
issuer’s securities remains below cost, ability and intent to hold the security
and any other factors that may raise doubt about the issuer’s ability to
continue as a going concern. Other-than-temporary impairment were recorded as a
realized loss which reduced net income and earnings per share. Temporary losses
were recorded as unrealized losses which did not impact net income and earnings
per share but reduced other comprehensive income. The Company recorded
other-than-temporary impairment charges of $1.2 million relating to its
portfolio of investment securities during the year ended December 31, 2006
as the Company did not have the ability nor intent to hold these securities to
recovery.





Pledged
Assets





In accordance with the terms of the
letter of credit facility, the Company is required to maintain assets on deposit
to secure the drawn portion of the facility. As at December 31, 2007 and
2006, approximately $82.0 million and $75.4 million, respectively, of fixed
maturity securities were pledged in favor of ceding companies and other
counterparties to comply with reinsurance contract provisions and insurance
laws.




64
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  6.    LOSS
AND LOSS ADJUSTMENT EXPENSE RESERVES





Loss and loss adjustment expense
reserves consist of:




As
      at
                
                As
      atDecember
      31, 2007
                
                December
      31, 2006Case
      reserves
                
                $
                74,693
                
                
                $
                3,322IBNR
      reserves
                
                
                106,285
                
                
                
                19,194Loss
      and loss adjustment expense reserves
                
                $
                180,978
                
                
                $
                22,516


The following table represents an
analysis of paid and incurred losses and a reconciliation of the beginning and
ending loss and loss adjustment expense reserves for the years ended
December 31, 2007 and 2006:




Year
      Ended
                  
                  Year
      EndedDecember
      31, 2007
                  
                  December
      31, 2006Gross
      liability at beginning of year
                  
                  $
                  22,516
                  
                  
                  $
                  -Reinsurance
      recoverable at beginning of year
                  
                  
                  -
                  
                  
                  
                  -Net
      liability at beginning of year
                  
                  
                  22,516
                  
                  
                  
                  -Net
      incurred losses related to:Current
      year
                  
                  
                  196,734
                  
                  
                  
                  26,660Prior
      year
                  
                  
                  (3,875
                  )
                  
                  
                  -192,859
                  
                  
                  
                  26,660Net
      paid losses related to:Current
      year
                  
                  
                  32,664
                  
                  
                  
                  4,144Prior
      year
                  
                  
                  6,948
                  
                  
                  
                  -39,612
                  
                  
                  
                  4,144Effects
      of foreign exchange rate changes
                  
                  
                  2,726
                  
                  
                  
                  -Loss
      reserve on acquisition of Island Heritage
                  
                  
                  2,489
                  
                  
                  
                  -Net
      liability at end of year
                  
                  
                  180,978
                  
                  
                  
                  22,516Reinsurance
      recoverable at end of year
                  
                  
                  -
                  
                  
                  
                  -Gross
      liability at end of year
                  
                  $
                  180,978
                  
                  
                  $
                  22,516


Certain business written by the Company
has loss experience generally characterized as low frequency and high severity
in nature. This may result in volatility in the Company’s financial results.
Actuarial assumptions used to establish the liability for losses and loss
adjustment expenses are periodically adjusted to reflect comparisons to actual
losses and loss adjustment expenses development, inflation and other
considerations.  Prior period development arises from changes to loss
estimates recognized in the current year that relate to loss reserves first
reported in the previous calendar year.  These reserve changes were
made as part of our regular quarterly reserving process and primarily arose from
better than expected emergence of actual claims relative to our prior year
estimates. During the year ended December 31, 2007, we had net positive
development relating to the 2006 year of $3.9 million primarily related to the
property catastrophe line of business.





The Company was incorporated on
October 4, 2005, commenced operations on December 20, 2005 and did not
write any reinsurance contracts during the period ended December 31,
2005.





7.    REINSURANCE





The Company purchases reinsurance to
reduce its net exposure to losses. Reinsurance provides for recovery by the
Company of a portion of gross losses and loss adjustment expenses from its
reinsurers. The Company remains liable to the extent that its reinsurers do not
meet their obligations under these agreements and the Company therefore
regularly evaluates the financial condition of its reinsurers and monitors
concentration of credit risk. The reinsurance claims recoverable as at
December 31, 2007 and 2006 was $nil for both years.




65
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  Assumed
and ceded net premiums written and earned and loss and loss adjustment expenses
for the years ended December 31, 2007 and 2006 are as follows:




Year
      Ended December 31, 2007Loss
      and lossPremiums
                
                Premiums
                
                adjustmentwritten
                
                earned
                
                expensesAssumed
                
                $
                577,150
                
                
                $
                517,902
                
                
                $
                192,859Ceded
                
                
                (50,119
                )
                
                
                (40,765
                )
                
                
                -Net
                
                $
                527,031
                
                
                $
                477,137
                
                
                $
                192,859Year
      Ended December 31, 2006Loss
      and lossPremiums
                
                Premiums
                
                adjustmentwritten
                
                earned
                
                expensesAssumed
                
                $
                302,489
                
                
                $
                203,831
                
                
                $
                26,660Ceded
                
                
                (19,991
                )
                
                
                (11,768
                )
                
                
                -Net
                
                $
                282,498
                
                
                $
                192,063
                
                
                $
                26,660


For the period ended December 31,
2005, the Company recorded no premiums written or premiums earned.





As at December 31, 2007 and 2006, the
provision for doubtful accounts was $1.0 million and $0.1 million,
respectively.





8.    DERIVATIVE
INSTRUMENTS





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 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.





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 consolidated financial statements.  There were no
derivatives designated as hedges as of December 31, 2006.





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 long term debt.  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 year ended
December 31, 2007, the Company recorded $0.5 million of realized and
unrealized gains on interest rate swaps.  As at December 31,
2006, there were no interest rate swaps in the portfolio.





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 pay 3.962% and 4.096%
interest, respectively. The 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
pay 4.095% interest.  The agreement will terminate on July 30,
2012.  As of December 31, 2007, the fair value of these swaps was $0.4
million and the Company recorded $0.4 million of unrealized gains on these
swaps.





Foreign
currency swaps





The Company periodically uses foreign
currency swaps to minimize the effect of fluctuating foreign currencies or to
gain exposure to interest rate differentials between differing market rates. In
September 2006, the Company entered into a foreign currency swap in
relation to the euro-denominated 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
pay LIBOR plus 371 basis points. The swap expires on September 15, 2011 and
had a fair value of $2.5 million and $0.4 million as at December 31,
2007 and 2006, respectively. During the years ended December 31, 2007 and 2006,
the Company recorded $2.0 million and $0.4 million, respectively, of realized
and unrealized gains 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 December 31, 2007 and 2006 was
$311.1 million and $84.9 million, and had a fair value of $(7.1) million
and $0.5 million, respectively. The Company designated $264.4 million of
foreign currency forwards contractual value as hedges, which had a fair value of
$(3.4) million as of December 31, 2007.  During the years ended
December 31, 2007 and 2006, the Company recorded $14.0 million and
$1.0 million respectively of realized and unrealized losses on foreign
currency forward contracts.  The Company recorded $3.5 million of
unrealized losses directly into comprehensive income as part of the cumulative
translation adjustment for the effective portion of the hedge.  There
were no foreign currency forwards designated as hedges as of December 31,
2006.


66
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  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 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 year ended December
31, 2007, the Company recorded $4.7 million of realized and unrealized losses on
total return swaps.  As of December 31, 2006, there were no total
returns swaps in the portfolio.





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 December 31, 2007 and 2006, the notional principal
amount of TBAs was $18.2 million and $35.9 million and the fair value was
$0.2 million and $(0.1) million, respectively. During the years ended
December 31, 2007 and 2006, the Company recorded $(0.8) million and
$1.6 million respectively of realized and unrealized gains (losses) on
TBAs.





Futures





The Company has entered into
index and interest rate futures. At December 31, 2007 and 2006, the
notional amount of index and interest rate futures were $421.0 million and
$178.5 million respectively. The net fair value of futures contracts was
($2.2) million and $1.9 million as at December 31, 2007 and 2006,
respectively. During the years ended December 31, 2007 and 2006, the
Company recorded $4.4 million and $8.3 million, respectively, of realized
and unrealized gains 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 $(1.3) million and $(0.2) million at
December 31, 2007 and 2006, respectively. During the years ended
December 31, 2007 and 2006, the Company recorded $1.7 million and
$0.4 million respectively of realized gains on ILWs determined to be
derivatives.





Fair
value disclosure





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




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


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
      reinsurancederivativesDescriptionOpening
      fair value
              
              $
              (197
              )Total
      realized and unrealized gains included in earnings
              
              
              1,749Net
      purchases and sales
              
              
              (2,857
              )Closing
      fair value
              
              $
              (1,305
              )


9.    TAXATION





The
Company is not subject to Bermuda income or capital gains tax under current
Bermuda law. The Company has received an undertaking from the Minister of
Finance in Bermuda that, in the event of any taxes being imposed, the Company
will be exempt from taxation in Bermuda until March 2016 pursuant to the Bermuda
Exempted Undertakings Tax Protection Act of 1966.  Flagstone Suisse
has been granted a partial tax holiday from the cantonal tax administration of
the canton of Valais providing an exemption from cantonal and municipal
corporate income taxes for a period of 10 years.




67
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)




The
Company has subsidiaries that operate in various other jurisdictions around the
world that are subject to tax and examination by taxing authorities in the
jurisdictions in which they operate. The significant jurisdictions in which the
Company’s subsidiaries are subject to tax are Canada, India, Switzerland, U.S.
Virgin Islands and the United Kingdom.  Income tax returns are
open for examination for the tax years 2004-2006 in Canada, 2004-2006 in the
U.S. Virgin Islands and 2006-2007 in India.  Due to its limited history,
the Company’s subsidiaries in Switzerland and the United Kingdom have not yet
filed income tax returns and therefore do not yet have any tax years open for
examination.




As a
global organization, the Company may be subject to a variety of transfer pricing
or permanent establishment challenges by taxing authorities in various
jurisdictions. Management believes that adequate provision has been made in the
consolidated financial statements for any potential assessments that may result
from tax examinations for all open tax years.





On
January 1, 2007, the Company adopted the provisions of FIN 48. The adoption of
FIN 48 did not result in any unrecognized tax benefits or expenses for the year
ended December 31, 2007. Management has deemed all material tax positions to
have a greater than 50% likelihood of being sustained on technical merits if
challenged. The Company does not expect any material unrecognized tax benefits
within 12 months of December 31, 2007.





Income
tax expense for the years ended December 31, 2007 and 2006 was as
follows:




Year
      Ended
                
                Year
      EndedDecember
      31, 2007
                
                December
      31, 2006Current Tax
      ExpenseCurrent
      Income Tax ExpenseCanada
                
                $
                203
                
                
                $
                128India
                
                
                43
                
                
                
                -Switzerland
                
                
                1
                
                
                
                -United
      Kingdom
                
                
                72
                
                
                
                -U.S.
      Virgin Islands
                
                
                464
                
                
                
                -Deferred
      Income Tax ExpenseCanada
                
                
                -
                
                
                
                -India
                
                
                -
                
                
                
                -Switzerland
                
                
                -
                
                
                
                -United
      Kingdom
                
                
                -
                
                
                
                -U.S.
      Virgin Islands
                
                
                -
                
                
                
                -Total
      income tax expense
                
                $
                783
                
                
                $
                128Net
      current liabilities
                
                $
                59
                
                
                $
                25Net
      deferred tax assets
                
                
                -
                
                
                
                -Net
      tax liabilities
                
                $
                59
                
                
                $
                25


For the period from October 4, 2005 to
December 31, 2005, the Company did not have operations in taxable
jurisdictions.





Deferred tax assets reflect the tax
impact of temporary differences between the carrying amounts of assets and
liabilities for financial reporting and income tax purposes. Significant
components of the net deferred tax assets as of December 31, 2007 and 2006
were as follows:




As
      at
                
                As
      atDecember
      31, 2007
                
                December
      31, 2006Deferred tax
      inventoryDeferred
      tax assetsNet
      operating loss carryforward
                
                $
                399
                
                
                $
                -Valuation
      allowance
                
                
                (399
                )
                
                
                -Deferred
      tax assets net of valuation allowance
                
                $
                -
                
                
                $
                -


The valuation allowance relates to an
operating loss in one of the Company’s foreign subsidiaries.  Although
local tax laws allow tax losses to be carried forward for a period of seven
years, the Company believes it is necessary to establish a valuation allowance
against this deferred tax asset due to its short operating history and
uncertainty regarding the Company’s ability to generate sufficient future income
to utilize the loss carried forward and realize the asset.


68
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  The
following table is a reconciliation of the actual income tax rate for to the
amount computed by applying the effective rate of 0% under Bermuda law to income
before income taxes:




Year
      Ended
                
                Year
      EndedDecember
      31, 2007
                
                December
      31, 2006Tax rate
      reconciliationIncome
      before taxes
                
                $
                168,705
                
                
                $
                152,466Reconciliation
      of effective tax rate (% of income before taxes)Expected
      rate
                
                
                0.0%
                
                
                
                0.0%Foreign
      taxes at the local expected rate
                
                
                0.2%
                
                
                
                0.1%Valuation
      allowance
                
                
                0.2%
                
                
                
                0.0%Other
                
                
                0.1%
                
                
                
                0.0%0.5%
                
                
                
                0.1%


10.   DEBT
AND FINANCING ARRANGEMENTS





Long
term debt





The Company’s debt outstanding as at
December 31, 2007 and 2006 is as follows:




OutstandingIssue
                
                Issue
                
                Notional
                
                Interest
                
                First
      Call
                
                Maturity
                
                Balance
      as atType
                
                Date
                
                Amount
                
                Rate
                
                Date
                
                Date
                
                December
      31, 2007Deferrable
      Interest Debentures
                
                August
      2006
                
                $120,000
                
                LIBOR
      + 3.54%
                September
      15, 2011
                
                September
      15, 2036
                
                $                         
       120,000Deferrable
      Interest Debentures
                
                August
      2006
                
                €
      13,000
                
                Euribor
      + 3.54%
                September
      15, 2011
                
                September
      15, 2036
                
                $                            
      19,006Junior
      Subordinated Deferrable Interest Notes
                June
      2007
                
                $100,000
                
                LIBOR
      + 3.00%
                July
      30, 2012
                
                July
      30, 2037
                
                $                          
      100,000Junior
      Subordinated Deferrable Interest Notes
                September
      2007
                
                $25,000
                
                LIBOR
      + 3.10%
                September
      15, 2012
                
                September
      15, 2037
                
                $                            
      25,000Other
      - IAL King Air
                
                July
      2007
                
                $945
                
                LIBOR
      + 1.95%
                n/a
                
                March
      15, 2009
                
                $                                 
      883$                          
      264,889


SFAS No. 107, “Disclosure about Fair
Value of Financial Instruments” (“SFAS 107”), requires disclosure
of  fair value information of financial instruments. For financial
instruments where quoted market prices are not available, the fair value of
these financial instruments is estimated by discounting future cash flows or by
using similar recent transactions. Because considerable judgment is used, these
estimates are not necessarily indicative of amounts that could be realized in a
current market exchange.  The Company does not carry its long term
debt at fair value on its consolidated balance sheets.  As at December
31, 2007 and 2006, the Company estimated the fair value of its long term debt to
be approximately equal to its carrying value as they were recently issued and
pay a floating interest rate.




The Note indentures contain various
covenants, including limitations on liens on the stock restricted subsidiaries,
restrictions as to the disposition of the stock of restricted subsidiaries and
limitations on mergers and consolidations.  The Company was in
compliance with all the covenants contained in the Note indentures at December
31, 2007.





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 Notes to the earliest
they may be called by the Company. For the years ended December 31, 2007
and 2006, the Company incurred interest expense and amortization of debt
offering expenses of $18.7 million, and $4.6 million on the
Notes.  For the period October 4, 2005 through December 31, 2005, the
Company did not incur any interest expense.  Also, at
December 31, 2007 and 2006, the Company had $1.9 million and
$0.5 million, respectively, of interest payable included in other
liabilities in the consolidated balance sheets.





Future principal and interest
payments on long term debt are expected to be as follows:




Year2008
                
                $
                21,2892009
                
                
                21,8702010
                
                
                21,1072011
                
                
                21,1072012
                
                
                21,107Later
      years
                
                
                773,031Total
      minimum future principal and interest payments
                
                $
                879,511


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 December 31, 2007 and 2006, $73.8 million and
$67.8 million, respectively, had been drawn under this facility, and the
drawn amount of the facility was secured by respectively $82.0 million and
$75.4 million of fixed maturity securities from the Company’s investment
portfolio.


69
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  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 December 31, 2007, if drawn upon, the
utilized portion of the facility will be secured by an appropriate portion of
securities from the Company’s investment portfolio.





11.   SHAREHOLDERS’
EQUITY





Common
shares





At December 31, 2007 and 2006, the
total authorized common voting shares of the Company were 150,000,000 with a par
value of $0.01 per common share.





The holders of common voting shares are
entitled to receive dividends as declared from time to time and are entitled to
one vote per common share, subject to certain restrictions. Voting rights of all
shares may be amended under the voting adjustment provisions in the Company’s
bye-laws designed to preserve certain U.S. shareholders’ tax positions with
respect to their shares to ensure their voting interest is less than 9.9% to
comply with certain provisions of the Internal Revenue Code and the rules and
regulations promulgated thereunder.





On December 20, 2005, the Company
issued 55,239,491 common shares for gross proceeds of $552.4 million and
incurred issuance costs of $4.6 million.





On
February 1 and February 23, 2006, the Company had two additional share
subscriptions from which it raised $148.0 million and $15.1 million,
respectively, raising the total number of issued common shares to 71,547,891.
Issuance costs related to February 2006 subscriptions were
$0.3 million.





On April
4, 2007, the Company completed an initial public offering of 13,000,000 of its
common shares for gross proceeds of $175.5 million and incurred issuance costs
of $16.2 million. On April 30, 2007, the underwriters of the initial public
offering exercised their option to purchase an additional 750,000 common shares
of the Company at the public offering price less underwriting discounts and
commissions. Gross proceeds of $10.1 million were received by the Company and
$0.7 million issuance costs were incurred.  The Company has
contributed the proceeds from this offering to Flagstone to increase its
underwriting capacity and Flagstone has invested the proceeds according to its
investment strategy.





The
following table is a summary of common shares issued and
outstanding:




Period
      October 4,Year
      Ended
                
                Year
      Ended
                
                2005
      throughDecember
      31, 2007
                
                December
      31, 2006
                
                December
      31, 2005Balance
      - beginning of period
                
                
                71,547,891
                
                
                
                55,239,491
                
                
                
                -Conversion
      of restricted share units
                
                
                11,216
                
                
                
                -
                
                
                
                -Issue
      of shares
                
                
                13,750,000
                
                
                
                16,308,400
                
                
                
                55,239,491Balance
      - end of period
                
                
                85,309,107
                
                
                
                71,547,891
                
                
                
                55,239,491


Warrant





In connection with the initial closing
of the private placement for the Company’s common shares in December 2005,
the Company issued a warrant to Haverford for its role in these capital raising
activities (the “Warrant”). The Company has
determined the Warrant to be compensatory and has recorded its fair value as
compensation in the issuance period as there is no required service period. The
Warrant granted the holder the right, at any time during the period commencing
on December 1, 2010 and ending December 31, 2010, to purchase from the
Company up to 12.0% of the issued share capital of the Company at the
consummation of the initial private placements of the Company at an exercise
price of $14.00 per common share.





The Warrant has been classified as an
equity instrument, in accordance with Emerging Issues Task Force Issue
No. 00-19, “Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
Stock”.The
compensation expense based on the fair value at the date of grant was
$12.2 million for the initial closing of the private placement, and is
included in general and administrative expenses and in additional paid-in
capital in the consolidated financial statements for the period ended
December 31, 2005. This value has been calculated using the Black-Scholes
option pricing model. The assumptions used were: risk-free interest rate 4.4%;
expected life 4.95 years; volatility 26.0%; dividend yield nil. The
volatility assumption was based on the average historical volatility of a group
of comparable companies over a period equal to the expected life of the Warrant.
As at December 31, 2005, 6,628,739 common shares would be issuable pursuant
to the Warrant.





Subsequently, in connection with the
February 1 and February 23, 2006 additional closings of the private
placement of 1,957,008 common shares, the Warrant was amended such that the
number of common shares that could be issuable upon exercise of the Warrant
would be 8,585,747, being 12.0% of the issued share capital as at
February 23, 2006. The additional compensation expense based on the fair
value on the date of grant was $3.4 million and is included in general and
administrative expenses and in additional paid-in capital in the consolidated
financial statements for the year ended December 31, 2006. This value has
been calculated using the Black-Scholes option pricing model. The assumptions
used were: risk-free interest rate 4.6%, expected life 4.8 years,
volatility 25.0%, dividend yield nil. The volatility assumption was based on the
average historical volatility of a group of comparable companies over a period
equal to the expected life of the Warrant. With the completion of the Company’s
private placement in February 2006, there have been and will be no further
additions to the number of common shares underlying the Warrant other than due
to stock splits or otherwise in accordance with the terms of the
Warrant.





12.    SHARE
BASED COMPENSATION





The Company accounts for share based
compensation in accordance with SFAS No. 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.


70
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  Performance
Share Units





The 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 (the “Committee”), PSUs may be granted to
executive officers and certain other key employees and vesting is contingent
upon the Company meeting certain DROE goals.





Upon vesting, the PSU holder shall be
entitled to receive a number of common shares of the Company (or the cash
equivalent, at the election of the Company) equal to the product of the number
of PSUs granted multiplied by a factor based on the Company’s DROE during the
vesting period. The factor will range between zero and two, depending on the
DROE achieved during the vesting period. PSUs vest over a period of
approximately three years. At the Company’s board meeting and the special
general meeting of shareholders held on November 16, 2006, the PSU Plan was
amended to increase the maximum number of PSUs that can be issued under the PSU
Plan from 1.5 million to 2.8 million and to increase the maximum number of
common shares that can be issued under the PSU Plan from 3.0 million to 5.6
million. The fair value of PSUs granted under the PSU Plan is estimated on the
date of grant using the fair value on the grant date and the most probable DROE
outcome. If certain DROE goals are not met, no compensation cost is recognized.
A summary of the activity under the PSU Plan as at December 31, 2007, 2006
and 2005 and changes during the year ended December 31, 2007 and 2006 and
the period from October 4, 2005 through December 31, 2005, are as
follows:




Number
                
                Weighted
      average grant date fair value
                
                Weighted
      average remaining contractual termOutstanding
      at October 4, 2005
                
                
                -Granted
                
                
                321,000
                
                
                $
                10.00Outstanding
      at December 31, 2005
                
                
                321,000
                
                
                
                10.00
                
                
                
                3.0Granted
                
                
                392,000
                
                
                
                10.06Outstanding
      at December 31, 2006
                
                
                713,000
                
                
                
                10.03
                
                
                
                2.0Forfeited
                
                
                (30,000
                )
                
                
                11.21Granted
                
                
                975,700
                
                
                
                13.54Outstanding
      at December 31, 2007
                
                
                1,658,700
                
                
                
                12.07
                
                
                
                1.7


As at December 31, 2007 and 2006,
there was a total of $11.9 million and $5.0 million, respectively, of
unrecognized compensation cost related to non-vested PSUs; that cost is expected
to be recognized over a period of approximately 2.1 and 2.0 years,
respectively. A compensation expense of $6.0 million, $2.1 million and
$34,000 has been recorded in general and administrative expenses for the years
ended December 31, 2007 and 2006 and for the period from October 4,
2005 through December 31, 2005, 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 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 December 31, 2007 and 2006 and changes during the years ended
December 31, 2007 and 2006 are as follows:




Number
                
                Weighted
      average grant date fair value
                
                Weighted
      average remaining contractual termOutstanding
      at December 31, 2005
                
                
                -Granted
                
                
                123,677
                
                
                $
                10.49
                
                
                
                1.1Forfeited
                
                
                (5,950
                )
                
                
                10.37Outstanding
      at December 31, 2006
                
                
                117,727
                
                
                
                10.49
                
                
                
                0.8Granted
                
                
                250,899
                
                
                
                13.31Forfeited
                
                
                (30,800
                )
                
                
                12.15Converted
      into common shares
                
                
                (11,216
                )
                
                
                12.02Outstanding
      at December 31, 2007
                
                
                326,610
                
                
                
                12.45
                
                
                
                0.6


As at December 31, 2007 and 2006,
there was a total of $1.3 million and $0.5 million, respectively of
unrecognized compensation cost related to non-vested RSUs; that cost is expected
to be recognized over a period of approximately 0.9 and 1.5 years,
respectively. A compensation expense of $2.2 million and $0.7 million has
been recorded in general and administrative expenses for the years ended
December 31, 2007 and 2006, respectively, in relation to the RSU
Plan.





No RSUs granted to employees have
vested or been cancelled since the inception of the Plan.  During the
years ended December 31, 2007 and 2006, 62,449 and 53,827 RSU’s, respectively,
were granted to the directors.  During the year ended 2007, upon
termination of service of a director, 11,216 RSUs were converted into common
shares of the Company.




71
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  13.   EARNINGS
(LOSS) PER COMMON SHARE





The computation of basic and diluted
earnings per common share for the year ended December 31, 2007 and 2006,
and the period from October 4, 2005 through December 31, 2005 is as
follows:





Year
      Ended
                December
      31, 2007
              
              Year
      Ended
                December
      31, 2006
              
              Period
      October 4,
                2005 through
                December
      31, 2005Basic earnings per common
      shareNet
      income (loss)
              
              $
              167,922
              
              
              $
              152,338
              
              
              $
              (12,384
              )Weighted
      average common shares outstanding
              
              
              81,882,866
              
              
              
              70,027,100
              
              
              
              55,239,491Weighted
      average vested restricted share units
              
              
              92,518
              
              
              
              26,987
              
              
              
              -Weighted
      average common shares outstanding—Basic
              
              
              81,975,384
              
              
              
              70,054,087
              
              
              
              55,239,491Basic
      earnings (loss) per common share
              
              $
              2.05
              
              
              $
              2.17
              
              
              $
              (0.22
              )Diluted earnings per common
      shareNet
      income (loss)
              
              $
              167,922
              
              
              $
              152,338
              
              
              $
              (12,384
              )Weighted
      average common shares outstanding
              
              
              81,882,866
              
              
              
              70,027,100
              
              
              
              55,239,491Weighted
      average vested restricted share units outstanding
              
              
              92,518
              
              
              
              26,987
              
              
              
              -81,975,384
              
              
              
              70,054,087
              
              
              
              55,239,491Share
      equivalents:Weighted
      unvested restricted share units
              
              
              136,206
              
              
              
              -
              
              
              
              -Weighted
      unvested performance share units
              
              
              -
              
              
              
              339,734
              
              
              
              -Weighted
      average common shares outstanding—Diluted
              
              
              82,111,590
              
              
              
              70,393,821
              
              
              
              55,239,491Diluted
      earnings (loss) per common share
              
              $
              2.05
              
              
              $
              2.16
              
              
              $
              (0.22
              )


As at
December 31, 2007, 2006, and 2005, there were securities which would result
in the issuance of common shares that were excluded in the computation of
diluted earnings (loss) per common share because the effect would be
anti-dilutive.  These securities were as follows:




Period
      October 4,Year
      Ended
                
                Year
      Ended
                
                2005
      throughDecember
      31, 2007
                
                December
      31, 2006
                
                December
      31, 2005Warrant
                
                
                8,585,747
                
                
                
                8,585,747
                
                
                
                6,628,739Unvested
      performance share units
                
                
                -
                
                
                
                -
                
                
                
                321,000Unvested
      restricted share units
                
                
                221,550
                
                
                
                63,900
                
                
                
                -Total
                
                
                8,807,297
                
                
                
                8,649,647
                
                
                
                6,949,739


In
addition, because the number of shares contingently issuable under the PSU Plan
depends on the average DROE over a three year period, commencing in 2007, the
PSUs are excluded from the calculation of diluted earnings (loss) 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.





14.  
MINORITY INTEREST





At December 31, 2007, the Company’s
consolidated results include the results of Mont Fort from January 12, 2007
onwards (see Note 4). The portions of Mont Fort’s net income and shareholders’
equity attributable to holders of the preferred shares for the year ended
December 31, 2007 are recorded in the consolidated financial statements of the
Company as minority interest.  In relation to Mont Fort, the Company
recorded a minority interest expense of $33.6 million for the year ended
December 31, 2007 and $165.2 million was included in minority interest on the
consolidated balance sheet as at December 31, 2007.





At December 31, 2007, the Company’s
consolidated results include the results of Island Heritage from July 1, 2007
onwards (see Note 3). The portions of Island Heritage’s net income and
shareholders’ equity attributable to the minority shareholders for the year
ended December 31, 2007 are recorded in the consolidated financial statements of
the Company as minority interest.   In relation to Island
Heritage, the Company recorded a minority interest expense of $2.2 million for
the year ended December 31, 2007 and $19.6 million was included in minority
interest on the consolidated balance sheet as at December 31, 2007.





15.   RELATED
PARTY TRANSACTIONS





Haverford sponsored the Company’s
formation in October 2005 and invested $100.0 million in its initial
private placement. The Company’s Executive Chairman, Mark Byrne (“Mr. Byrne”),
and the Company’s Chief Executive Officer, David Brown (“Mr. Brown”), serve as
directors of Haverford.





As at December 31, 2007 and 2006,
Haverford directly owns 10.0 million common shares, or 11.7% and 13.9%
respectively, of the Company’s outstanding common shares and is the holder of
the Warrant which will entitle it to purchase up to an additional 8,585,747
common shares of the Company in December 2010. The impact of the conversion
of the Warrant would increase Haverford’s ownership interest to 19.8% and 23.2%
of the outstanding voting common shares at December 31, 2007 and 2006,
respectively. The Company paid $1.0 million to Haverford in relation to
services performed in respect of the initial private placement.





Haverford also owns all of the share
capital of Haverford Investment Holdings Ltd., which owns 6.0% of the
voting common shares of Haverford Capital Partners (Cayman) Limited (“HCP”). The Chief Executive
Officer of HCP is also a director of the Company. HCP directly owns 2.5 million
common shares, or 2.9% and 3.5% of the outstanding common shares of the Company
at December 31, 2007 and 2006, respectively.


72
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  During
the period ended December 31, 2005, the Company paid $0.2 million to
HCP in relation to services performed in respect of the initial capital
subscription. The Company entered into a consultancy arrangement with
Meetinghouse LLC, a company controlled by the Chief Executive Officer of HCP.
The consultancy arrangement provided for 150 hours of actuarial services at
a rate of $500 per hour, for the period from December 2005 through
March 2006. During the period from October 4, 2005 through
December 31, 2005, the Company incurred $21,000 for services relating to
the development of financial and business models. During the year ended
December 31, 2006, additional expenses of $54,000 were incurred for
services relating to business model development. These expenses have been
recorded in general and administrative expenses.





On December 20, 2005 Flagstone
entered into a 24-month Operational Support Agreement (“OSA”) with West End. Mr. Byrne
and Mr. Brown had ownership interests in West End, of 70.6% and 16.6%,
respectively. West End provided Flagstone with certain insurance management and
related support services for a fee pursuant to an OSA. Flagstone incurred $nil,
$1.0 million and $25,000 in expenses under the OSA for the years ended
December 31, 2007 and 2006 and the period from October 4, 2005 through
December 31, 2005, respectively. Fees charged under the OSA were based on
an hourly fee rate for certain individuals.





On March 31, 2006, the Company
purchased all of the common shares of West End for a purchase price of
$16.1 million. The Company purchased 12,000 shares (representing a 70.6%
interest) from Mr. Byrne and 2,829 shares (representing a 16.6% interest) from
Mr. Brown.





On March 31, 2006, Flagstone
acquired 63,783 common shares of Island Heritage from Haverford, representing at
the time 18.7% of the common shares and 22.5% of the votes for a purchase price
of $7.3 million.





Flagstone entered into an excess of
loss reinsurance agreement with Island Heritage during 2007 and 2006 under which
Flagstone assumed a share of Island Heritage’s residential and commercial
property risks. Premiums written under the agreement included in the Company’s
consolidated financial statements during the year ended December 31, 2007
and 2006 amounted to $1.7 million and $1.4 million, respectively and
$0.4 million was due from Island Heritage at December 31, 2006.
Employees of the Company serve as directors of Island Heritage.  As a
result of the acquisition of the controlling interest in July 2007, the results
of operations of Island Heritage have been included in the Company’s
consolidated financial statements from July 1, 2007, and therefore, the results
of the excess of loss reinsurance agreement from July 2007 onwards have been
eliminated with the consolidation of Island Heritage’s results into the
Company’s consolidated financial statements.





On March 31, 2006, the Company
purchased all of the common shares of Mont Fort from Haverford for a purchase
price of $0.1 million (see note 4).





On June 5, 2006, West End entered into
an investment management agreement with Mont Fort in respect of Mont Fort ILW
under which West End earns an investment management fee of 0.5% per year based
on the current size of Mont Fort ILW and a performance-based fee of 15.0% of the
increase, if any, in the net asset value of Mont Fort ILW over the course of
each year. During the year ended December 31, 2006, West End earned
$1.3 million from Mont Fort ILW under this arrangement. With effect from
January 12, 2007, the results of Mont Fort are consolidated in the Company’s
consolidated financial statements, and therefore, Mont Fort’s results during
year ended December 31, 2007 have been eliminated.





On June 6, 2006, Flagstone entered into
a reinsurance agreement with Mont Fort in respect of Mont Fort ILW under which
Mont Fort ILW assumed a share of Flagstone’s Industry Loss Warranty exposure.
Premiums ceded to Mont Fort ILW during the year ended December 31, 2006
amounted to $15.1 million and $0.6 million was included in amounts due
from related parties as at December 31, 2006. In accordance with the
reinsurance agreement, Flagstone earned a ceding commission of $0.4 million
from Mont Fort ILW during the year ended December 31, 2006. On
August 28, 2006, Mont Fort repurchased the preferred shares held by
Flagstone for $5.1 million, and Mont Fort in respect of Mont Fort ILW
entered into a quota share reinsurance contract with Flagstone under which
Flagstone assumes 8.3% of the business written by Mont Fort ILW.





The Company has extensively used two
aircraft owned and operated by entities controlled by Mr.
Byrne.  Given the Company’s worldwide operations, in July 2007 the
Company’s Board voted unanimously that it was in the Company’s best interest to
acquire from Mr. Byrne the aircraft and the operating company that supported the
aircraft.  The Company’s Code of Ethics adopted in June of 2006 and
the Audit Committees Charter require the Audit Committee to review any situation
in which a private interest of an employee or Director has a potential
conflict of interest or is a related party transaction. The above transactions
were reviewed directly with the Chairman of the Audit Committee in accordance
with its Charter.





On August 22, 2007, the Company,
through its wholly owned subsidiary, Flagstone Leasing Services Limited
(“Flagstone Leasing”) entered into a Share Purchase Agreement (“King Air
Agreement”) with Mr. Byrne, owner of 100% of the issued and outstanding common
voting shares of IAL King Air Limited (“IAL King Air”).   Pursuant to
the terms of the King Air Agreement, Flagstone Leasing, on August 28, 2007,
acquired all of the issued and outstanding common voting shares of IAL
King Air for a cash purchase price of $1.6 million. The purchase price
equaled the value of the net assets acquired, inclusive of debt of $0.9 million.
IAL King Air owned, as its principal asset, a King Air B-200
aircraft.  The value attributed to the aircraft for the purpose of
this transaction was determined by the average of two independent
appraisals.





On August 23, 2007, Flagstone Leasing
entered into a Share Purchase Agreement (“IAL Agreement”) with Mr. Byrne,
Haverford and West End to acquire 100% of the issued and outstanding
common voting shares of IAL Leasing Limited (“IAL”).  Mr. Byrne, Haverford
and West End owned 90%, 5% and 5%, respectively, of the issued and outstanding
common voting shares of IAL.   Pursuant to the terms of the IAL
Agreement, Flagstone Leasing, on August 28, 2007, acquired all of the
issued and outstanding common voting shares of IAL for a cash purchase price of
$1.4 million. The purchase price equaled the value of the net assets acquired,
inclusive of debt of $17.1 million due to Banc of America Leasing and Capital
LLC (“BoA”). IAL owned, as its principal asset, a Dassault Falcon 900B aircraft
(“the Falcon”).   In consideration of Mr. Byrne forgiving debt due to
him from IAL, and his undertaking with respect to the indemnities contained in
the IAL Agreement, he received 100% of the purchase price. The value attributed
to the aircraft for the purpose of this transaction was determined by the
average of two independent appraisals.  On September 25, 2007, IAL
concluded a sale lease-back transaction with BoA in relation to the Falcon. With
this transaction, IAL sold the Falcon and the related debt financing to BoA for
a cash consideration of $1.4 million and entered into an operating lease with
BoA to lease the Falcon for a term of 10 years.





Effective, August 29, 2007 Longtail
Aviation Limited (“Longtail”), an entity controlled by Mr. Byrne, entered into
an Amalgamation Agreement (“Agreement”) with a wholly owned subsidiary of the
Company, Longtail Aviation International Limited (“Longtail International”) .
Longtail provides support, maintenance and pilot services for the aircraft
utilized by the Company in its worldwide operations.  Pursuant to the terms
of the Agreement, Longtail was, subject to certain regulatory approvals required
by the Bermuda Registrar of Companies, amalgamated (merged) into Longtail
International in consideration of payment for agreed net assets in Longtail as
of July 31, 2007 and forgiveness of debt owed to Mr. Byrne by
Longtail.    Mr. Byrne, as Longtail’s principal shareholder
received $1.9 million from Longtail International. The consideration paid to Mr.
Byrne was equal to the net assets received by Longtail
International.





Prior to
the acquisition of Longtail in August 2007, the Company participated in a
charter agreement with Longtail which permitted the Company to charter private
aircraft. The Company incurred an expense of $1.1 million, $1.9 million and
$20,000 in relation to this agreement during the years ended December 31,
2007 and 2006 and the period October 4, 2005 through December 31, 2005,
respectively, which was included within general and administrative expenses, and
$0.2 million was included in due to related parties as at December 31,
2006.


73
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  In July
2006, the Company entered into a sale agreement with IAL for the purchase of a
Westwind 1124A aircraft. The Company paid IAL $1.8 million for the private
aircraft. The value for the transaction was determined by the average of two
independent appraisals from qualified aircraft valuation experts. The
transaction closed on July 31, 2006. Prior to the acquisition of Longtail
in August 2007, Flagstone Westwind Holdings Limited (“Flagstone Westwind”), a
wholly owned subsidiary of the Company, had entered into a 24-month management
and joint use agreement on August 1, 2006 with Longtail for the management
and charter of its Westwind 1124A aircraft. Pursuant to the agreement, Flagstone
Westwind paid Longtail a management fee of $6,000 per month and received a fee
from Longtail of $2,000 per charter hour flown. Flagstone Westwind bears the
costs of maintaining the aircraft. As at December 31, 2006, Flagstone
Westwind had an amount of $0.1 million due to Longtail which was included
in amounts due to related parties.





During the year ended December 31,
2006, West End earned advisory and performance fees from Rockridge, Mont Fort
and Island Heritage of $1.8 million, $1.3 million, and $39,044. As a
result of the acquisition of the controlling interest in Island Heritage by
Flagstone, the results of operations of Island Heritage have been included in
the Company’s consolidated financial statements from July 1, 2007, and
therefore, the investment advisory fees from July 1, 2007 onwards have been
eliminated with the consolidation of Island Heritage’s results into the
Company’s consolidated financial statements.  Investment advisory fees
earned from Island Heritage from January 1, 2007 through June 30, 2007 were
$nil.  With effect from January 12, 2007, the results of Mont Fort are
consolidated in the Company’s consolidated financial statements, and therefore,
Mont Fort’s investment advisory fees during year ended December 31, 2007 have
been eliminated.  During the year ended December 31, 2006, the
Company earned investment advisory fees of $1.4 million from Value Capital
L.P. A subsidiary of the Company was the General Partner of Value Capital L.P.
On June 30, 2006, the Company terminated its investment advisory agreement
with Value Capital L.P.





During the years ended
December 31, 2007 and 2006 and the period from October 4, 2005 through
December 31, 2005, the Company made lease payments of $0.3 million,
$0.4 million, and $nil, respectively to Eye Patch Holdings Limited, a
company in which Haverford has a 40.0% stake and from which the Company leases
office space.





On September 5, 2006, the Company
entered into a foreign currency swap agreement with Lehman Brothers Inc. in
relation to the issuance of the Deferrable Interest Debentures. Under the terms
of the agreement, the Company exchanged €13.0 million for
$16.7 million, will receive Euribor plus 354 basis points and will pay
LIBOR plus 371 basis points. The agreement will terminate on September 15,
2011 and had a fair value of $2.5 million and $0.4 million as at
December 31, 2007 and 2006, respectively. Affiliates of Lehman
Brothers Inc. are shareholders of the Company and preferred shareholders of
Mont Fort. Lehman Brothers Inc. provided additional investment banking
services to the Company in connection with the initial private placement of the
Company, for which it received fees of $2.0 million. Lehman Brothers Inc.
acted as an underwriter of the Company's initial public offering, for which it
received fees of $3.4 million.





On December 7, 2007, the Company
entered into an interest rate swap agreement with Lehman Brothers Special
Financing Inc. Under the terms of the agreement, the Company exchanged interest
on a notional amount of $25.0 million, will receive interest at three month
LIBOR and will pay 4.096% interest. The agreement will terminate on
September 15, 2012. On December 7, 2007, the Company entered into an
interest rate swap agreement with Lehman Brothers Special Financing Inc.
Under the terms of the agreement, the Company exchanged interest on a notional
amount of $120.0 million, will receive interest at three month LIBOR and will
pay 3.962% interest. The agreement will terminate on September 15, 2011.
The fair value of the two swaps was $0.2 million as at December 31,
2007.





16.   COMMITMENTS
AND CONTINGENCIES





Concentrations
of credit risk





Credit risk arises out of the failure
of a counter-party to perform according to the terms of the contract. The
Company is exposed to credit risk in the event of non-performance by the
counterparties to the Company’s foreign exchange forward contracts, currency
swaps and interest rate swaps. However, because the counterparties to these
agreements are high credit quality international banks, the Company does not
anticipate any non-performance. The difference between the contract amounts and
the related fair market values in excess of the contract amount is the Company’s
maximum credit exposure.





As at December 31, 2007 and 2006,
substantially all of the Company’s cash and investments were held with two
custodians.





The Company’s investment portfolio is
managed by external advisors in accordance with prudent standards of
diversification. Specific provisions limit the allowable holdings of a single
issue or issuer. The Company believes that there are no significant
concentrations of credit risk associated with its investments.





Brokers





The Company also underwrites the
majority of its reinsurance business through brokers and a credit risk exists
should any of these brokers be unable to fulfill their contractual obligations
with respect to the payments of reinsurance balances to the Company.
Concentrations of credit risk with respect to reinsurance balances are as
described in Note 18.





For the years ended December 31,
2007 and 2006, four brokers respectively accounted for approximately 83% and 87%
of gross premiums written respectively, each of which individually accounted for
10% or more of the total gross premiums written.





Lease
commitments





The Company and its subsidiaries lease
office space and guest accommodations in the countries in which they operate
under operating leases which expire at various dates. The Company renews and
enters into new leases in the ordinary course of business as required. Total
rent expense with respect to these operating leases for the years ended
December 31, 2007 and 2006 was approximately $1.2 million and
$0.6 million.




74
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)




Future
minimum rental lease payments under the leases are expected to be as
follows:




Lease
      Commitments - RentalYear2008
              
              $
              1,7492009
              
              
              1,5462010
              
              
              1,1622011
              
              
              1,0212012
              
              
              854Later
      years
              
              
              1,631Total minimum future rental lease commitments
              
              $
              7,963


On September 25, 2007, IAL Leasing
entered into an operating lease with BoA to lease a Dassault Falcon 900B
aircraft which an original cost of $18.5 million for a term of 10
years.  The monthly rent commenced in November 2007 in the amount of
$0.1 million per month.  During the term of the lease, the Company has
the option to exercise an early buyout option at month 60 of the lease term for
83.90% of the lessor’s cost, at month 96 for 69.79% of the lessor’s cost,
purchase the aircraft at fair value at the end of the lease term, or return the
aircraft to the lessor. The Company and Flagstone are acting as guarantors under
the lease agreement.




On April 15, 2007, Flagstone King Air
Holdings entered into an operating lease with BoA to lease a King Air 350
aircraft which an original cost of $2.9 million for a term of 10
years.  The monthly rent commenced in May 2007 in the amount of
$27,388 per month.  During the term of the lease, the Company has the
option to exercise an early buyout option at month 60 of the lease term for
75.986% of the lessor’s cost, at month 102 for 51.465% of the lessor’s cost,
purchase the aircraft at fair value at the end of the lease term, or return the
aircraft to the lessor. Flagstone is acting as guarantor under the lease
agreement.




Future minimum lease payments under the
leases regarding the aircraft are expected to be as follows:




Lease
      Commitments - AircraftYear2008
              
              $
              1,9822009
              
              
              1,9822010
              
              
              1,9822011
              
              
              1,9822012
              
              
              1,982Later
      years
              
              
              9,275Total minimum future lease commitments
              
              $
              19,185


Legal
proceedings





In the normal course of business, the
Company may become involved in various claims litigation and legal proceedings.
As at December 31, 2007 and 2006, the Company was not a party to any
litigation or arbitration proceedings.





Investment
Commitments





During 2006, the Company made certain
commitments with respect to an investment in a private equity fund. As at
December 31, 2007 and 2006, the total outstanding investment commitment was
$6.4 million and $8.4 million, respectively.





Other
Commitments





Effective November 20, 2007, Island
Heritage entered into a share re-purchase agreement with one of its minority
shareholders. Under this agreement, Island Heritage will buy back 16,919 shares
(representing 5% of its common shares) on June 30, 2008 at a price of 1.78 times
the fully diluted book value as at December 31, 2007, amounting to $3.5
million.  The amount will be settled with fifty percent cash on or before
June 30, 2008 and fifty percent cash on or before December 31,
2008.





17.   DIVIDEND
RESTRICTIONS AND STATUTORY REQUIREMENTS





The Company’s ability to pay dividends
to common shareholders is subject to certain regulatory restrictions on the
payment of dividends by its subsidiaries.





The Insurance Act 1978 and Related
Regulations (“the
Act”) requires
Flagstone to maintain minimum levels of solvency and liquidity. The Act requires
Flagstone to maintain a minimum statutory capital and surplus equal to the
greater of $100.0 million, 50% of net premiums written (being gross
premiums written less ceded premiums, with a maximum of 25% of gross premiums
considered as ceded premiums for the purpose of this calculation) or 15% of the
loss and loss adjustment expense reserves. To satisfy these requirements,
Flagstone was required to maintain a minimum level of statutory capital and
surplus of $228.0 million and $141.2 million, as at December 31, 2007
and 2006, respectively. Actual statutory capital and surplus as at
December 31, 2007 and 2006 was $1.4 billion and $969.9 million,
respectively. In addition, Flagstone is required to maintain a minimum liquidity
ratio and is required to prepare annual statutory financial statements and to
file a statutory financial return.  As at December 31, 2007
and 2006, Flagstone was in compliance with all of the requirements of the
Act.





Flagstone Suisse is licensed to
operate as a reinsurer in Switzerland. Swiss law permits dividends to be
declared only after profits have been allocated to the reserves required by law
and to any reserves required by the articles of incorporation.  The
articles of incorporation of Flagstone Suisse do not require any specific
reserves.  Therefore, Flagstone Suisse must allocate any profits first
to the reserve required by Swiss law generally, and may pay as dividends only
the balance of the profits remaining after that allocation.  In the
case of Flagstone Suisse, Swiss law requires that 5% of the company’s profits be
allocated to a “general reserve” until the reserve reaches 20% of its paid-in
share capital.




75
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
  18.   SEGMENT
REPORTING





The Company’s management views the
operations and management of the Company as one operating segment. The Company
is primarily focused on writing global property, property catastrophe and short
tail specialty and casualty reinsurance. The Company regularly reviews the
financial results and assesses its performance on a single segment basis. As the
Company commenced operations on December 20, 2005, the Company did not
underwrite any risks for the period ended December 31, 2005.





The following tables set forth a
breakdown of the Company’s gross premiums written by line of business and
geographic area of risks insured for the periods indicated:




Year
      Ended December 31, 2007
              
              Year
      Ended December 31, 2006Gross
      premiums written
              
              Percentage
      of total
              
              Gross
      premiums written
              
              Percentage
      of totalLine of
      businessProperty
      catastrophe
              
              $
              411,566
              
              
              71.3
              %
              
              $
              219,102
              
              
              72.4
              %Property
              
              
              94,503
              
              
              16.4
              %
              
              
              56,417
              
              
              18.7
              %Short-tail
      specialty and casualty
              
              
              71,081
              
              
              12.3
              %
              
              
              26,970
              
              
              8.9
              %Total
              
              $
              577,150
              
              
              100.0
              %
              
              $
              302,489
              
              
              100.0
              %Year
      Ended December 31, 2007
              
              Year
      Ended December 31, 2006Gross
      premiums written
              
              Percentage
      of total
              
              Gross
      premiums written
              
              Percentage
      of totalGeographic area of risk insured(1)North
      America
              
              $
              297,928
              
              
              51.6
              %
              
              $
              160,384
              
              
              53.0
              %Worldwide
      risks (2)
              
              
              99,365
              
              
              17.2
              %
              
              
              37,815
              
              
              12.5
              %Europe
              
              
              79,894
              
              
              13.8
              %
              
              
              45,737
              
              
              15.1
              %Caribbean
              
              
              48,103
              
              
              8.3
              %
              
              
              10,291
              
              
              3.4
              %Japan
      and Australasia
              
              
              39,547
              
              
              6.9
              %
              
              
              31,690
              
              
              10.5
              %Other
              
              
              12,313
              
              
              2.2
              %
              
              
              16,572
              
              
              5.5
              %Total
              
              $
              577,150
              
              
              100.0
              %
              
              $
              302,489
              
              
              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.




For the years ended December 31,
2007 and 2006, premiums produced by brokers were as follows:




Year
      Ended December 31, 2007
              
              Year
      Ended December 31, 2006Gross
      premiums written
              
              Percentage
      of total
              
              Gross
      premiums written
              
              Percentage
      of totalName
      of brokerGuy
      Carpenter
              
              $
              153,781
              
              
              26.6
              %
              
              $
              49,845
              
              
              16.5
              %Benfield
              
              
              149,651
              
              
              25.9
              %
              
              
              78,217
              
              
              25.9
              %Aon
      Re Worldwide
              
              
              96,013
              
              
              16.6
              %
              
              
              63,675
              
              
              21.1
              %Willis
      Group
              
              
              77,030
              
              
              13.3
              %
              
              
              72,424
              
              
              23.9
              %Other
      brokers
              
              
              100,675
              
              
              17.6
              %
              
              
              38,328
              
              
              12.6
              %Total
              
              $
              577,150
              
              
              100.0
              %
              
              $
              302,489
              
              
              100.0
              %


19.   SUBSEQUENT
EVENTS





On
February 29, 2008, a quarterly dividend of $0.04 per common share was
declared.  The dividend was payable on March 12, 2008 to
shareholders of record at the close of business on March 6, 2008.





Imperial
Reinsurance Company Limited





On March 6, 2008 the Company signed an
agreement to subscribe to a majority stake (65%) in Imperial Reinsurance Company
Limited (“Imperial Re”).  The transaction is subject to regulatory
approvals and closing conditions and is expected to close in the second quarter
of 2008. The subscription amount, to be determined upon completion of
Imperial Re’s audited financial statements, will be approximately $20.8
million.


76
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)


Imperial
Re is domiciled in South Africa and writes multiple lines of reinsurance in
sub-Saharan Africa.  The Company believes that its capital and technical
support will enhance Imperial Re’s services, increase its market penetration and
broaden its product distribution within Africa.




20.  RECLASSIFICATIONS





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





21.  UNAUDITED
QUARTERLY FINANCIAL INFORMATION




Fourth
              
              Third
              
              Second
              
              FirstQuarter
              
              Quarter
              
              Quarter
              
              Quarter2007Net
      premiums written
              
              $
              55,786
              
              
              $
              91,132
              
              
              $
              181,345
              
              
              $
              198,768Net
      premiums earned
              
              
              125,270
              
              
              
              138,799
              
              
              
              111,842
              
              
              
              101,226Net
      investment income
              
              
              22,624
              
              
              
              17,022
              
              
              
              20,531
              
              
              
              13,631Net
      realized and unrealized gains (losses)
              
              
              (3,558
              )
              
              
              8,298
              
              
              
              (1,901
              )
              
              
              4,514Other
      income
              
              
              2,926
              
              
              
              1,961
              
              
              
              251
              
              
              
              673Total
      revenues
              
              
              147,262
              
              
              
              166,080
              
              
              
              130,723
              
              
              
              120,044Loss
      and loss adjustment expenses
              
              
              30,415
              
              
              
              37,439
              
              
              
              77,257
              
              
              
              47,748Acquisition
      costs
              
              
              26,054
              
              
              
              28,795
              
              
              
              14,725
              
              
              
              12,718General
      and administrative expenses
              
              
              24,229
              
              
              
              19,763
              
              
              
              13,800
              
              
              
              14,669Interest
      expense
              
              
              6,020
              
              
              
              5,873
              
              
              
              3,520
              
              
              
              3,264Net
      foreign exchange gains
              
              
              (2,109
              )
              
              
              (1,842
              )
              
              
              (56
              )
              
              
              (1,282
              )Total
      expenses
              
              
              84,609
              
              
              
              90,028
              
              
              
              109,246
              
              
              
              77,117Income
      before income taxes, minority interest and interest in earnings of equity
      investments
              
              
              62,653
              
              
              
              76,052
              
              
              
              21,477
              
              
              
              42,927Provision
      for income tax
              
              
              (432
              )
              
              
              (229
              )
              
              
              (77
              )
              
              
              (45
              )Minority
      interest
              
              
              (10,852
              )
              
              
              (9,317
              )
              
              
              (7,892
              )
              
              
              (7,733
              )Interest
      in earnings of equity investments
              
              
              -
              
              
              
              (257
              )
              
              
              1,186
              
              
              
              461Net
      income
              
              $
              51,369
              
              
              $
              66,249
              
              
              $
              14,694
              
              
              $
              35,610Basic
      net income per common share
              
              $
              0.60
              
              
              $
              0.78
              
              
              $
              0.17
              
              
              $
              0.50Diluted
      net income per common share
              
              $
              0.60
              
              
              $
              0.77
              
              
              $
              0.17
              
              
              $
              0.49Dividends
      declared per common share
              
              $
              0.04
              
              
              $
              0.04
              
              
              $
              -
              
              
              $
              -Fourth
              
              
              Third
              
              Second
              
              FirstQuarter
              
              
              Quarter
              
              Quarter
              
              Quarter2006Net
      premiums written
              
              $
              26,508
              
              
              $
              50,525
              
              
              $
              118,739
              
              
              $
              86,726Net
      premiums earned
              
              
              72,335
              
              
              
              63,481
              
              
              
              37,275
              
              
              
              18,972Net
      investment income
              
              
              9,562
              
              
              
              9,849
              
              
              
              8,173
              
              
              
              6,628Net
      realized and unrealized gains (losses)
              
              
              10,041
              
              
              
              10,827
              
              
              
              (5,526
              )
              
              
              (3,095
              )Other
      income
              
              
              2,874
              
              
              
              1,216
              
              
              
              2,009
              
              
              
              -Total
      revenues
              
              
              94,812
              
              
              
              85,373
              
              
              
              41,931
              
              
              
              22,505Loss
      and loss adjustment expenses
              
              
              7,110
              
              
              
              9,723
              
              
              
              3,609
              
              
              
              6,218Acquisition
      costs
              
              
              10,895
              
              
              
              10,946
              
              
              
              5,253
              
              
              
              2,845General
      and administrative expenses
              
              
              10,843
              
              
              
              7,649
              
              
              
              8,399
              
              
              
              7,850Interest
      expense
              
              
              3,357
              
              
              
              1,291
              
              
              
              -
              
              
              
              -Net
      foreign exchange gains
              
              
              (335
              )
              
              
              (419
              )
              
              
              (1,166
              )
              
              
              (159
              )Total
      expenses
              
              
              31,870
              
              
              
              29,190
              
              
              
              16,095
              
              
              
              16,754Income
      before income taxes and interest in earnings of equity
      investments
              
              
              62,942
              
              
              
              56,183
              
              
              
              25,836
              
              
              
              5,751Provision
      for income tax
              
              
              (50
              )
              
              
              (78
              )
              
              
              -
              
              
              
              -Interest
      in earnings of equity investments
              
              
              691
              
              
              
              804
              
              
              
              259
              
              
              
              -Net
      income
              
              $
              63,583
              
              
              $
              56,909
              
              
              $
              26,095
              
              
              $
              5,751Basic
      net income per common share
              
              $
              0.89
              
              
              $
              0.79
              
              
              $
              0.36
              
              
              $
              0.09Diluted
      net income per common share
              
              $
              0.88
              
              
              $
              0.79
              
              
              $
              0.36
              
              
              $
              0.09Dividends
      declared per common share
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              $
              -


77
 Table of Contents
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTES TO THE CONSOLIDATED
FINANCIAL STATEMENTS
 (Amounts in tables
expressed in thousands of U.S. dollars, except for ratios, share and per share
amounts)
   REPORT
ON SCHEDULES I-IV


Schedule
            
            
            
            PageI
      Summary of Investments
            
            
            
            79II
      Condensed Financial Information of Registrant
            
            
            
            80III
      Supplementary Insurance Information
            
            
            
            84IV
      Reinsurance
            
            
            
            85





All other schedules specified in
Regulation S-X are omitted for the reason that they are not required, are
not applicable, or that equivalent information has been included in the
consolidated financial statements, and notes thereto.




78
 Table of Contents
   FLAGSTONE REINSURANCE
HOLDINGS LIMITED


SCHEDULE I


SUMMARY
OF INVESTMENTS—OTHER THAN INVESTMENTS IN RELATED PARTIES AS AT DECEMBER 31,
2007


($ in thousands)




Amortized
              
              
              Fair
              
              
              Balance
      sheetcost
      or cost
              
              
              value
              
              
              amountType
      of investmentsFixed
      maturitiesBonds:United
      States Government and government agencies and authorities
              
              $
              479,462
              
              
              $
              493,969
              
              
              $
              493,969States,
      municipalities and political subdivisions
              
              
              -
              
              
              
              -
              
              
              
              -Foreign
      government
              
              
              545
              
              
              
              558
              
              
              
              558Public
      utilities
              
              
              -
              
              
              
              -
              
              
              
              -Convertible
      and bonds with warrants attached
              
              
              -
              
              
              
              -
              
              
              
              -All
      other corporate bonds
              
              
              619,142
              
              
              
              614,578
              
              
              
              614,578Certificates
      of deposit
              
              
              -
              
              
              
              -
              
              
              
              -Redeemable
      preferred stock
              
              
              -
              
              
              
              -
              
              
              
              -Total
      fixed maturities
              
              
              1,099,149
              
              
              
              1,109,105
              
              
              
              1,109,105Equities
      securities:Common
      stocksPublic
      utilities
              
              
              -
              
              
              
              -
              
              
              
              -Banks,
      trust and insurance companies
              
              
              -
              
              
              
              -
              
              
              
              -Industrial,
      miscellaneous and all other
              
              
              73,603
              
              
              
              74,357
              
              
              
              74,357Nonredeemable
      preferred stocks
              
              
              -
              
              
              
              -
              
              
              
              -Total
      equity securities
              
              
              73,603
              
              
              
              74,357
              
              
              
              74,357Mortgage
      loans on real estate
              
              
              -
              
              
              
              -
              
              
              
              -Real
      estate
              
              
              -
              
              
              
              -
              
              
              
              -Policy
      loans
              
              
              -
              
              
              
              -
              
              
              
              -Other
      long-term investments
              
              
              295,469
              
              
              
              293,166
              
              
              
              293,166Short-term
      investments
              
              
              23,660
              
              
              
              23,616
              
              
              
              23,616Total
      investments
              
              $
              1,491,881
              
              
              $
              1,500,244
              
              
              $
              1,500,244


79
 Table of Contents


FLAGSTONE
REINSURANCE HOLDINGS LIMITED


SCHEDULE II


CONDENSED FINANCIAL INFORMATION OF
REGISTRANT




FLAGSTONE
REINSURANCE HOLDINGS LIMITED


BALANCE
SHEETS


As
at December 31, 2007 and 2006


(PARENT
COMPANY)




($
in thousands of U.S. dollars)




2007
              
              2006ASSETSCash
      and cash equivalents
              
              $
              55
              
              
              $
              1,806Investment
      in subsidiaries
              
              
              1,230,824
              
              
              
              1,003,419Goodwill
              
              
              2,000
              
              
              
              2,000Other
      assets
              
              
              5,849
              
              
              
              7,206Total
      Assets
              
              $
              1,238,728
              
              
              $
              1,014,431LIABILITIESDue
      to subsidiaries
              
              $
              30,453
              
              
              $
              6,515Long
      term debt
              
              
              164,006
              
              
              
              137,159Accrued
      interest payable
              
              
              539
              
              
              
              529Other
      liabilities
              
              
              724
              
              
              
              1,181Total
      Liabilities
              
              
              195,722
              
              
              
              145,384SHAREHOLDERS’
      EQUITYCommon
      voting shares, 150,000,000 authorized, $0.01 par value, issued and
      outstanding (2007 - 85,309,107; 2006 - 71,547,891)
              
              
              853
              
              
              
              715Additional
      paid-in capital
              
              
              905,316
              
              
              
              728,378Retained
      earnings (deficit)
              
              
              136,837
              
              
              
              139,954Total
      Shareholders’ Equity
              
              
              1,043,006
              
              
              
              869,047Total
      Liabilities and Shareholders’ Equity
              
              $
              1,238,728
              
              
              $
              1,014,431





80
 Table of Contents
  FLAGSTONE
REINSURANCE HOLDINGS LIMITED


SCHEDULE
II


CONDENSED FINANCIAL INFORMATION OF REGISTRANT -
CONTINUED




FLAGSTONE
REINSURANCE HOLDINGS LIMITED


STATEMENTS
OF OPERATIONS


For
the years December 31, 2007 and 2006 and the Period from October 4, 2005 through
December 31, 2005


(PARENT
COMPANY)




($
in thousands of U.S. dollars)





2007
              
              2006
              
              2005REVENUESNet
      investment income
              
              $
              196
              
              
              $
              415
              
              
              $
              39Net
      realized and unrealized gains - investments
              
              
              2,228
              
              
              
              437
              
              
              
              -Total
      revenues
              
              
              2,424
              
              
              
              852
              
              
              
              39EXPENSESGeneral
      and administrative expenses
              
              
              2,888
              
              
              
              1,297
              
              
              
              175Share
      based compensation expense
              
              
              8,136
              
              
              
              6,208
              
              
              
              12,248Interest
      expense
              
              
              13,856
              
              
              
              4,648
              
              
              
              -Net
      foreign exchange gains
              
              
              1,845
              
              
              
              469
              
              
              
              -Total
      expenses
              
              
              26,725
              
              
              
              12,622
              
              
              
              12,423Income
      (loss) before income taxes, minority interest and interest in earnings of
      equity investments
              
              
              (24,301
              )
              
              
              (11,770
              )
              
              
              (12,384
              )Interest
      in earnings of equity investments
              
              
              192,223
              
              
              
              164,108
              
              
              
              -NET
      INCOME (LOSS)
              
              $
              167,922
              
              
              $
              152,338
              
              
              $
              (12,384
              )








81
 Table of Contents
  FLAGSTONE
REINSURANCE HOLDINGS LIMITED


SCHEDULE
II


CONDENSED FINANCIAL INFORMATION OF REGISTRANT -
CONTINUED




FLAGSTONE
REINSURANCE HOLDINGS LIMITED


STATEMENTS
OF CASH FLOWS


For
the years December 31, 2007 and 2006 and the Period from October 4, 2005 through
December 31, 2005


(PARENT
COMPANY)




($
in thousands of U.S. dollars)




2007
              
              2006
              
              2005Cash flows provided by (used
      in) operating activities:Net
      income (loss)
              
              $
              167,922
              
              
              $
              152,338
              
              
              $
              (12,384
              )Adjustments to reconcile net
      income to net cash provided by operating
activities:Net
      realized and unrealized gains
              
              
              (2,228
              )
              
              
              (437
              )
              
              
              -Share
      based compensation expense
              
              
              8,136
              
              
              
              6,208
              
              
              
              12,248Interest
      in earnings of equity investments
              
              
              (192,223
              )
              
              
              (164,108
              )
              
              
              -Changes
      in assets and liabilities, excluding net assets acquired:Other
      assets
              
              
              (33
              )
              
              
              (3,150
              )
              
              
              -Due
      to subsidiaries
              
              
              -
              
              
              
              -
              
              
              
              42Due
      to related parties
              
              
              -
              
              
              
              (42
              )
              
              
              97Accrued
      interest payable
              
              
              11
              
              
              
              529
              
              
              
              -Other
      liabilities
              
              
              (198
              )
              
              
              677
              
              
              
              449Net
      cash provided by operating activities
              
              
              (18,613
              )
              
              
              (7,985
              )
              
              
              452Cash flows used in investing
      activities:Net
      cash paid in acquisitions of subsidiaries
              
              
              (199,244
              )
              
              
              (311,386
              )
              
              
              (529,925
              )Net
      cash used in investing activities
              
              
              (199,244
              )
              
              
              (311,386
              )
              
              
              (529,925
              )Cash flows provided by (used
      in) financing activities:Issue
      of common shares, net of issuance costs paid
              
              
              171,644
              
              
              
              162,833
              
              
              
              547,805Issue
      of notes, net of issuance costs paid
              
              
              24,744
              
              
              
              132,810
              
              
              
              -Intercompany
      financing
              
              
              23,901
              
              
              
              6,473
              
              
              
              -Dividend
      paid on common shares
              
              
              (6,824
              )
              
              
              -
              
              
              
              -Other
              
              
              2,641
              
              
              
              729
              
              
              
              -Net
      cash provided by financing activities
              
              
              216,106
              
              
              
              302,845
              
              
              
              547,805(Decrease)
      increase in cash and cash equivalents
              
              
              (1,751
              )
              
              
              (16,526
              )
              
              
              18,332Cash
      and cash equivalents - beginning of period
              
              
              1,806
              
              
              
              18,332
              
              
              
              -Cash
      and cash equivalents - end of period
              
              $
              55
              
              
              $
              1,806
              
              
              $
              18,332Supplemental
      cash flow information:Interest
      paid
              
              $
              12,913
              
              
              $
              3,861
              
              
              $
              -


















82
 Table of Contents






FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 SCHEDULE
II
 CONDENSED
FINANCIAL INFORMATION OF REGISTRANT
 
 FLAGSTONE
REINSURANCE HOLDINGS LIMITED
 NOTE
TO CONDENSED FINANCIAL STATEMENTS
 As at
December 31, 2007 and 2006
 (PARENT
COMPANY)
 
 ($
in thousands of U.S. dollars)
 
 
 DEBT
AND FINANCING ARRANGEMENTS
 
 Long
term debt
 
 The Company’s debt outstanding as at
December 31, 2007 and 2006 is as follows:
 
 Issue
                  Type
              
              Issue
                  Date
              
              Notional
                  Amount
              
              Interest
                  Rate
              
              First
      Call
                  Date
              
              Maturity
                  Date
              
              Outstanding
                  Balance
      as at
                  December 31,
      2007Deferrable
      Interest Debentures
              
              August
      2006
              
              $
              120,000
              
              LIBOR
      + 3.54%
              
              September
      15, 2011
              
              September
      15, 2036
              
              $
              120,000Deferrable
      Interest Debentures
              
              August
      2006
              
              €
              13,000
              
              Euribor
      + 3.54%
              
              September
      15, 2011
              
              September
      15, 2036
              
              $
              19,006Junior
      Subordinated Deferrable Interest Notes
              
              September
      2007
              
              $
              25,000
              
              LIBOR
      + 3.10%
              
              September
      15, 2012
              
              September
      15, 2037
              
              $
              25,000$
              164,006
 
 SFAS No. 107, “Disclosure about Fair
Value of Financial Instruments” (“SFAS 107”), requires disclosure
of  fair value information of financial instruments. For financial
instruments where quoted market prices are not available, the fair value of
these financial instruments is estimated by discounting future cash flows or by
using similar recent transactions. Because considerable judgment is used, these
estimates are not necessarily indicative of amounts that could be realized in a
current market exchange. The Company does not carry its long term debt at fair
value on its consolidated balance sheets. As at December 31, 2007 and 2006, the
Company estimated the fair value of its long term debt to be equal to its
carrying value.
 
 The Notes indentures contain various
covenants, including limitations on liens on the stock restricted subsidiaries,
restrictions as to the disposition of the stock of restricted subsidiaries and
limitations on mergers and consolidations. The Company was in compliance with
all the covenants contained in the Notes indentures at December 31,
2007.
 
 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 Notes to the earliest
they may be called by the Company. For the years ended December 31, 2007
and 2006, the Company incurred interest expense and amortization of debt
offering expenses of $13.7 million, and $4.5 million on the Notes. For the
period October 4, 2005 through December 31, 2005 the Company did not incur any
interest expense. Also, at December 31, 2007 and 2006, the Company had
$0.5 million and $0.5 million, respectively, of interest payable
included in other liabilities in the consolidated balance sheets.
 
 Future
principal and interest payments on long term debt are expected to be as
follows:
 
 Year2008
              
              $
              13,4052009
              
              
              13,4052010
              
              
              13,4052011
              
              
              13,4052012
              
              
              13,405Later
      years
              
              
              484,320Total
              
              $
              551,344




83
 Table of Contents









FLAGSTONE
REINSURANCE HOLDINGS LIMITED


SCHEDULE
III


SUPPLEMENTARY
INSURANCE INFORMATION


As
at and for the Periods Ended December 31, 2007, 2006, and 2005


($
in thousands)







December
      31, 2007
                
                
                For
      the year ended December 31, 2007Future
      policy
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                Amortizationbenefits,
                
                
                
                
                
                
                
                
                
                
                
                Benefits,
                
                
                ofDeferred
                
                
                losses,
                
                
                
                
                
                
                
                
                
                
                
                claims,
                
                
                deferredpolicy
                
                
                claims
      and
                
                
                
                
                
                
                
                
                Net
                
                
                losses
      and
                
                
                policy
                
                
                Otheracquisition
                
                
                loss
                
                
                Unearned
                
                
                Premium
                
                
                investment
                
                
                settlement
                
                
                acquisition
                
                
                operating
                
                
                Premiumscosts
                
                
                expenses
                
                
                premiums
                
                
                revenue
                
                
                income
                
                
                expenses
                
                
                costs
                
                
                expenses
                
                
                written$
                30,607
                
                
                $
                180,978
                
                
                $
                175,607
                
                
                $
                477,137
                
                
                $
                73,808
                
                
                $
                192,859
                
                
                $
                82,292
                
                
                $
                72,461
                
                
                $
                577,150December
      31, 2006
                
                
                For
      the year ended December 31, 2006Future
      policy
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                Amortizationbenefits,
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                Benefits,
                
                
                ofDeferred
                
                
                losses,
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                claims,
                
                
                deferredpolicy
                
                
                claims
      and
                
                
                
                
                
                
                
                
                
                
                Net
                
                
                losses
      and
                
                
                policy
                
                
                Otheracquisition
                
                
                loss
                
                
                Unearned
                
                
                Premium
                
                
                investment
                
                
                settlement
                
                
                acquisition
                
                
                operating
                
                
                Premiumscosts
                
                
                expenses
                
                
                premiums
                
                
                revenue
                
                
                income
                
                
                expenses
                
                
                costs
                
                
                expenses
                
                
                written$
                11,909
                
                
                $
                22,516
                
                
                $
                98,659
                
                
                $
                192,063
                
                
                $
                34,212
                
                
                $
                26,660
                
                
                $
                29,939
                
                
                $
                34,741
                
                
                $
                302,489December
      31, 2005
                
                
                For
      the period from October 4, 2005 through December 31, 2005Future
      policy
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                Amortizationbenefits,
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                Benefits,
                
                
                ofDeferred
                
                
                losses,
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                claims,
                
                
                deferredpolicy
                
                
                claims
      and
                
                
                Net
                
                
                
                
                
                
                Net
                
                
                losses
      and
                
                
                policy
                
                
                Otheracquisition
                
                
                loss
                
                
                unearned
                
                
                Premium
                
                
                investment
                
                
                settlement
                
                
                acquisition
                
                
                operating
                
                
                Premiumscosts
                
                
                expenses
                
                
                premiums
                
                
                revenue
                
                
                income
                
                
                expenses
                
                
                costs
                
                
                expenses
                
                
                written$
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                629
                
                
                $
                -
                
                
                $
                -
                
                
                $
                13,013
                
                
                $
                -





84
 Table of Contents


FLAGSTONE
REINSURANCE HOLDINGS LIMITED


SCHEDULE
IV


REINSURANCE


As
at and for the Periods Ended December 31, 2007, 2006, and 2005


($
in thousands)





Percentage
      ofCeded
      to
              
              
              Assumed
      from
              
              
              
              
              
              amountGross
              
              
              other
              
              
              other
              
              
              Net
              
              
              assumed
      toamount
              
              
              companies
              
              
              companies
              
              
              amount
              
              
              net2007
      - Property and casualty
              
              $
              -
              
              
              $
              50,119
              
              
              $
              577,150
              
              
              $
              527,031
              
              
              
              110
              %2006
      - Property and casualty
              
              $
              -
              
              
              $
              19,991
              
              
              $
              302,489
              
              
              $
              282,498
              
              
              
              107
              %2005
      - Property and casualty
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              
              0
              %




85
 Table of Contents


ITEM 9.   CHANGES
IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE





None.





ITEM 9A.CONTROLS AND
PROCEDURES





In
connection with the preparation of this Form 10-K, our management has
performed an evaluation pursuant to Rule 13a-15(b) under the Securities Exchange
Act of 1934 (the “Exchange Act”), with the participation of our Chief Executive
Officer and Chief Financial Officer, of the effectiveness of our disclosure
controls and procedures (as defined in Rule 13a-15(e) under the Exchange
Act) as of December 31, 2007.  Disclosure controls and procedures are
designed to ensure that information required to be disclosed in reports filed or
submitted under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified by SEC rules and forms and that such
information is accumulated and communicated to management, including our Chief
Executive Officer and Chief Financial Officer, to allow for timely decisions
regarding required disclosures. Based on their evaluation, our Chief Executive
Officer and Chief Financial Officer concluded that, as of December 31, 2007, the
Company’s disclosure controls and procedures were effective.




This Form
10-K does not include a report of management’s assessment regarding internal
control over financial reporting or an attestation report of the Company’s
independent registered public accounting firm due to a transition period
established by rules of the Securities and Exchange Commission for newly public
companies.





ITEM 9B. OTHER
INFORMATION




None.





86
 Table of Contents


PART III





ITEM 10. DIRECTORS,
EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE





The information required by this item
is incorporated by reference from a definitive proxy statement (the “Proxy
Statement”) that will be filed with the SEC not later than 120 days after the
close of the fiscal year ended December 31, 2007 pursuant to Regulation 14A
under the Exchange Act.





We have adopted a Code of Business
Practices for the Company’s principal executive, financial and accounting
officers. These documents will be published on the Company’s website, www.flagstonere.bm, and will
be provided upon written request to the Company’s Secretary at its registered
office address, Crawford House, 23 Church Street, Hamilton HM 11, Bermuda. 
We intend to disclose any amendments to this Code by posting such information on
our website, as well as disclosing any waivers of this code applicable to our
principal executive officer, principal financial officer, principal accounting
officer or controller and other executive officers who perform similar functions
through such means or by filing a Form 8-K.




ITEM
11.EXECUTIVE
COMPENSATION





The information required by this item
is incorporated by reference in the Proxy Statement that will be filed with the
SEC not later than 120 days after the close of the fiscal year ended December
31, 2007 pursuant to Regulation 14A under the Exchange Act.





ITEM 12. SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, MANAGEMENT AND RELATED STOCKHOLDER
MATTERS





The information required by this item
is incorporated by reference in the Proxy Statement that will be filed with the
SEC not later than 120 days after the close of the fiscal year ended December
31, 2007 pursuant to Regulation 14A under the Exchange Act.





ITEM 13. CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE





The
information required by this item is incorporated by reference in the Proxy
Statement that will be filed with the SEC not later than 120 days after the
close of the fiscal year ended December 31, 2007 pursuant to Regulation 14A
under the Exchange Act.





The Company has extensively used two
aircraft owned and operated by entities controlled by Mark Byrne, the Company’s
Executive Chairman (“Mr. Byrne”). Given the Company’s worldwide operations, in
July 2007 the Company’s Board voted unanimously that it was in the Company’s
best interest to acquire from Mr. Byrne the aircraft and the operating company
that supported the aircraft.





On August 22, 2007, the Company,
through its wholly owned subsidiary, Flagstone Leasing Services Limited
(“Flagstone Leasing”) entered into a Share Purchase Agreement (“King Air
Agreement”) with Mr. Byrne, owner of 100% of the issued and outstanding common
voting shares of IAL King Air Limited (“King Air”). Pursuant to the terms of the
King Air Agreement, Flagstone Leasing, on August 28, 2007, acquired all of the
issued and outstanding common voting shares of IAL King Air for a cash purchase
price of $1.6 million. The purchase price equaled the value of the net assets
acquired, inclusive of debt of $0.9 million, and Mr. Byrne received 100% of the
purchase price. IAL King Air owned, as its principal asset, a King Air B-200
aircraft. The value attributed to the aircraft for the purpose of this
transaction was determined by the average of two independent
appraisals.





On August 23, 2007, Flagstone Leasing
entered into a Share Purchase Agreement ( “IAL Agreement”) with Mr. Byrne,
Haverford ( Bermuda) Ltd. and West End Capital Management (Bermuda) Limited to
acquire 100% of the issued and outstanding common voting shares of IAL Leasing
Limited (“IAL”). Mr. Byrne, Haverford (Bermuda) Ltd. and West End Capital
Management (Bermuda) Limited, a wholly owned subsidiary of the Company, owned
90%, 5% and 5%, respectively, of the issued and outstanding common voting shares
of IAL. Pursuant to the terms of the IAL Agreement, Flagstone Leasing, on August
28, 2007, acquired all of the issued and outstanding common voting shares of IAL
for a cash purchase price of $1.4 million. The purchase price equaled the value
of the net assets acquired, inclusive of debt of $17.1 million due to Banc of
America Leasing and Capital, LLC (“BoA”). IAL owned, as its principal asset, a
Dassault Falcon 900B aircraft (“the Falcon”). In consideration of Mr. Byrne
forgiving debt due to him from IAL, and his undertaking with respect to the
indemnities contained in the IAL Agreement, Mr. Byrne received 100% of
the purchase price. The value attributed to the aircraft for the purpose of this
transaction was determined by the average of two independent appraisals. On
September 25, 2007, IAL concluded a sale lease-back transaction with BoA in
relation to the Falcon. With this transaction, IAL sold the Falcon and the
related debt financing to BoA for a cash consideration of $1.4 million and
entered into an operating lease with BoA to lease the Falcon for a term of 10
years.





Effective August 29, 2007, Longtail
Aviation Limited (“Longtail”), an entity controlled by Mr. Byrne, entered into
an Amalgamation Agreement (“Agreement”) with a wholly owned subsidiary of the
Company, Longtail Aviation International Limited (“Longtail International”).
Longtail provides support, maintenance and pilot services for the aircraft
utilized by the Company in its worldwide operations. Pursuant to the terms of
the Agreement, Longtail was, subject to certain regulatory approvals required by
the Bermuda Registrar of Companies, amalgamated (merged) into Longtail
International in consideration of payment for agreed net assets in Longtail as
of July 31, 2007 and forgiveness of debt owed to Mr. Byrne by Longtail. Mr.
Byrne, as Longtail’s principal shareholder, received $1.9 million from Longtail
International. The consideration paid to Mr. Byrne was equal to the net assets
received by Longtail International.  Prior to
the acquisition of Longtail in August 2007, the Company participated in a
charter agreement with Longtail which permitted the Company to charter private
aircraft. The Company incurred an expense of $1.1 million, in relation to this
agreement during the year ended December 31, 2007.




During
the year ended December 31, 2007, the Company made lease payments of $0.3
million to Eye Patch Holdings Limited, a company in which Haverford has a 40.0%
stake and from which the Company leases office space.  Haverford
sponsored the Company's formation in October 2005 and invested $100.0 million in
its initial private placement.  Mr. Byrne and David A. Brown, the
Company's Chief Executive Officer, serve as directors of
Haverford.  As at December 31, 2007, Haverford directly owned 10.0
million common shares, or 11.7%, of the Company’s outstanding shares and is the
holder of the Warrant which will entitle it to purchase up to an additional
8,585,747 common shares of the Company in December 2010.  The impact
of the conversion of the Warrant would increase Haverford's ownership interest
to 19.8% of the outstanding voting common shares at December 31,
2007.  The Company paid $1.0 million to Haverford in relation to
services performed in respect of the initial private placement.
 
 Haverford
also owns all of the share capital of Haverford Investment Holdings Ltd., which
owns 6.0% of the voting common shares of Haverford Capital Partners (Cayman)
Limited (“HCP”).  The Chief Executive Officer of HCP is also a
director of the Company.  HCP directly owns 2.5 million common shares,
or 2.9%, of the outstanding common shares of the Company at December 31,
2007.
 
 On
December 7, 2007, the Company entered into an interest rate swap agreement with
Lehman Brothers Special Financing Inc. Under the terms of the agreement, the
Company exchanged interest on a notional amount of $25.0 million, will receive
interest at three month LIBOR and will pay 4.096% interest. The agreement will
terminate on September 15, 2012. On December 7, 2007, the Company entered into
an interest rate swap agreement with Lehman Brothers Special Financing Inc.
Under the terms of the agreement, the Company exchanged interest on a notional
amount of $120.0 million, will receive interest at three month LIBOR and will
pay 3.962% interest. The agreement will terminate on September 15, 2011. The
fair value of the two swaps was $0.2 million as at December 31,
2007.  Affiliates of Lehman Brothers Inc. are shareholders of the
Company and preferred shareholders of Mont Fort. Lehman Brothers Inc. acted as
an underwriter of the Company's IPO, for which it received fees of $3.4
million.




The Company’s Code of Ethics adopted in
June of 2006 and the Audit Committees Charter require the Audit Committee to
review any situation in which a private interest of an employee or Director has
a potential conflict of interest or is a related party transaction. The above
transactions were reviewed directly with the Chairman of the Audit Committee in
accordance with its Charter.





ITEM 14. PRINCIPAL
ACCOUNTANT FEES AND SERVICES





The information required by this item
is incorporated by reference in the Proxy Statement that will be filed with the
SEC not later than 120 days after the close of the fiscal year ended December
31, 2007 pursuant to Regulation 14A under the Exchange Act.




87
 Table of Contents


PART IV





ITEM 15. EXHIBITS
AND FINANCIAL STATEMENT SCHEDULES










88
 Table of Contents


SIGNATURES


Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act
of 1934, the Company has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized, on March 19, 2008.




FLAGSTONE
      REINSURANCE HOLDINGS LIMITEDBy:
              /s/
      David A. BrownName: 
      David A. BrownTitle:   
      Chief Executive Officer and Director




Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Company and in the
capacities and on the dates indicated.


Signature
              
              Title
              
              Date/s/
      Mark
      J. Byrne
              
              Executive
      Chairman and Director
              
              March 19, 2008Mark
      J. Byrne/s/
      David
      A. Brown
              
              Chief
      Executive Officer (Principal Executive Officer) and
      Director
              
              March 19, 2008David
      A. Brown/s/
      James
      O’Shaughnessy
              
              Chief
      Financial Officer (Principal Financial Officer and Principal Accounting
      Officer)
              
              March 19, 2008James
      O’Shaughnessy/s/  Gary
      Black
              
              Director
              
              March 19, 2008Gary
      Black/s/
      Stephen Coley
              
              Director
              
              March 19, 2008Stephen
      Coley/s/ Thomas
      Dickson
              
              Director
              
              March 19, 2008Thomas
      Dickson/s/
      Stewart Gross
              
              Director
              
              March 19, 2008Stewart
      GrossDirector
              
              March 19, 2008E. Daniel
      James/s/
      Tony
      Knap
              
              Director
              
              March 19, 2008Tony
      Knap/s/
      Marc Roston
              
              Director
              
              March 19, 2008Marc
      Roston/s/
      Jan Spiering
              
              Director
              
              March 19, 2008Jan
      Spiering/s/
      Wray T. Thorn
              
              Director
              
              March 19, 2008Wray
      T. Thorn/s/
      Peter Watson
              
              Director
              
              March 19, 2008Peter
      Watson








89




EXHIBIT
INDEX


Pursuant
to Item 601 of Regulation S-K
   Exhibit
      No.
              Description
      of Exhibit3.1
              Memorandum
      of Association (incorporated by reference to Exhibit 3.1 to Amendment
      No. 1 to the registration statement of the Company
                on
      Form S-1 (file no. 333-138182) (the “Registration Statement”) filed
      December 8, 2006)3.2
              Amended
      and Restated Bye-laws (incorporated by reference to Exhibit 3.1 to
      the Company’s Quarterly Report on Form 10-Q filed August 9,
      2007)3.3
              Certificate
      of Deposit of Memorandum of Increase of Share Capital (incorporated by
      reference to Exhibit 3.3 to Amendment No. 4 to the Registration
      Statement filed February 14, 2007)4.1
              Specimen
      Common Share Certificate (incorporated by reference to Exhibit 4.1 to
      Amendment No. 4 to the Registration Statement filed February 14,
      2007)4.2
              Warrant
      dated February 23, 2006 (incorporated by reference to Exhibit 4.2 to
      Amendment No. 1 to the Registration Statement filed December 8,
      2006)4.3
              Junior
      Subordinated Indenture dated as of August 23, 2006 between Flagstone
      Reinsurance Holdings Limited and JPMorgan Chase Bank, N.A., as trustee
                (incorporated
      by reference to Exhibit 4.3 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)4.4
              Indenture,
      dated as of June 8, 2007, between Flagstone Finance S.A., as Issuer,
      Flagstone Reinsurance Holdings Limited,
                as
      Guarantor, and Wilmington Trust Company, as Trustee (incorporated by
      reference to Exhibit 4.1 to the Company’s Current Report
                on
      Form 8-K dated June 14, 2007)10.1
              Amended
      and Restated Shareholders’ Agreement
      dated as of November 15, 2006 among Flagstone Reinsurance Holdings Limited
      and the shareholders
                listed
      therein(incorporated
      by reference to Exhibit 10.1 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.3*
              Flagstone
      Reinsurance Holdings Limited Performance Share Unit Plan (incorporated by
      reference to Exhibit 10.3 to Amendment No. 1 to
                theRegistration
      Statementfiled
      December 8, 2006)10.4*
              Flagstone
      Reinsurance Holdings Limited Restricted Share Unit Plan (incorporated by
      reference to Exhibit 10.4 to Amendment No. 1 to
                the
      Registration Statement filed December 8, 2006)
   90
   10.5
              Pledge
      Agreement dated as of August 28, 2006 between Flagstone Reinsurance
      Limited and Citibank Ireland Financial Services plc
                (incorporated
      by reference to Exhibit 10.5 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.6
              Account
      Control Agreement dated as of August 28, 2006 among Flagstone Reinsurance
      Limited and Citibank Ireland Financial Services plc
                (incorporated
      by reference to Exhibit 10.6 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.7
              Insurance
      Letters of Credit—Master Agreement dated as of August 28, 2006 among
      Flagstone Reinsurance Limited and Citibank Ireland Financial Services plc
                (incorporated
      by reference to Exhibit 10.7 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.8*
              Employment
      Agreement dated October 18, 2006 between Mark Byrne and Flagstone
      Reinsurance Holdings Limited
                (incorporated
      by reference to Exhibit 10.8 to the Registration Statement filed
      December 8, 2006)10.9*
              Employment
      Agreement dated October 15, 2006 between David Brown and Flagstone
      Reinsurance Holdings Limited
                (incorporated
      by reference to Exhibit 10.9 to the Registration Statement filed
      October 24, 2006)10.10*
              Employment
      Agreement dated October 18, 2006 between James O'Shaughnessy and Flagstone
      Reinsurance Holdings Limited
                (incorporated
      by reference to Exhibit 10.10 to the Registration Statement filed
      October 24, 2006)10.11*
              Employment
      Agreement dated October 18, 2006 between Gary Prestia and Flagstone
      Reinsurance Limited
                (incorporated
      by reference to Exhibit 10.11 to the Registration Statement filed
      October 24, 2008)10.12*
              Employment
      Agreement dated October 18, 2006 between Guy Swayne and Flagstone
      Reinsurance Limited
                (incorporated
      by reference to Exhibit 10.12 to the Registration Statement filed
      October 24, 2006)10.13
              Consultancy
      arrangement dated December 21, 2005 between Flagstone Reinsurance Limited
      and Meetinghouse LLC
                (incorporated
      by reference to Exhibit 10.13 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.14
              Charter
      agreement dated December 20, 2005 with Longtail Aviation Ltd.
      (incorporated by reference to Exhibit 10.14 to Amendment No. 1 to
      the
                Registration
      Statement filed December 8, 2006)10.15
              Aircraft
      Purchase Agreement dated as of July 24, 2006 between Flagstone
      Westwind Holdings Limited and IAL Leasing Ltd.
                (incorporated
      by reference to Exhibit 10.15 to Amendment No. 1 to the
      Registration Statement filed December 8, 2006)
   91
   10.16
              Quota
      Share Reinsurance Treaty dated August 28, 2006 between Flagstone
      Reinsurance Limited and Mont Fort Re Ltd. in respect of its segregated
      account,
                designated
      as ILW Cell (incorporated by reference to Exhibit 10.16 to Amendment
      No. 1 to the Registration Statement filed December 8,
  2006)10.17
              Lease
      dated October 1, 2005 among West End Capital Management, Eye Patch
      Holdings Limited and Gibbons Management Services Limited
                (incorporated
      by reference to Exhibit 10.17 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.18
              Operational
      Support Agreement dated as of December 20, 2005 between Flagstone
      Reinsurance Limited and West End Capital Management (Bermuda) Limited
                (incorporated
      by reference to Exhibit 10.18 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.19
              Letter
      agreement dated February 23, 2006 between Lightyear Fund II (Cayman) L.P.
      and Flagstone Reinsurance Holdings Limited
                (incorporated
      by reference to Exhibit 10.19 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.20
              Share
      Purchase Agreement dated as of March 15, 2006 between Flagstone
      Reinsurance Bermuda Limited and Haverford (Bermuda) Limited relating to
      the
                purchase
      of common shares in Island Heritage Insurance Company (incorporated by
      reference to Exhibit 10.20 to Amendment No. 1 to the
                Registration
      Statement filed December 8, 2008)10.21
              Security
      Purchase Agreement dated as of March 14, 2006 among Flagstone Reinsurance
      Bermuda Limited, Mark Byrne, David Brown, Tim Calveley,
                Simon
      Biggs,and
      John Goodridge relating to the purchase of all of the common shares of
      West End Capital Management (Bermuda) Limited
                (incorporated
      by reference toExhibit
      10.21 to Amendment No. 1 to the Registration Statement filed December 6,
      2006)10.22
              Purchase
      Agreement dated March 6, 2006 between Flagstone Reinsurance Holdings
      Limited and Haverford (Bermuda) Ltd. for the purchase of all of
      the
                common
      shares of Mont Fort Re Ltd. (incorporated by reference to Exhibit
      10.22 to Amendment No. 1 to the Registration Statement filed December 8,
      2006)10.23
              Management
      and Joint Use Agreement dated as of August 1, 2006 between Westwind
      Holdings Limited and Longtail Aviation Ltd.
                (incorporated
      by reference to Exhibit 10.23 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.24
              2006
      Residential Property Catastrophe Excess of Loss Reinsurance Agreement
      between Flagstone Reinsurance Limited and Island Heritage Insurance
      Company
                Limited
      (incorporated by reference to Exhibit 10.24 to Amendment No. 1 to the
      Registration Statement filed December 8, 2006)10.25
              2006
      Umbrella Property Catastrophe Excess of Loss Reinsurance Agreement between
      Flagstone Reinsurance Limited and Island Heritage Insurance
      Company
                Limited(incorporated
      by reference to Exhibit 10.25 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)
   92
   10.26
              Tenancy
      Agreement dated September 29, 2006 between Flagstone Réassurance Suisse
      and MARTIVAL Sàrl for property located in Martigny, Switzerland
                (incorporated
      by reference to Exhibit 10.26 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.27
              Lease
      of Office Space dated July 26, 2005 between Crombie Developments Limited
      and West End Capital Services (Halifax) Limited as amended on August 16,
      2005,
                March
      20, 2006 and May 1, 2006 (incorporated by reference to Exhibit 10.27 to
      Amendment No. 1 to the Registration Statement filed December 8,
      2006)10.28
              Facultative
      Obligatory Surplus Reinsurance Contract effective June 5, 2006 between
      Flagstone Reinsurance Limited and Mont Fort Re Ltd. in respect of
      its
                segregated
      account, designated as ILW Cell (incorporated by reference to Exhibit
      10.28 to Amendment No. 1 to the Registration Statement filed December 8,
      2006)10.29
              Foreign
      Currency Swap Agreement effective September 5, 2006 between Flagstone
      Reinsurance Holdings Limited and Lehman Brothers Special Financing Inc.
                (incorporated
      by reference to Exhibit 10.29 to Amendment No. 1 to the Registration
      Statement filed December 8, 2006)10.30
              Quota
      Share Reinsurance Treaty dated January 4, 2007 between Flagstone
      Reinsurance Limited and Mont Fort Re Ltd. in respect of its segregated
      account,
                designated
      as ILW 2 Cell (incorporated by reference to Exhibit 10.30 to
      Amendment No. 4 to the Registration Statement filed February 14,
      2007)10.31
              Facultative
      Obligatory Surplus Reinsurance Contract effective January 1, 2007 between
      Flagstone Reinsurance Limited and Mont Fort Re Ltd.
                in
      respect of its segregated account, designated as ILW 2 Cell (incorporated
      by reference to Exhibit 10.31 to Amendment No. 4 to the Registration
      Statement
                filed
      February 14, 2007)10.32
              Quota
      Share Reinsurance Treaty dated January 12, 2007 between Flagstone
      Reinsurance Limited and Mont Fort Re Ltd. in respect of its segregated
      account,
                designated
      as High Layer Cell (incorporated by reference to Exhibit 10.32 to
      Amendment No. 4 to the Registration Statement filed February 14,
      2007)10.33
              Facultative
      Obligatory Surplus Reinsurance Contract effective January 1, 2007 between
      Flagstone Reinsurance Limited and Mont Fort Re Ltd.
                in
      respect of its segregated account, designated as High Layer Cell
      (incorporated by reference to Exhibit 10.33 to Amendment No. 4 to the
      Registration Statement
                filed
      February 14, 2007)10.34
              Discretionary
      Investment Management Agreement dated as of June 5, 2006 between West End
      Capital Management (Bermuda) Limited and Mont Fort Re Ltd. ILW Cell
      (incorporated
      by reference to Exhibit 10.34 to Amendment No. 4 to the Registration
      Statement filed February 14, 2008)10.35
              Discretionary
      Investment Management Agreement dated as of January 1, 2007 between
      West End Capital Management (Bermuda) Limited and Mont Fort Re Ltd. ILW 2
      Cell(incorporated
      by reference to Exhibit 10.35 to Amendment No. 6 to the Registration
      Statement filed March 14, 2007)
  93
   10.36
              Investment
      Manager Agreement dated as of November 15, 2006 between Flagstone
      Reinsurance Limited and BlackRock
                (through
      its subsidiary BlackRock Financial Management, Inc.) (incorporated by
      reference to Exhibit 10.36 to
                Amendment
      No. 6 to the Registration Statement filed March 14,
  2007)21.1
              Subsidiaries
      of the Company23.1
              Consent
      of Deloitte & Touche, Independent Registered Public Accounting
      Firm31.1
              Certification
      of Principal Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002,
                with
      respect to the Company’s Annual Report on Form 10-K for the year
      ended December 31, 200731.2
              Certification
      of Principal Financial Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002,
                with
      respect to the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2007.32.1
              Certification
      of Principal Executive Officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002,
                with
      respect to the Company’s Annual Report on Form 10-K for the year
      ended December 31, 200732.2
              Certification
      of Principal Financial Officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002,
                with
      respect to the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2007
   *
              Management contract
      or compensatory plan, contract or
arrangement.




94