The following is a discussion and analysis of our financial condition as at June
30, 2012 and December 31, 2011, and our results of operations for the three and
six months ended June 30, 2012 and 2011, including, as specified, our
discontinued operations. The historical results presented in this Quarterly
Report are not necessarily indicative of the results to be expected for any
future period and results for any interim period may not necessarily be
indicative of the results expected for a full year. This discussion should be
read in conjunction with our unaudited condensed consolidated financial
statements and related notes included in Part 1, Item 1 of this Quarterly Report
on Form 10-Q (this "Quarterly Report") and with "Management's Discussion and
Analysis of Financial Condition and Results of Operations", and the audited
consolidated financial statements and notes thereto, presented under Item 7 and
Item 8, respectively, of our Annual Report on Form 10-K for the fiscal year
ended December 31, 2011 (our "2011 Annual Report"), filed with the SEC on March
13, 2012. Some of the information contained in this discussion and analysis is
included elsewhere in this document, including information with respect to our
plans and strategy for our business, and includes forward-looking statements
that involve risks and uncertainties. Please see the "Cautionary Statement
Regarding Forward-Looking Statements" for more information. You should review
the information described under "Recent Developments", the risks described in
this Quarterly Report and in Item 1A, "Risk Factors" contained in the 2011
Annual Report for a discussion of important factors that could cause actual
results to differ materially from the results described in or implied by the
forward-looking statements.
References in this Quarterly Report to the "Company", "Flagstone", "we", "us",
and "our" refer to Flagstone Reinsurance Holdings, S.A. and/or its subsidiaries,
including Flagstone Réassurance Suisse SA, its wholly-owned Switzerland
reinsurance company, Flagstone Alliance Insurance & Reinsurance PLC, its
wholly-owned Cyprus insurance and reinsurance company, Flagstone Reinsurance
Africa Limited, its wholly-owned South African reinsurance company, Mont Fort Re
Ltd., its wholly-owned Bermuda reinsurance company, and any other direct or
indirect wholly-owned subsidiary, but not including its United Kingdom Lloyd's
managing agency Flagstone Syndicate Management Limited, or Island Heritage
Holdings Ltd., each of which are discontinued operations, unless the context
suggests otherwise. On October 24, 2011, we announced a strategic decision to
divest our ownership positions in our former Lloyd's and Island Heritage
reportable segments. On April 5, 2012, the Company completed the sale of the
business comprising its former Island Heritage reportable segment. On April 3,
2012, the Company announced that it had entered into definitive agreements to
divest the business comprising its former Lloyd's reportable segment. The
Company has classified the assets and liabilities associated with its former
Lloyd's and Island Heritage reportable segments as held for sale and the assets
and liabilities have been recorded at the lower of the carrying value or fair
value less costs to sell. The financial results for the Lloyd's discontinued
operations have been presented as discontinued operations in the Company's
consolidated statements of operations for all periods presented and the
financial results for the Island Heritage discontinued operations have been
presented as discontinued operations in the Company's consolidated statements of
operations for all periods presented up to and including March 31, 2012. Unless
otherwise noted, all discussions and amounts presented in this Quarterly Report
relate to our business without giving effect to our discontinued operations.
References to "Flagstone Suisse" refer to Flagstone Réassurance Suisse SA, its
wholly-owned subsidiaries and its Bermuda branch. References to "FSML" refer to
Flagstone Syndicate Management Limited, its wholly-owned subsidiaries and
Syndicate 1861. References to "Island Heritage" refer to Island Heritage
Holdings Ltd. and its subsidiaries. References to "Flagstone Africa" refer to
Flagstone Reinsurance Africa Limited. References to "Mont Fort" refer to Mont
Fort Re Ltd. References in this Quarterly Report to "dollars" or "$" are to the
lawful currency of the United States of America (the "U.S."), unless the context
otherwise requires. All amounts in the following tables are expressed in
thousands of U.S. dollars, except share amounts, per share amounts, percentages
or unless otherwise stated. References in this Quarterly Report to (i) "foreign
currency" are to currencies other than U.S. dollars and (ii) "foreign exchange"
transactions or "foreign investments" are to transactions or investments,
respectively, involving currencies other than U.S. dollars, in each case unless
the context otherwise requires. References in this Quarterly Report to "foreign
subsidiaries" are to subsidiaries of Flagstone that are not domiciled in the
U.S. or whose primary transactions are in foreign currency.
Executive Overview
We are pleased with our second quarter results as we continue to benefit from
the strategic shift in our business model as we become a more focused and
efficient underwriter. Evidence of the effectiveness of this strategy and its
benefits could be seen this quarter with reduced frequency and attritional
losses, coupled with our ongoing expense saving initiatives, which drove
positive underwriting performance despite significant tornado, wind, and
wildfire industry losses in the United States during the quarter. Our improved
performance in the second quarter also reflects the benefits of attractive rates
in our core business, which partially offset the reduction in income as we
continue to reposition our portfolio.
23
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Index
We are, in all material respects, nearing the completion of the business
realignment we announced in October 2011. As previously announced on April 2,
2012, and April 3, 2012, the Company entered into definitive agreements to
divest its former Island Heritage and Lloyd's reportable segments, respectively.
The Island Heritage transaction was completed on April 5, 2012, and has been
recorded in the second quarter results, including a gain on disposal of $4.5
million. The Lloyd's segment transaction is expected to be completed in the
third quarter of 2012. Upon closing, we anticipate recording a small gain on
this divestiture, net of any deal-related expenses. These divestitures are part
of a strategic business realignment to address changing business conditions,
refocus the Company's underwriting strategy on its property catastrophe
reinsurance business and reduce its focus on operating segments that absorb
capital and produce lower returns. Except as explicitly described as held for
sale or as discontinued operations, and unless otherwise noted, all discussions
and amounts presented herein relate to our continuing operations. See Note 4,
"Assets Held for Sale and Discontinued Operations" in our unaudited condensed
consolidated financial statements (Item 1 above) for additional information
related to discontinued operations. All prior years presented have been
reclassified to conform to this new presentation.
We are a global reinsurance company. Our management views the operations and
management of our continuing operations as one reportable segment and does not
differentiate our lines of business into separate reportable segments. Our
continuing operations provide reinsurance primarily through our property and
property catastrophe business as well as short-tail specialty and casualty
reinsurance lines of business. We diversify our risks across business lines by
risk zones, each of which combines a geographic zone with one or more types of
peril (for example, Texas Windstorm, Florida Hurricane or California
Earthquake). The majority of our reinsurance contracts contain loss limitation
provisions such as fixed monetary limits to our exposure and per event caps. We
specialize in underwriting where we believe sufficient data exists to analyze
effectively the risk/return profile, and where we are subject to legal systems
we believe are reasonably fair and reliable. Previously, the underwriting
results associated with our discontinued operations were included in our former
Lloyd's and Island Heritage reportable segments.
Our financial statements are prepared in accordance with accounting principles
generally accepted in the U.S ("U.S. GAAP") and our fiscal year ends on December
31. Because a substantial portion of the reinsurance we write in our
discontinued and continuing operations provides protection from damages relating
to natural and man-made catastrophes, our results depend to a large extent on
the frequency and severity of such catastrophic events, and the specific
coverages we offer to clients affected by these events. This has resulted and
may continue to result in volatility in our results of operations, cash flows
and financial condition. In addition, the amount of premiums written with
respect to any particular line of business may vary from quarter to quarter and
year to year as a result of available capital and retrocessional support and
market and other conditions.
We measure our financial success through long term growth in diluted book value
per share plus accumulated distributions measured over intervals of three years.
We believe this is the most appropriate measure of our performance, a measure
that focuses on the return provided to our common shareholders. Diluted book
value per share is obtained by dividing Flagstone shareholders' equity by the
number of common shares and common share equivalents outstanding including all
potentially dilutive securities such as a warrant, Performance Share Units
("PSUs") and Restricted Share Units ("RSUs").
Our continuing operations derive revenues primarily from net premiums earned on
the reinsurance policies we write, net of any retrocessional or reinsurance
coverage purchased, income from our investment portfolio, and fees for services
provided. Premiums are generally a function of the number and type of contracts
we write, as well as prevailing market prices. Premiums are normally due in
installments and earned over the contract term, which ordinarily is 12 or 24
months.
Income from our investment portfolio primarily comprises interest on fixed
maturity, short term investments and cash and cash equivalents and net realized
and unrealized gains (losses) on our investment portfolio including our
derivative positions, net of investment expenses.
Our expenses consist primarily of the following: loss and loss adjustment
expenses ("LAE") incurred on the policies of reinsurance that we sell;
acquisition costs which typically represent a percentage of the premiums that we
write; general and administrative expenses which primarily consist of salaries,
benefits and related costs, including costs associated with awards under our
Performance Share Unit Plan ("PSU Plan") and Restricted Share Unit Plan ("RSU
Plan"), and other general operating expenses; interest expense related to our
debt obligations; and noncontrolling interest, which represents the interest of
external parties with respect to the net income of Mont Fort (on March 25, 2011
there were no longer third party investors in Mont Fort) and our Island Heritage
discontinued operations. We are also subject to taxes in certain jurisdictions
in which we operate; however, since the majority of our income to date has been
earned in Bermuda, a non-taxable jurisdiction, the tax impact on our operations
has historically been minimal. The Company is a Luxembourg tax resident entity
due to its change of jurisdiction of incorporation from Bermuda to Luxembourg
effective May 17, 2010 (the "Redomestication"); therefore, it is subject to
Luxembourg corporate income tax, municipal business tax, withholding tax, and
net wealth tax. The Company minimizes the income tax impact on the Company
through effective tax planning.
24--------------------------------------------------------------------------------
Index
Recent Developments
On April 3, 2012, the Company announced that it had entered into a definitive
agreement with a wholly-owned subsidiary of ANV Holdings BV ("ANV"), under which
ANV, with capital support from Ontario Teachers' Pension Plan Board, will
acquire the Company's Lloyd's operations. The UK Financial Services Authority
has approved the change in control and the Company now expects other regulatory
approvals to be obtained, and the transaction completed, by August 31, 2012, for
total proceeds of approximately $49.7 million. Our letter of credit for Funds at
Lloyd's in the amount of approximately $158.7 million will also be released on
the same day. The divestiture will be recorded in the third quarter results and
the Company anticipates a small gain on disposal, net of any deal-related
expenses.
You should review all the information in this Quarterly Report in conjunction
with the information under this "Recent Developments."
Critical Accounting Policies
Our critical accounting policies are discussed in "Management's Discussion and
Analysis of Financial Condition and Results of Operations" in Item 7 of the 2011
Annual Report. Our critical accounting policies at June 30, 2012 have not
changed compared to December 31, 2011.
It is important to understand our accounting policies in order to understand our
financial position and results of operations. Our unaudited condensed
consolidated financial statements contain certain amounts that are inherently
subjective in nature and have required our management to make assumptions and
best estimates to determine the reported values. If events or other factors,
including those described herein and in Item 1A, "Risk Factors," of the 2011
Annual Report, cause actual events or results to differ materially from
management's underlying assumptions or estimates, there could be a material
adverse effect on our results of operations, financial condition and liquidity.
Results of Operations - For the Three and Six Months Ended June 30, 2012 and
2011
Our reporting currency is the U.S. dollar. Our subsidiaries have one of the
following functional currencies: U.S. dollar, Swiss franc, Euro, British pound
sterling, Canadian dollar, Indian rupee, and South African rand. As a
significant portion of our operations are transacted in foreign currencies,
fluctuations in foreign exchange rates may affect period-to-period
comparisons. To the extent that fluctuations in foreign currency exchange rates
affect comparisons, their impact has been quantified, when possible, and
discussed in each of the relevant sections. See Note 2 "Significant Accounting
Policies" to the consolidated financial statements in Item 8, "Financial
Statements and Supplementary Data", in the 2011 Annual Report for a discussion
on translation of foreign currencies.
For the three months For the six months
ended ended
U.S. dollar strengthened (weakened)
against: June 30, 2012 June 30, 2012
Canadian dollar 2.0 % (0.1) %
Swiss franc 4.9 % 1.0 %
Euro 5.1 % 2.2 %
British pound sterling 2.1 % (0.8) %
Indian rupee 8.8 % 4.9 %
South African rand 6.2 % 1.3 %
25--------------------------------------------------------------------------------
Index
Summary Overview
The following table sets forth selected key financial information for the three months
ending June 30, 2012 and 2011:
For the three months ended June 30,
2012 2011 $ Change % Change
Underwriting income (loss) $ 6,990 $ (22,496) $ 29,486 131.1 %
Net investment income $ 3,866 $ 12,300 $ (8,434) (68.6) %
Net realized and unrealized gains
(losses) - investments $ 5,365 $ (7,905) $ 13,270 167.9 %
Net realized and unrealized (losses
) gains - other $ (4,990) $ 13,986 $ (18,976) (135.7) %
Income (loss) from continuing
operations $ 12,342 $ (32,973) $ 45,315 137.4 %
Income (loss) from continuing
operations per common share - Basic $ 0.17 $ (0.49) $ 0.67
Income (loss) from continuing
operations per common share -
Diluted(1) $ 0.17 $ (0.49) $ 0.66
Loss ratio 54.1 % 81.3 %
Expense ratio 40.0 % 38.2 %
Combined ratio 94.1 % 119.5 %
The following table sets forth selected key financial information for the six months ended June 30, 2012 and 2011:
For the six months ended June 30,
2012 2011 $ Change % Change
Underwriting income (loss) $ 11,607 $ (178,316) $ 189,923 106.5 %
Net investment income $ 8,933 $ 21,498 $ (12,565) (58.4) %
Net realized and unrealized gains -
investments $ 23,468 $ 2,866 $ 20,602 718.8 %
Net realized and unrealized gains -
other $ 1,393 $ 13,296 $ (11,903) 89.5 %
Income (loss) from continuing
operations $ 40,190 $ (181,146) $ 221,336 122.2 %
Income (loss) from continuing
operations per common share - Basic $ 0.55 $ (2.62) $ 3.17
Income (loss) from continuing
operations per common share -
Diluted(1) $ 0.55 $ (2.62) $ 3.17
Loss ratio 56.4 % 125.0 %
Expense ratio 39.5 % 31.1 %
Combined ratio 95.9 % 156.1 %
The following table sets forth selected key non-GAAP financial measures as at June 30, 2012 and December 31, 2011:
As at
June 30, December 31,
2012 2011 $ Change % Change
Basic book value per common share $ 11.73 $ 11.21 $ 0.52 4.6 %
Diluted book value per common share $ 11.52 $ 10.90 $ 0.62 5.7 %
Diluted book value per common share
plus accumulated distributions $ 12.32 $ 11.62 $ 0.70 6.0 %
(1)Income (loss) from continuing operations per common share - Diluted for the three and six months ended June 30,
2012 and 2011 does not contain the effect of:
a. a warrant conversion as this would be anti-dilutive for U.S. GAAP purposes
b. the PSU conversion until the end of the performance period, when the number of shares issuable under the PSU Plan
will be known. There were 1,010,800 and 1,762,442 PSU's expected to vest under the PSU plan as at June 30, 2012 and
2011, respectively . Only the minimum number of PSUs that will vest under each grant are included in the calculation
of diluted earnings in a period of net income.
The increase in underwriting income in the six months ended June 30, 2012, is
primarily due to the lack of significant catastrophe losses (net of reinsurance
and reinstatements) in the period compared to the same period last year, which
included Australian floods ($27.2 million), cyclone Yasi ($29.8 million), New
Zealand earthquake of February 2011 ($114.8 million) and the Japan earthquake
and tsunami ($93.9 million).
26
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Index
The decrease in net investment income on the three months ended June 30, 2012,
is principally due to lower invested assets and the change in asset allocation
during the quarter. The decrease in net investment income on the six months
ended June 30, 2012, is primarily due to lower investment assets, the change in
asset allocation and to lower interest rates during the period.
The increase in the net realized and unrealized gains and losses - investments,
for the six months ended June 30, 2012, is primarily associated with the foreign
currency forward contracts and is related to the currency hedges on non-U.S.
dollar bonds, offset by net realized and unrealized gains on the fixed maturity
investments as a result of tightening credit spreads, change in asset allocation
and higher foreign currency impact on the portfolio.
The decrease in the net realized and unrealized gains and losses - other, for
the six months ended June 30, 2012, is primarily associated with currency swaps
and foreign currency forward contracts and is due to currency fluctuations which
are partially offset by net gains recorded through balance sheet currency
revaluations and are attributable to operational hedges on reinsurance balances.
These items are discussed in more detail in the following sections.
Non-GAAP Reconciliation
In addition to the U.S. GAAP financial measures set forth in this Quarterly
Report, we have presented "basic book value per common share" and "diluted book
value per common share", which are non-GAAP financial measures. Our management
uses growth in diluted book value per common share as a prime measure of the
value we are generating for our common shareholders, as we believe that growth
in our diluted book value per common share ultimately translates into growth in
our stock price.
Basic book value per common share is defined as total Flagstone shareholders'
equity divided by the number of common shares outstanding at the end of the
period plus vested RSUs, giving no effect to dilutive securities. Diluted book
value per common share is defined as total Flagstone shareholders' equity
divided by the number of common shares and common share equivalents outstanding
at the end of the period including all potentially dilutive securities such as a
warrant, PSUs and RSUs. When the effect of securities would be anti-dilutive,
these securities are excluded from the calculation of diluted book value per
common share. The warrant was anti-dilutive and was excluded from the
calculation of diluted book value per common share as at June 30, 2012 and
December 31, 2011.
While we believe that these non-GAAP financial measures provide useful
supplemental information to investors, there are limitations associated with the
use of these non-GAAP financial measures. Basic book value per common share does
not reflect the number of common shares that may be issued upon vesting or
exercise of dilutive securities. On the other hand, by giving effect to dilutive
securities, diluted book value per common share takes into account common share
equivalents and not just the number of common shares actually outstanding. These
non-GAAP financial measures are not prepared in accordance with GAAP, are not
based on any comprehensive set of accounting rules or principles, are not
reported by all of our competitors and may not be directly comparable to
similarly titled measures of our competitors due to potential differences in the
exact method of calculation. In light of these limitations, we use these
non-GAAP financial measures only as supplements to GAAP financial measures and
provide a reconciliation of the non-GAAP financial measures to their most
comparable GAAP financial measures.
27
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Index
As at
June 30, 2012 December 31, 2011
Flagstone shareholders' equity $ 836,660 $ 789,048
Potential net proceeds from assumed:
Exercise of PSU (1) - -
Exercise of RSU (1) - -
Conversion of warrant (2) - -
Diluted Flagstone shareholders' equity $ 836,660 $
789,048
Cumulative distributions paid per
outstanding common share $ 0.80 $
0.72
Common shares outstanding - end of
period 71,058,922
70,167,142
Vested RSUs 293,565
233,709
Total common shares outstanding - end
of period 71,352,487
70,400,851
Potential shares to be issued:
PSUs expected to vest 1,010,800 1,676,125
RSUs outstanding 250,950 290,470
Conversion of warrant (2) - -
Common shares outstanding - diluted 72,614,237
72,367,446
Basic book value per common share $ 11.73 $
11.21
Diluted book value per common share $ 11.52 $
10.90
Basic book value per common share plus
accumulated distributions $ 12.53 $
11.93
Diluted book value per common share
plus accumulated distributions $ 12.32 $
11.62
Distributions per common share paid
during the period $ 0.08 $
0.16
(1)No proceeds due when exercised
(2)Below strike price - not dilutive
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Index
Outlook and Trends
Market Outlook
At the important June 1, 2012 renewal period, North American rates were
approximately flat to up 5% from rates a year ago. Rates were flat to down
slightly in loss-free regions and ranging from flat to up 5% in loss-affected
regions. Looking forward toward the next major North American renewal period at
January 1, 2013, we would expect a similar range of rate levels barring any
significant potential loss activity occurring during this hurricane season.
Prior to renewal, many clients came out with their submissions early and
therefore business transacted in an orderly fashion prior to June 1st. On
average, clients sought slightly more capacity this year and moved retentions
upwards in addition to an increase in demand from Citizens Property Insurance
Corporation of Florida and the increased expected loss effects of Risk
Management Solutions, Inc.'s new hurricane risk model ("RMS V11"). However, an
increase in reinsurer capacity was allocated for this period, which meant that
programs reached subscription and were slightly oversubscribed to meet this
demand. On a regional basis, Florida, Southeast and Gulf of Mexico rates were
strongest and overall, rate levels continue to be adequate with pricing mostly
meeting return hurdles.
The second quarter is not overly meaningful to the International markets with
the exception of April 1, 2012 Japan renewals where we saw strong pricing
increases in these treaties. Overall price increases averaged over 20%.
Comparing 2012 prices with pre-Tohoku pricing, loss affected Japanese earthquake
programs paid 80-140% increases. Non-loss affected programs saw 40-75% increases
and Japanese wind programs were up 15-25%. Outside of Japan, Latin America also
renews during this period and rates in the region were flat to modestly up as
larger players competed for market share. In summary, outside of Japan, capacity
was generally abundant, and looking forward to the next major International
renewal period at January 1, 2013, we expect the level of International loss
activity to dictate the direction of rates.
Regarding the specialty lines, rates in the marine business, aviation, and
aerospace and satellite have been flat since the January 1, 2012 renewal last
quarter and as these lines renew throughout the remainder of the year we expect
a similar pattern to continue. Rates have generally failed to increase
materially and the modest profitability has been primarily due to a lack of loss
activity.
This information should be read in conjunction with the other information in the
2011 Annual Report, including "Risk Factors- Risks Related to our Business".
Underwriting Results
Our management views our operations and management of our continuing operations
as one reportable segment and does not differentiate its lines of business into
separate reportable segments. We provide reinsurance through our property and
property catastrophe business as well as high-margin short-tail specialty and
casualty reinsurance lines of business. We regularly review our financial
results and assess our performance on the basis of our single reportable segment
in accordance with the Segment Reporting Topic of the Financial Accounting
Standards Board ("FASB") Accounting Standards Codification ("ASC").
Those lines of business are more fully described as follows:
(1) Property Catastrophe Reinsurance. Property catastrophe reinsurance contracts
are typically "all risk" in nature, meaning that they protect against losses
from earthquakes and hurricanes, as well as other natural and man-made
catastrophes such as tornados, wind, fires, winter storms, and floods (where
the contract specifically provides for coverage). Losses on these contracts
typically stem from direct property damage and business interruption. To
date, property catastrophe reinsurance has been our most important
product. We write property catastrophe reinsurance primarily on an excess of
loss basis. In the event of a loss, most contracts of this type require us
to cover a subsequent event and generally provide for a premium to reinstate
the coverage under the contract, which is referred to as a "reinstatement
premium". These contracts typically cover only specific regions or
geographical areas, but may be on a worldwide basis.
(2) Property Reinsurance. We also provide property reinsurance on a pro rata
share basis and per risk excess of loss basis. Per risk reinsurance protects
insurance companies on their primary insurance risks on a single risk basis,
for example, covering a single large building. Generally, our property per
risk and pro rata business is written with loss limitation provisions, such
as per occurrence or per event caps, which serve to limit exposure to
catastrophic events.
(3) Short-tail Specialty and Casualty Reinsurance. We also provide short-tail
specialty and casualty reinsurance for risks such as aviation, energy,
accident and health, satellite, marine and workers' compensation
catastrophe. Generally, our short-tail specialty and casualty reinsurance is
written with loss limitation provisions.
.
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Index
Gross Premiums Written
Details of the consolidated gross premiums written by line of business and
geographic area of risk insured for our continuing operations are provided
below:
For the three months ended June 30,
2012 2011
Gross Gross
premiums Percentage of premiums Percentage of
written total written total
Line of business
Property catastrophe $ 126,755 74.1 % $ 170,394 64.5 %
Property 28,781 16.8 % 53,224 20.2 %
Short-tail specialty 15,614 9.1 % 40,510 15.3 %
and casualty
Total $ 171,150 100.0 % $ 264,128 100.0 %
For the six months ended June 30,
2012 2011
Gross Gross
premiums Percentage of premiums Percentage of
written total written total
Line of business
Property catastrophe $ 233,096 68.3 % $ 372,256 60.4 %
Property 66,666 19.5 % 119,023 19.3 %
Short-tail specialty 41,616 12.2 % 125,524 20.3 %
and casualty
Total $ 341,378 100.0 % $ 616,803 100.0 %
For the three months ended June 30,
2012 2011
Gross premiums Percentage of Gross premiums Percentage of
written total written total
Geographic area of risk
insured (1)
Caribbean $ 7,484 4.4 % $ 1,623 0.6 %
Europe 18,744 11.0 % 13,187 5.0 %
Japan and Australasia 21,965 12.8 % 27,805 10.5 %
North America 108,139 63.2 % 177,557 67.2 %
Worldwide risks (2) 13,491 7.9 % 32,706 12.4 %
Other 1,327 0.7 % 11,250 4.3 %
Total $ 171,150 100.0 % $ 264,128 100.0 %
For the six months ended June 30,
2012 2011
Gross premiums Percentage of Gross premiums Percentage of
written total written total
Geographic area of risk
insured (1)
Caribbean $ 8,984 2.6 % $ 3,416 0.6 %
Europe 68,003 19.9 % 89,702 14.5 %
Japan and Australasia 33,062 9.7 % 70,304 11.4 %
North America 179,558 52.6 % 301,576 48.9 %
Worldwide risks (2) 43,101 12.6 % 125,333 20.3 %
Other 8,670 2.6 % 26,472 4.3 %
Total $ 341,378 100.0 % $ 616,803 100.0 %
(1)Except as otherwise noted, each of these categories includes contracts that cover risks
located primarily in the designated geographic area.
(2)Includes contracts that cover risks in two or more geographic zones.
30
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Index
Premiums Ceded
In the normal course of our business, we purchase reinsurance in order to manage
our exposures. The amount and type of reinsurance that we enter into is
dependent on a variety of factors, including the cost of a particular
reinsurance cover, our appetite and capacity to write certain risks and the
nature of our gross premiums written during a particular period.
The majority of these contracts are excess-of-loss contracts covering one or
more lines of business or quota share reinsurance with respect to specific lines
of business. We also purchase protection through catastrophe bond structures,
Montana Re, and industry loss warranty ("ILW") policies which provide coverage
for certain losses provided they are triggered by events exceeding a specified
industry loss size. Reinsurance purchases to date have represented prospective
cover; that is, ceded reinsurance purchased to protect against the risk of
future losses as opposed to covering losses that have already been incurred but
have not been paid.
Various factors will continue to affect our appetite and capacity to write and
retain risk. These include the impact of changes in frequency and severity
assumptions used in our models and the corresponding pricing required to meet
our return targets, capital levels, evolving industry-wide capital requirements,
increased competition, and other considerations.
Below is a summary of our underwriting results and ratios for the three months ended June 30,
2012 and 2011:
For the three months ended June 30,
2012 2011 $ Change % Change
Property catastrophe
reinsurance $ 126,755 $ 170,394 $ (43,639) (25.6) %
Property reinsurance 28,781 53,224 (24,443) (45.9) %
Short tail specialty and
casualty reinsurance 15,614 40,510 (24,896) (61.5) %
Gross premiums written 171,150 264,128 (92,978) (35.2) %
Premiums ceded (6,285) (44,409) 38,124 (85.8) %
Net premiums written 164,865 219,719 (54,854) (25.0) %
Net premiums earned 102,499 118,620 (16,121) (13.6) %
Other related income 909 731 178 24.4 %
Loss and loss adjustment
expenses (55,483) (96,490) 41,007 (42.5) %
Acquisition costs (22,113) (25,613) 3,500 (13.7) %
General and administrative
expenses (18,822) (19,744) 922 (4.7) %
Underwriting income (loss) $ 6,990 $ (22,496) $ 29,486 131.1 %
Loss ratio 54.1 % 81.3 %
Acquisition cost ratio 21.6 % 21.6 %
General and administrative
expense ratio 18.4 % 16.6 %
Combined ratio 94.1 % 119.5 %
· The increase in net underwriting results is the result of the lack of
significant loss events during the second quarter of 2012 compared to the same
period in 2011 (New Zealand earthquake of June 2011 and U.S. tornadoes),
offset by a significant reduction in gross premiums written and net premiums
earned, which is in line with our current underwriting strategy.
· The decrease in gross premiums written for all lines of business is a result
of an overall decrease in our risk appetite and in our shareholder's equity
following the significant worldwide losses we sustained in 2011. During the
three months ended June 30, 2012, we recorded $3.9 million of gross
reinstatement premiums compared to $5.8 million recorded for the same period
in 2011.
· The decrease in ceded premiums is primarily related to higher reinstatement
premiums incurred in 2011 on our ceded reinsurance due to loss activity and
the increased level of reinsurance purchases after the loss events during the
first quarter of 2011.
† The decrease in the loss ratio compared to the same period in 2011 is primarily
due to more significant losses from catastrophic events in the prior period,
which included the New Zealand earthquake of $18.5 million and U.S. tornadoes
of $19.4 million. Losses are net of retrocession but exclude reinstatement
premiums.
· Each quarter we revisit our loss estimates for previous catastrophe
events. During the quarter ended June 30, 2012, based on updated estimates
provided by clients and brokers, we recorded net favorable developments of
$1.4 million for prior accident years. During the second quarter of 2011, the
net positive developments for prior catastrophe events were $12.8 million.
31
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Index
· The acquisition cost ratio compared to the same period in 2011 has remained
stable.
· The decrease in general and administrative expenses is primarily the result of
expense reduction initiatives in accordance with our overall decrease in
underwriting activities, partially offset by lower staff compensation accrual
in the same period in 2011 as a result of the significant underwriting loss.
Below is a summary of the underwriting results and ratios for the six months ended June 30,
2012 and 2011:
For the six months ended June 30,
2012 2011 $ Change % Change
Property catastrophe
reinsurance $ 233,096 $ 372,256 $ (139,160) (37.4) %
Property reinsurance 66,666 119,023 (52,357) (44.0) %
Short tail specialty and
casualty reinsurance 41,616 125,524 (83,908) (66.8) %
Gross premiums written 341,378 616,803 (275,425) (44.7) %
Premiums ceded (91,184) (163,159) 71,975 (44.1) %
Net premiums written 250,194 453,644 (203,450) (44.8) %
Net premiums earned 216,244 319,673 (103,429) (32.4) %
Other related income 2,744 1,003 1,741 173.6 %
Loss and loss adjustment
expenses (121,932) (399,489) 277,557 (69.5) %
Acquisition costs (44,766) (63,684) 18,918 (29.7) %
General and administrative
expenses (40,683) (35,819) (4,864) 13.6 %
Underwriting income (loss) $ 11,607 $ (178,316) $ 189,923 106.5 %
Loss ratio 56.4 % 125.0 %
Acquisition cost ratio 20.7 % 19.9 %
General and administrative
expense ratio 18.8 % 11.2 %
Combined ratio 95.9 % 156.1 %
· The increase in net underwriting results is the result of the lack of
significant loss events in 2012 compared to the same period in 2011
(Australian floods, cyclone Yasi, New Zealand earthquakes of February 2011 and
June 2011, Japan earthquake and tsunami, and U.S. tornadoes), offset by a
significant reduction in gross premiums written and net premiums earned, which
is in line with our current underwriting strategy.
· The decrease in gross written premiums for all lines of business is a result
of an overall decrease in our risk appetite and in our shareholder's equity
following the significant worldwide losses we sustained in 2011. During the
six months ended June 30, 2012, we recorded $11.3 million of gross
reinstatement premiums compared to $17.8 million recorded for the same period
in 2011. The decrease in reinstatements premiums was due to lower catastrophe
losses in the current period.
· The decrease in ceded premiums is primarily related to higher reinstatement
premiums incurred in 2011 on our ceded reinsurance due to loss activity and
the increased level of reinsurance purchases after the loss events during the
first quarter of 2011.
· The decrease in the loss ratio compared to the same period in 2011 is
primarily due to more significant losses from catastrophic events in the prior
period, including net incurred losses related to the Australian floods ($27.2
million), cyclone Yasi ($29.8 million), New Zealand earthquake of February
2011 ($100.8 million), the Japan earthquake and tsunami ($99.1 million), New
Zealand earthquake of June 2011 ($18.5 million) and the U.S. tornadoes ($19.4
million). Losses are net of retrocession but exclude reinstatement premiums.
· Each quarter we revisit our loss estimates for previous catastrophe events.
During the six months ended June 30, 2012, based on updated estimates provided
by clients and brokers, we recorded net adverse developments of $6.1 million,
related to cumulative prior accident years. In addition, we undertook our
scheduled first quarter review of actuarial reserving assumptions. As a result
of revised development factors for non-cat business based in part on
experience, we recorded $7.0 million of negative reserves development.
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Index
· The increase in general and administrative expenses is primarily the result of
staff compensation accrual and performance based compensation returning to
more typical levels in the current period as compared to levels in the same
period in 2011, which were adjusted downward as a result of the significant
underwriting loss.
Income from Discontinued Operations
Income from discontinued operations includes the financial results of our former
reportable segments, Lloyd's (for all periods presented) and Island Heritage
(for all periods presented up to and including March 31, 2012). Included in
income from discontinued operations for the six months ended June 30, 2012 is
underwriting income of $8.6 million, compared to underwriting losses of $3.6
million for the same period in 2011. The $12.2 million increase in underwriting
income is primarily attributable to more significant catastrophic events during
2011 compared to 2012.
In addition, as of June 30, 2012, we had liabilities associated with
discontinued operations of $393.8 million, all associated with our Lloyd's
former reportable segment. Although we account for the business comprising our
former Lloyd's and Island Heritage reportable segments as discontinued
operations, we owned the Island Heritage business until completing its sale on
April 5, 2012, and we will continue to own the Lloyd's business and be subject
to the risks associated with that business until the Lloyd's divestiture is
complete.
Investment Results
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.
The total return on our investment portfolio, excluding the noncontrolling
interests in the investment portfolio, comprises investment income and realized
and unrealized gains and losses on investments.
For the three months ended June 30, For the six months ended June 30,
2012 2011 % Change 2012 2011 % Change
Investment
portfolio return 0.5 % 0.3 % 0.2 % 2.4 % 1.3 % 1.1 %
Net investment income
Net investment income is derived from interest earned on investments, reduced by
investment management and custody fees. We allocate expenses directly related to
investment activities to investment income.
The following tables set forth net investment income for the three months ended June 30,
2012 and 2011:
For the three months ended June 30,
2012 2011 $ Change
Cash and cash equivalents $ 214 $ 385 $ (171)
Fixed maturity investments 2,177 12,861 (10,684)
Short term investments 243 222 21
Other investments 2,160 (29) 2,189
Investment expenses (928) (1,139) 211
Net investment income $ 3,866 $ 12,300 $ (8,434)
· The decrease in net investment income is primarily due to lower invested
assets and the change in asset allocation during the quarter.
· The increase in investment income from other investments is primarily due to
the positive performance of the investment funds.
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Index
The following table sets forth net investment income for the six months ended June 30, 2012 and
2011:
For the six months ended June 30,
2012 2011 $ Change
Cash and cash equivalents $ 484 $ 779 $ (295)
Fixed maturity investments 7,944 22,669 (14,725)
Short term investments 365 428 (63)
Other investments 2,148 (88) 2,236
Investment expenses (2,008) (2,290) 282
Net investment income $ 8,933 $ 21,498
$ (12,565)
· The overall decrease in net investment income is primarily due to lower
invested assets, the change in asset allocation and lower interest rates
during the period.
· The increase in investment income from other investments is primarily due to
the positive performance of the investment funds.
Net realized and unrealized gains and losses - investments
Net realized and unrealized gains and losses - investments comprises fixed
maturities, equities, other investments, and investment portfolio
derivatives. We enter into investment portfolio derivatives including global
equity futures, global bond futures, commodity futures and TBAs. We enter into
index futures contracts to gain or reduce our exposure to an underlying asset or
index. We also purchase TBAs as part of our investing activities. We enter into
interest rate futures in order to manage portfolio duration and interest rate
risk. Exposure to these instruments is managed based on guidelines established
by management and is approved by the Board.
The following table is a breakdown of net realized and unrealized (losses) gains -
investments for the three months ended June 30, 2012 and 2011:
For the three months ended June 30,
2012 2011 $ Change
Net realized gains on fixed maturity
investments $ 14,589 $ 22,615 $ (8,026)
Net unrealized (losses) gains on fixed
maturity investments (27,417) 3,328 (30,745)
Net realized losses on equity investments - (845)
845
Net unrealized (losses) gains on equity
investments (15) 781
(796)
Net realized and unrealized gains
(losses) on derivative instruments -
investments (see table below) 15,510 (34,096)
49,606
Net realized and unrealized gains on
other investments 2,698 312
2,386
Net realized and unrealized gains
(losses) - investments $ 5,365 $ (7,905) $ 13,270
For the three months ended June 30,
2012 2011 $ Change
Futures contracts $ (74) $ (16,554) $ 16,480
Foreign currency forward contracts 15,584 (17,542) 33,126
Net realized and unrealized gains
(losses) on derivative instruments -
investments $ 15,510 $ (34,096) $ 49,606
· The change in net realized and unrealized on fixed maturity investments is
primarily due to the change in asset allocation and to foreign currency impact
on the portfolio.
· The change in net realized and unrealized on other investments is primarily
due to the positive performance on investment funds.
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Index
· The change in net realized and unrealized on futures contracts is primarily
due to less exposure to risky assets during 2012.
· The change in net realized and unrealized on foreign currency forward
contracts is related to the currency hedges on non-U.S. dollar bonds and is
offset by net realized and unrealized losses on the fixed maturity
investments.
The following table is a breakdown of the net realized and unrealized gains - investments for the
six months ended June 30, 2012 and 2011:
For the six months ended June 30,
2012 2011 $ Change
Net realized gains on fixed maturity
investments $ 23,186 $ 36,708 $ (13,522)
Net unrealized (losses) gains on fixed
maturity investments (11,487) 22,470 (33,957)
Net realized losses on equity investments - (845) 845
Net unrealized (losses) gains on equity
investments (18) 750 (768)
Net realized and unrealized gains (losses)
on derivatives instruments - investments
(see table below) 3,205 (60,506) 63,711
Net realized and unrealized gains on other
investments 8,582 4,289 4,293
Net realized and unrealized gains -
investments $ 23,468 $ 2,866 $ 20,602
For the six months ended June 30,
2012 2011 $ Change
Futures contracts $ 179 $ (8,986) $ 9,165
Foreign currency forward contracts 3,026 (51,518) 54,544
Mortgage-backed securities TBA - (2)
2
Net realized and unrealized gains
(losses) on derivatives instruments -
investments $ 3,205 $ (60,506) $ 63,711
· The change in net realized and unrealized on fixed maturity investments is
primarily due to the tightening of credit spreads, to the change in asset
allocation and to higher foreign currency impact on the portfolio.
· The change in net realized and unrealized on other investments is primarily
due to the positive performance on investment funds.
· The change in net unrealized and unrealized on futures contracts is primarily
due to less exposure to risky assets during 2012.
· The change in net realized and unrealized on foreign currency forward
contracts is related to the currency hedges on non-U.S. dollar bonds and is
offset by net realized and unrealized gains on the fixed maturity investments.
Treasury Hedging and Other
Net realized and unrealized gains and losses - other
Our policy is to hedge the majority of our currency exposure with derivative
instruments such as currency swaps and foreign currency forward contracts.
Currency swaps and foreign currency forward contracts are used to hedge the
economic currency exposure of our investment in foreign subsidiaries and to
hedge operational balances such as premiums receivable, loss reserves and the
portion of our long term debt issued in Euros.
Reinsurance derivatives relate to ILWs that are structured as derivative
transactions. The amounts shown in the tables below are premiums earned on ILWs.
35
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Index
The following tables are a breakdown of net realized and unrealized (losses) gains -
other for the three and six months ended June 30, 2012 and 2011:
For the three months ended June 30,
2012 2011 $ Change
Currency swaps $ (937) $ 467 $ (1,404)
Foreign currency forward contracts (4,053) 13,519 (17,572)
Net realized and unrealized (losses)
gains - other $ (4,990) $ 13,986 $ (18,976)
· The net realized and unrealized losses associated with the currency swaps are
due to currency fluctuations, which are partially offset by net gains
recorded through the balance sheet currency revaluations on the foreign
currency long term debt.
† The net realized and unrealized losses associated with foreign currency
forward contracts are due to currency fluctuations, which are partially
offset by net gains recorded through the balance sheet currency revaluations
on reinsurance balances.
For the six months ended June 30,
2012 2011 $ Change
Currency swaps $ (509) $ 1,547 $ (2,056)
Foreign currency forward contracts 1,902 11,508 (9,606)
Reinsurance derivatives - 241
(241)
Net realized and unrealized gains - other $ 1,393$ 13,296$ (11,903)
· The net realized and unrealized losses associated with the currency swaps are
due to currency fluctuations, which are partially offset by net gains recorded
through balance sheet currency revaluations on the foreign currency long term
debt.
· The net realized and unrealized losses associated with foreign currency
forward contracts are due to currency fluctuations, which are partially offset
by net losses recorded through balance sheet currency revaluations on
reinsurance balances.
· The last reinsurance derivative expired in 2011and we have not written any
further derivatives.
Interest Expense
Interest expense consists of interest due on outstanding debt securities and the
amortization of debt offering expenses. Interest expense was $3.0 million and
$5.9 million, respectively, for the three and six months ended June 30, 2012,
compared to $2.9 million and $5.7 million, respectively, for the three and six
months ended June 30, 2011.
Foreign Exchange
For the three and six months ended June 30, 2012, we experienced net foreign
exchange gains of $3.4 million and net foreign exchange losses of $0.9 million,
respectively, compared to net foreign exchange losses of $27.4 million and $37.0
million, respectively, for the three and six months ended June 30, 2011. This
net change is primarily due to the impact of the strengthening U.S. dollar on
our net liabilities. Net realized and unrealized gains and losses on derivatives
used to hedge those balances are included in "Net realized and unrealized gains
(losses) - other" in the unaudited condensed consolidated statements of
operations.
We designated foreign currency forwards with notional contractual value of $51.9
million and $51.6 million as hedging instruments, which had a fair value of
$(1.1) million and $(0.5) million at June 30, 2012 and December 31, 2011,
respectively. During the three and six months ended June 30, 2012 and 2011, we
recorded $3.1 million and $1.0 million, respectively, of realized and
unrealized gains, directly into comprehensive income as part of the cumulative
translation adjustment for the effective portion of the hedge.
Income Tax Expense
We have 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 our subsidiaries are subject to tax are South
Africa, Canada, India, Switzerland, United Kingdom, and the U.S. However, since
the majority of our income to date has been earned in Bermuda where we are
exempt from income tax, the impact of income taxes to date has been minimal.
36
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Index
During the three and six months ended June 30, 2012, income tax expense was $0.2
million and $0.3 million, respectively, compared to income tax recovery of $0.8
million and $1.1 million, respectively, for the three and six months ended June
30, 2011.
Noncontrolling Interest
The following table is the breakdown of income attributable to noncontrolling
interest in the unaudited condensed consolidated statements of operations into
its various components:
For the three months ended June
30, For the six months ended June 30,
2012 2011 2012 2011
Income attributable to
Island Heritage $ - $ 1,197 $ 1,135 $ 1,465
Income attributable to
Mont Fort - - - 556
Income attributable to
noncontrolling interest $ - $ 1,197 $ 1,135 $ 2,021
The portions of Mont Fort's net income and shareholders' equity attributable to
the preferred shareholders and Island Heritage's net income and shareholders'
equity attributable to minority shareholders are recorded as noncontrolling
interest in accordance with the FASB ASC Topic on Consolidation. Effective March
25, 2011, upon the final redemption of Mont Fort preferred shares, there is no
longer a noncontrolling interest in Mont Fort. Effective April 5, 2012, upon
final disposal of the former Island Heritage reportable segment, there is no
longer a noncontrolling interest in Island Heritage.
Comprehensive Income (Loss)
The following table is the breakdown of comprehensive income (loss) in the
unaudited condensed consolidated statements of operations into its various
components:
For the three months ended June
30, For the six months ended June 30,
2012 2011 2012 2011
Net income (loss) $ 13,490 $ (19,013) $ 53,810 $ (179,409)
Change in currency
translation adjustment (4,669) 873 (132) 3,750
Change in defined benefit
pension plan obligation 136 (158) (72) (158)
Comprehensive income
(loss) 8,957 (18,298) 53,606 (175,817)
Less: Comprehensive loss
attributable to
noncontrolling interest - (1,197) (1,135) (2,021)
Comprehensive income
(loss) attributable to
Flagstone $ 8,957 $ (19,495) $ 52,471 $ (177,838)
The currency translation adjustment is a result of the translation of our
foreign subsidiaries into U.S. dollars, net of transactions designated as hedges
of net foreign investments. We have entered into certain foreign currency
forward contracts that we have designated as hedges in order to hedge our net
investment in foreign subsidiaries. To the extent that the contracts are
effective as a hedge, both the realized and unrealized gains and losses
associated with the designated hedge instruments are recorded in other
comprehensive income as part of the cumulative translation adjustment. For
further information, on foreign currency forward contracts, please refer to the
Foreign Exchange section noted above.
Financial Condition, Liquidity, and Capital Resources
Financial Condition
Our investment portfolio on a risk basis, at June 30, 2012, comprised 93.9%
fixed maturities, short-term investments and cash and cash equivalents with the
balance in other investments. We believe our investments can be liquidated and
converted into cash within a very short period of time. However, our investment
funds, which represent 5.0% of our total investments and cash and cash
equivalents at June 30, 2012, do not trade in active markets and are subject to
redemption provisions that prevent us from converting them into cash
immediately. During the quarter, we made changes to our investment portfolio
allocations due to continued economic uncertainty in the global markets. Our
investment portfolio was repositioned to have shorter duration and higher credit
quality. We continuously monitor the economic environment and global markets
and will consider appropriate changes to the investment portfolio allocations if
and when warranted.
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Index
At June 30, 2012 and December 31, 2011, all of the fixed maturity investments in
our investment portfolio were rated investment-grade (BBB- or higher) by
Standard & Poor's (or an equivalent rating by another rating agency) with an
average rating of AAA and AA, respectively.
The average duration of our investment portfolio was 0.3 years at June 30, 2012
and 1.8 years at December 31, 2011.
Other investments as at June 30, 2012, amounted to $142.4 million compared to
$125.5 million at December 31, 2011. At June 30, 2012, the other investments
comprised $71.8 million in catastrophe bonds and $68.2 million in investment
funds, which are recorded at fair value and our equity method investment of
$2.4 million. The increase in other investments during the first six months of
2012 is principally related to additional investments in investment funds and
catastrophe bonds along with positive performance on investment funds partially
offset by negative performance in the catastrophe bonds.
As at
June 30, 2012 December 31, 2011
Investment funds $ 68,235 $ 59,278
Catastrophe bonds 71,762 64,016
Equity method investment 2,446 2,158
Total $ 142,443 $ 125,452
The net payable for investments purchased at June 30, 2012, was $0.1 million,
compared to a net payable for investments purchased of $6.2 million at December
31, 2011. Net receivables and payables for investments are a result of timing
differences only, as investments are accounted for on a trade date basis.
See Note 5 "Investments" to the unaudited condensed consolidated financial
statements for further details on amortized cost, gross unrealized gains and
losses, and rating and maturity distributions.
Liquidity
Cash flows from operations for the six months ended June 30, 2012 used $181.0
million, as compared to providing $95.2 million during the same period in
2011. This decrease in cash flows from operations was primarily related to
decreased loss and loss adjustment expense reserves resulting from the volume of
claims paid on the 2011 loss events, partially offset by higher net income in
the current period due to the absence of significant loss events during the six
months ended June 30, 2012. Because a large portion of the coverages we provide
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 distributions
to shareholders, share related transactions and the issuance or repayment of
debt. During the six months ended June 30, 2012, net cash of $7.0 million was
used in financing activities, compared to $52.3 million for the same period in
2011. For the six months ended June 30, 2012, the net cash used in financing
activities related principally to the payment of distributions. For the six
months ended June 30, 2011, the net cash used in financing activities related
principally to the redemption of preferred shares in Mont Fort High Layer.
We may incur additional indebtedness in the future if we determine that it would
improve the efficiency of our capital structure.
Generally, positive cash flows from our operating and financing activities are
invested in our investment portfolio.
To date, we have had sufficient cash flows 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 the proceeds from sales and
maturities of our investment portfolio. The divestiture of Island Heritage did
not have a significant impact on our operation's needs for liquidity. In
addition, with reference to "Recent Developments" above, as of the date of this
Quarterly Report, we do not anticipate the divestiture of Lloyd's to have a
significant impact on our operation's needs for liquidity.
In the current financial environment, it may be difficult for the insurance
industry generally, and us in particular, to raise additional capital when
required, on acceptable terms or at all. Cash and cash equivalents were $186.3
million at June 30, 2012. On October 24, 2011, A.M. Best Co. commented that the
Company's recent restructuring announcement has not changed the issuer credit
ratings ("ICRs") of "a-" of Flagstone Reassurance Suisse S.A. (Martigny,
Switzerland), Island Heritage Insurance Company Ltd. (Cayman Islands) and
Flagstone Alliance Insurance and Reinsurance PLC (Limassol, Cyprus) as well as
the ICR of "bbb-" of Flagstone
38
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Index
Reinsurance Holdings S.A. (Luxembourg), nor has the announcement changed the
indicative debt ratings of "bb" on preferred stock, "bb+" on subordinated debt
and "bbb-" on senior debt for securities available under the Company's shelf
registration statement. A.M. Best Co. noted that the outlook for all ratings,
with the exception of Island Heritage Insurance Company Ltd., remains negative.
On April 4, 2012, after the Company announced that it had entered into
definitive agreements for the sale of its Lloyd's business and Island Heritage,
A.M. Best Co. commented these ICRs remain unchanged and that the outlook for all
ratings remains negative. On May 18, 2012, A.M. Best Co. again commented that
these ICRs remain unchanged and that the outlook for all ratings remains
negative. The Company's ICRs, including those of its wholly owned subsidiaries,
are important to maintaining the Company's liquidity. A reduction in these
credit ratings, the continued negative outlook or a failure to resolve the
negative outlook could reduce the Company's access to debt markets or materially
increase the cost of issuing debt, trigger additional collateral or funding
requirements, and decrease the number of counterparties willing or permitted,
contractually or otherwise, to do business with or lend to the Company, thereby
curtailing the Company's business operations and reducing its profitability.
Capital Resources
Our total capital resources at June 30, 2012 and December 31, 2011 were as
follows:
As at
June 30, 2012 December 31, 2011
Long term debt $ 250,202 $ 250,575
Common shares 845 845
Common shares held in treasury (150,202)
(160,448)
Additional paid-in capital 857,714 872,819
Accumulated other comprehensive loss (12,788) (12,584)
Retained earnings 141,091 88,416
Total capital $ 1,086,862 $ 1,039,623
The movement in both common shares held in treasury and additional paid-in
capital during the six months ended June 30, 2012, arises from the use of
treasury shares to settle vested stock based compensation grants.
For the six months ended June 30, 2012, accumulated other comprehensive loss
arose from the changes in currency translation adjustment of $(0.1) million and
the defined benefit pension plan obligation of $(0.1) million.
Letter of credit facilities
On August 31, 2011, Flagstone Suisse and Flagstone Capital Management Luxembourg
SICAF - FIS ("FCML") entered into a $200.0 million secured committed letter of
credit facility with Barclays Bank Plc (the "Barclays Facility"). The Barclays
Facility is for letters of credit with a maximum tenor of 15 months and is used
to support the reinsurance obligations of the Company. As of June 30, 2012,
$46.0 million had been drawn under the Barclays Facility, and the drawn amount
was secured by $48.4 million of fixed maturity investments from the Company's
investment portfolio. The Barclays Facility replaced a $200.0 million credit
facility with Barclays Bank Plc which commenced on March 5, 2009.
On April 28, 2010, Flagstone Suisse and FCML entered into a secured $450.0
million standby letter of credit facility with Citibank Europe Plc (the "Citi
Facility"). The Citi Facility comprised a $225.0 million facility for letters of
credit with a maximum tenor of 15 months, to be used to support reinsurance
obligations of the Company, and a $225.0 million facility for letters of credit
drawn in respect of Funds at Lloyd's with a maximum tenor of 60 months. On
December 21, 2010, the Citi Facility was amended to increase the amount
available under the facility by $100.0 million to $550.0 million, with all the
terms and conditions remaining unchanged. The Citi Facility now comprises a
$275.0 million facility for letters of credit with a maximum tenor of 15 months,
to be used to support reinsurance obligations of the Company, and a $275.0
million facility for letters of credit drawn in respect of Funds at Lloyd's with
a maximum tenor of 60 months. As at June 30, 2012, $507.5 million had been drawn
under the Citi Facility, and the drawn amount of the facility was secured by
$554.7 million of fixed maturity investments from the Company's investment
portfolio. The Citi Facility replaced a $450.0 million credit facility with
Citibank Europe Plc which commenced on January 22, 2009.
These facilities are used to provide security to reinsureds and for Funds at
Lloyd's, and they are fully collateralized by the Company, to the extent of the
letters of credit outstanding at any given time.
The divestiture of Island Heritage did not have a significant impact on our
capital resources. In addition, we do not anticipate any significant impact on
our capital resources as a result of the divestiture of Lloyd's discussed in
"Recent Developments" above. However, the Lloyd's divestiture will result in a
reduction in the utilization of our letter of credit facilities.
39
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Index
Restrictions and Specific Requirements
Luxembourg
We do not conduct the business of an insurer or reinsurer in Luxembourg and
therefore are not required to be registered with the Commissairiat aux
Assurances, which is the authority in Luxembourg that regulates insurers and
reinsurers.
Under Luxembourg Law, our shareholders may declare dividends at a general
meeting of shareholders through the passage of an ordinary resolution, but, in
accordance with our Articles, the dividend may not exceed the amount recommended
by our Board. Dividends may only be declared from our distributable reserves. In
accordance with Luxembourg Law, no distributions to shareholders may be made
when, on the closing date of the relevant financial year, the net assets as set
out in the annual accounts are, or would be following such a distribution, lower
than the subscribed capital plus the reserves that may not be distributed under
Luxembourg Law or in accordance with our Articles. The amount of a distribution
to shareholders may not exceed the amount of profits at the end of the last
financial year plus any profits carried forward and any amounts drawn from
reserves which are available for that purpose, less any losses carried forward
and sums to be placed to reserve in accordance with the Luxembourg Law or in
accordance with the Articles.
Subject to Luxembourg Company Law, our Board may declare interim dividends. The
declaration of interim dividends is subject to the approval of shareholders at
the next general meeting. Where the payments made on account of interim
dividends exceed the amount of dividends subsequently approved by shareholders
at the general meeting, they shall, to the extent of the overpayment, be deemed
to have been paid on account of the next dividend. Our Articles allow for the
declaration of interim dividends, but any payment of interim dividends is
subject to the conditions that: (i) interim accounts are drawn up showing that
the funds available for distribution are sufficient; (ii) the amount to be
distributed may not exceed total profits made since the end of the last
financial year for which the accounts have been approved, plus any profits
carried forward and sums drawn down from reserves available for this purpose,
less losses carried forward any sums to be placed to reserve pursuant to the
requirements of the law or our Articles; (iii) the decision of our Board to
distribute an interim dividend may not be taken more than two months after the
date at which the interim accounts have been made up; (iv) in their report, our
Board of Directors and the statutory auditor shall verify whether the above
conditions have been satisfied.
Certain of our investment management activities are based in Luxembourg and
managed through Flagstone Capital Management Luxembourg SICAF - FIS
("FCML"). FCML is a closed-end investment fund and is regulated by the
Luxembourg Commission de Surveillance du Secteur Financier. In accordance with
the various documents governing the operation of FCML, a general meeting
determines how the profits (including net realized capital gains) of FCML are
disposed of and may from time to time declare, or authorize the Board of
Directors of FCML to declare dividends, provided however that the capital of
FCML including issue premiums does not fall below €1,250,000 or the equivalent
thereof in any currency in which shares in FCML are issued. Dividends may also
be paid out of net unrealized capital gains after deduction of realized
losses. The Board of Directors of FCML is further authorized to pay interim
dividends subject to the relevant provisions of Luxembourg law.
Switzerland
Flagstone Suisse is licensed to operate as a reinsurer in Switzerland and is
also licensed in Bermuda through the Flagstone Suisse branch office and is not
licensed in any other jurisdictions. 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 Suisse to post a letter of credit or other
collateral.
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 20% of the company's
profits be allocated to a "general reserve" until the reserve reaches 50% 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.
Bermuda
Flagstone Suisse is licensed as a Class 4 insurer in Bermuda through its branch
office. The Bermuda Insurance Act requires Flagstone Suisse to maintain a
minimum solvency margin (being the minimum amount that the statutory assets must
exceed the statutory liabilities as required by the Bermuda 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.
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The Company established a Luxembourg SICAF fund, FCML, on September 8, 2008 to
manage the group's investments in Luxembourg. FCML is a wholly owned subsidiary
of Flagstone Suisse. This structure offers the group many advantages such as the
benefits of centralized investment management, tax and regulatory efficiencies.
For purposes of the Swiss Solvency Test, the investment in FCML is consolidated
in Flagstone Suisse's accounts, as approved by FINMA since 2008.
In preparing the stand alone Bermuda statutory financial statements of Flagstone
Suisse, FCML is recorded as an investment in affiliate on the balance sheet and
as such does not automatically qualify as a relevant asset for the purposes of
the liquidity ratio.
The Company applied to the Bermuda Monetary Authority (the "BMA") for FCML to
qualify as a relevant asset for the purposes of meeting the 2011 liquidity ratio
requirements and on March 13, 2012 the application was approved by the BMA,
followed by the receipt of official documentation on May 1, 2012. Flagstone
Suisse is required to file statutory financial statements annually with the BMA
by April 30.
In addition, each Class 4 insurer must maintain its capital at a level equal to
its enhanced capital requirement ("ECR") which is established by reference to
the Bermuda Solvency Capital Requirement ("BSCR") model which came into force in
2008 to assist the BMA to better assess the adequacy of a Class 4 insurer's
capital.
Alternatively, under the Insurance Act, insurers may, subject to the terms of
the Insurance Act and to the BMA's oversight, elect to utilize an approved
internal capital model to determine regulatory capital. The BMA believes that
use of an internal model to substantiate the required regulatory capital
requirement may in many circumstances better reflect a specific insurer's
particular business profile than a market-wide regulatory model. An insurer's
internal model must satisfy certain criteria to be approved for the
determination of regulatory capital. In either case, the ECR shall at all times
equal or exceed the Class 4 insurer's Minimum Solvency Margin and may be
adjusted in circumstances where the BMA concludes that the insurer's risk
profile deviates significantly from the assumptions underlying its ECR or the
insurer's assessment of its risk management policies and practices used to
calculate the ECR applicable to it.
In 2009, the BMA launched its Bermuda Insurance Solvency Framework, which is
designed to enable Bermuda to achieve "equivalence" with Solvency II. As of the
date of this Quarterly Report, the impact of this initiative is currently being
monitored by the Company.
Bermuda law limits the maximum amount of annual dividends or distributions
payable by Flagstone Suisse 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 Suisse 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 Suisse's principal
representative, which states that in their opinion, declaration of those
dividends will not cause Flagstone Suisse to fail to meet its prescribed
solvency margin and liquidity ratio. Further, Flagstone Suisse 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 Suisse must also
maintain, as a Class 4 Bermuda reinsurer, paid-up share capital of $1 million.
South Africa
Flagstone Africa is regulated by the Financial Services Board ("FSB") and is
licensed to operate as a reinsurer in South Africa subject to statutory minimum
capital requirements under applicable legislation. In addition, a South African
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 requirements.
United Kingdom
Our discontinued operations FSML and Syndicate 1861 are regulated by the
Financial Services Authority ("FSA") in the U.K. The FSA is an independent
non-governmental body, given statutory powers by the Financial Services and
Markets Act 2000. Although accountable to treasury ministers and through them to
Parliament, it is funded entirely by the firms it regulates. The FSA has wide
ranging powers in relation to rule-making, investigation and enforcement to
enable it to meet its four statutory objectives, which are summarized as one
overall aim: "to promote efficient, orderly and fair markets and to help retail
consumers achieve a fair deal".
In relation to insurance business, the FSA regulates insurers, insurance
intermediaries and Lloyd's itself. The FSA and Lloyd's have common objectives in
ensuring that Lloyd's market is appropriately regulated and, to minimize
duplication, the FSA has agreed arrangements with Lloyd's for cooperation on
supervision and enforcement.
FSML's underwriting activities are therefore regulated by the FSA as well as
being subject to the Lloyd's "franchise". Both FSA and Lloyd's have powers to
remove their respective authorization to manage Lloyd's syndicates. Lloyd's
approves annually Syndicate 1861's business plan and any subsequent material
changes, and the amount of capital required to support that plan. Lloyd's may
require changes to any business plan presented to it or additional capital to be
provided to support the underwriting (known as Funds at Lloyd's).
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Solvency II
The European Parliament passed the Solvency II directive in April 2009, to
establish a revised set of European Union (EU) wide capital requirements and
risk management standards. All (re)insurers, including Lloyd's and its managing
agents, within the EU need to be compliant with Solvency II by January 1, 2014.
Flagstone's existing risk management framework and mechanisms closely mirror the
requirements for Solvency II. Since its inception, Flagstone has invested in its
internal model that generates the Group's risk profile and this model is also
used to calculate the internal capital requirements for Lloyd's. Flagstone is
working closely with Lloyd's to ensure full compliance with the regulations.
Flagstone believes that Solvency II will have a positive impact on its
operations and risk management framework.
Off Balance Sheet Arrangements
Montana Re is a special purpose reinsurer established in the Cayman Islands and
was formed as a program structure enabling further issuance of additional series
of notes in the future. During 2009, we entered into a reinsurance agreement
with Montana Re that provides us with $175.0 million of protection for certain
losses from global catastrophe events. During 2010, we entered into an
additional reinsurance agreement with Montana Re, which incepted on January 1,
2011, that provides us with $210.0 million of protection for certain losses from
global catastrophe events. These bonds have recently been downgraded by the
relevant rating agencies to reflect the increased likelihood of attachments due
to recent industry model changes.
We have determined that Montana Re has the characteristics of a variable
interest entity that are addressed by the Consolidation Topic of the FASB
ASC. In accordance with the Consolidation Topic, Montana Re is not consolidated
because we are not the primary beneficiary.
We are not party to any transaction, agreement or other contractual arrangement
to which a Flagstone affiliated unconsolidated entity is a party, other than
those noted above with Montana Re, that management believes is reasonably likely
to have a current or future effect on our financial condition, revenues or
expenses, results of operations, liquidity, capital expenditures or capital
resources that is material to investors.
For details relating to our letter of credit facilities see above "Financial
Condition, Liquidity and Capital Resources - Letter of Credit Facilities".
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