FLAGSTONE REINSURANCE HOLDINGS, S.A. – 10-Q – Management’s Discussion and Analysis of Financial Condition andResults of Operations
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The following is a discussion and analysis of our financial condition as atMarch 31, 2012 andDecember 31, 2011 , and our results of operations for the three months endedMarch 31, 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 endedDecember 31, 2011 (our "2011 Annual Report"), filed with theSEC onMarch 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 toFlagstone Reinsurance Holdings, S.A. and/or its subsidiaries, including Flagstone RéassuranceSuisse SA , its wholly-ownedSwitzerland reinsurance company,Flagstone Alliance Insurance & Reinsurance PLC , its wholly-ownedCyprus insurance and reinsurance company,Flagstone Reinsurance Africa Limited , its wholly-owned South African reinsurance company,Mont Fort Re Ltd. , its wholly-ownedBermuda reinsurance company, and any other direct or indirect wholly-owned subsidiary, but not including its United Kingdom Lloyd's managing agencyFlagstone Syndicate Management Limited , orIsland Heritage Holdings Ltd. , each of which are discontinued operations, unless the context suggests otherwise. OnOctober 24, 2011 , we announced a strategic decision to divest our ownership positions in our formerLloyd's and Island Heritage reportable segments. OnApril 5, 2012 , the Company completed the sale of the business comprising its former Island Heritage reportable segment. OnApril 3, 2012 , the Company announced that it had entered into definitive agreements to divest the business comprising its formerLloyd's reportable segment. The Company has classified the assets and liabilities associated with its formerLloyd'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 these operations have been presented as discontinued operations in the Company's consolidated statements of operations for all periods presented. 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 RéassuranceSuisse SA , its wholly-owned subsidiaries and itsBermuda branch. References to "FSML" refer toFlagstone Syndicate Management Limited , its wholly-owned subsidiaries and Syndicate 1861. References to "Island Heritage" refer toIsland Heritage Holdings Ltd. and its subsidiaries. References to "Flagstone Africa" refer toFlagstone Reinsurance Africa Limited . References to "Mont Fort" refer toMont Fort Re Ltd. References in this Quarterly Report to "dollars" or "$" are to the lawful currency ofthe 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
OnOctober 24, 2011 , we announced a strategic business decision to divest our ownership positions in our formerLloyd's and Island Heritage reportable segments. Our goal was to free up underwriting capital for our core business, substantially reducing risk while retaining acceptable return on equity levels, to continue to lower costs and to return to profitability. We have achieved these goals in the first quarter, and have started 2012 with a return to profitability, despite the ongoing challenging environment in the industry. Our improved performance this quarter reflects the benefits of improving rates in our core business, which partially offset the reduction in income as we pare back our risk levels. It also begins to demonstrate the benefits of our expense saving initiatives, as well as the avoidance of significant exposure to first quarter 2012 loss events. 23
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As previously announced onApril 2, 2012 , andApril 3, 2012 , the Company entered into definitive agreements to divest its former Island Heritage andLloyd's reportable segments, respectively. The Island Heritage transaction was completed onApril 5, 2012 , as previously announced. TheLloyd's segment transaction is expected to be completed before the end of the second quarter of 2012. 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 continue to make significant progress on our business realignment as we establish a more nimble, cost-effective and opportunistic business. We remain focused on leveraging the existing strengths in our core businesses in order to deliver enhanced value for our shareholders. 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 orCalifornia 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 formerLloyd'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 onDecember 31 . Because a substantial portion of the insurance and reinsurance we write in our discontinued operations and reinsurance we write in our 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 (onMarch 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 inBermuda , 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 fromBermuda to Luxembourg effectiveMay 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
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Recent Developments
OnApril 2, 2012 , the Company announced that it had entered into a definitive share purchase agreement with BF&M Limited ("BF&M"), and certain other parties, under which BF&M acquired Island Heritage for approximately$68 million in cash. The divesture process for Island Heritage was completed onApril 5, 2012 , for total proceeds of approximately$68.0 million , of which, the Company received approximately$40.8 million for its approximate 60% interest, which is subject to a purchase price adjustment based on a finalMarch 31, 2012 balance sheet. The divestiture will be recorded in the second quarter result and is not expected to result in a significant gain or loss on disposal. OnApril 3, 2012 , the Company announced that it had entered into a definitive agreement with a wholly-owned subsidiary ofANV Holdings BV ("ANV"), under which ANV, with capital support from Ontario Teachers' Pension Plan Board, will acquire the Company'sLloyd's operations for approximately$48 million in cash, subject to a purchase price adjustment based on a finalMarch 31, 2012 balance sheet. As a result of the transaction, the Company will release approximately$162 million of underwriting capital currently supporting itsLloyd's operation. This transaction is expected to be completed before the end of the second quarter of 2012, subject to the satisfaction of customary regulatory approvals and certain other customary closing conditions, and is not expected to result in a significant gain or loss on disposal.
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 atMarch 31, 2012 have not changed compared toDecember 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 Months Ended
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 ended U.S. dollar (weakened) strengthened against: March 31,2012 Canadian dollar (2.1) % Swiss franc (4.1) % Euro (3.0) % British pound sterling (3.0) % Indian rupee (4.2) % South African rand (5.2) % 25
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Summary Overview
The following table sets forth selected key financial information for the three months ended
For the three months ended March 31, 2012 2011 $ Change % Change Underwriting income (loss) $ 4,618 $ (155,819) $ 160,437 103.0 % Net investment income $ 5,067 $ 9,198 $ (4,131) (44.9) % Net realized and unrealized gains - investments $ 18,103 $ 10,771 $ 7,332 68.1 % Net realized and unrealized gains (losses) - other $ 6,383 $ (690) $ 7,073 1,025.1 % Income (loss) from continuing operations $ 27,848 $ (148,173) $ 176,021 118.8 % Income (loss) from continuing operations per common share - Basic $ 0.38 $ (2.15) $ 2.53 Income (loss) from continuing operations per common share - Diluted(1) $ 0.38 $ (2.15) $ 2.53 Loss ratio 58.4 % 150.7 % Expense ratio 39.1 % 26.9 % Combined ratio 97.5 % 177.6 %
The following table sets forth selected key non-GAAP financial measures as at
As at March 31, December 31, $ 2012 2011 Change % Change Basic book value per common share $ 11.62 $ 11.21 $ 0.41 3.7 % Diluted book value per common share $ 11.42 $ 10.90 $ 0.52 4.8 % Diluted book value per common share plus accumulated distributions $ 12.18 $ 11.62 $ 0.56 4.8 %
(1)Income (loss) from continuing operations per common share - Diluted for the three months ended
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 1,016,050 and 1,965,091 PSU's expected to vest under the PSU plan as atMarch 31, 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 three months endedMarch 31, 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 ($34.4 million ), cyclone Yasi ($31.0 million ),New Zealand earthquake ofFebruary 2011 ($81.5 million ) and theJapan earthquake and tsunami ($109.7 million ). The increase in the net realized and unrealized gains and losses - investments, for the three months endedMarch 31, 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. The increase in the net realized and unrealized gains and losses - other, for the three months endedMarch 31, 2012 , is primarily associated with currency swaps and foreign currency forward contracts are due to currency fluctuations which is partially offset by losses 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. 26
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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 atMarch 31, 2012 andDecember 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. As at March 31, 2012 December 31, 2011 Flagstone shareholders' equity $ 829,316 $ 789,048 Potential net proceeds from assumed: Exercise of PSU (1) - - Exercise of RSU (1) - - Conversion of warrant (2) - - Diluted Flagstone shareholders' equity $ 829,316 $
789,048
Cumulative distributions paid per outstanding common share $ 0.76 $
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 1,016,050 1,676,125 RSUs outstanding 260,050 290,470 Conversion of warrant (2) - - Common shares outstanding - diluted 72,628,587 72,367,446Basic book value per common share $ 11.62 $ 11.21 Diluted book value per common share $ 11.42 $ 10.90Basic book value per common share plus accumulated distributions $ 12.38 $ 11.93 Diluted book value per common share plus accumulated distributions $ 12.18 $ 11.62 Distributions per common share paid during the period $ 0.04 $
0.16
(1)No proceeds due when exercised (2)Below strike price - not dilutive 27
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Index Outlook and Trends Market Outlook At the importantJanuary 1, 2012 renewal period, North American rates increased approximately 10-15% from rates a year ago, averaging high single digit increases in loss-free regions and ranging from 15-40% increases in loss-affected regions. Looking forward toward the next major North American renewal period at mid-year, we expect a similar level of increases and a strong renewal. Many clients are now out with their submissions early, with several looking for modest increases in programs and recognizing the potential of price increases. On average, clients are buying more and therefore more capacity is needed, however we anticipate that reinsurers will also be willing to extend more capacity to meet this need in a measured approach. Furthermore, theFlorida market looks to be more orderly at the upcoming renewal, due in part to the successful cat bond placement byCitizens Property Insurance Corporation of Florida , which lessens the amount of capacity required of the private market. As such, we do not expect any significant dislocation in theFlorida market at the upcoming renewal. However, we believe there will be more financial flexibility in the system withFlorida companies finally seeing the rate increases from last year earn through, and most have filed for, and expect to receive, another round of double digit price increases. As such, we are expecting less resistance to rate increases from cedents who in the past have been squeezed by the rate environment inFlorida . The International market sawJanuary 1, 2012 rates up 5% on average for European business, and loss-affected areas such asAustralia showing more significant rate increases of 50-100%, which were expected given the recent catastrophic events in the region. AtApril 1, 2012 , renewals were primarily focused onJapan and saw strong pricing increases in these Japanese programs. 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%. The few European accounts that renewed in April were flat on a risk-adjusted basis.Caribbean accounts had to increase pricing by 10-20% to receive the required capacity. With theCaribbean competing for capacity with the U.S. wind accounts overall capacity was tight. In summary, outside of theCaribbean , capacity was generally abundant, and looking forward to the next major International renewal period atJanuary 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
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 theFinancial 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 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. 28
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.
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 March 31, 2012 2011 Gross Gross premiums Percentage of premiums Percentage of written total written total Line of business Property catastrophe $ 106,341 62.5 % $ 201,862 57.2 % Property 37,885 22.3 % 65,799 18.7 % Short-tail specialty and 26,002 15.2 % 85,014 24.1 % casualty Total $ 170,228 100.0 % $ 352,675 100.0 % For the three months ended March 31, 2012 2011 Gross premiums Percentage of Gross premiums Percentage of written total written total Geographic area of risk insured (1) Caribbean $ 1,500 0.9 % $ 1,793 0.5 % Europe 49,259 28.9 % 76,514 21.7 % Japan and Australasia 11,097 6.5 % 42,500 12.0 % North America 71,419 42.0 % 124,020 35.2 % Worldwide risks (2) 29,610 17.4 % 92,627 26.3 % Other 7,343 4.3 % 15,221 4.3 % Total $ 170,228 100.0 % $ 352,675 100.0 % (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.
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. 29
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Below is a summary of the underwriting results and ratios for the three months endedMarch 31, 2012 and 2011: For the three months ended March 31, 2012 2011 $ Change % Change Property catastrophe reinsurance $ 106,341 $ 201,862 $ (95,521) (47.3) % Property reinsurance 37,885 65,799 (27,914) (42.4) % Short tail specialty and casualty reinsurance 26,002 85,014 (59,012) (69.4) % Gross premiums written 170,228 352,675 (182,447) (51.7) % Premiums ceded (84,899) (118,750) 33,851 (28.5) % Net premiums written 85,329 233,925 (148,596) (63.5) % Net premiums earned 113,745 201,053 (87,308) (43.4) % Other related income 1,835 272 1,563 574.6 % Loss and loss adjustment expenses (66,449) (302,999) 236,550 (78.1) % Acquisition costs (22,653) (38,071) 15,418 (40.5) % General and administrative expenses (21,860) (16,075) (5,785) 36.0 % Underwriting income (loss) $ 4,618 $ (155,820) $ 160,438 103.0 % Loss ratio 58.4 % 150.7 % Acquisition cost ratio 19.9 % 18.9 % General and administrative expense ratio 19.2 % 8.0 % Combined ratio 97.5 % 177.6 %
· The increase in net underwriting results is the result of the lack of
significant loss events during the first quarter of 2012 compared to the same
period in 2011 (Australian floods, cyclone Yasi,
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
three months ended
reinstatement premiums compared to
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.
· 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 ($30.5
million), cyclone Yasi (
2011 (
are net of retrocession but excluding reinstatement premiums.
· Each quarter we revisit our loss estimates for previous catastrophe events.
During the quarter ended
by clients and brokers, we recorded net adverse developments of
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.
· The increase in general and administrative expenses is primarily the result of
staff compensation accrual and performance based compensation having been
adjusted downward in the same period in 2011 as a result of the significant underwriting loss. 30
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Income from Discontinued Operations
Income from discontinued operations includes the financial results of our former reportable segments,Lloyd's and Island Heritage. Included in income from discontinued operations for the three months endedMarch 31, 2012 is underwriting income of$11.6 million , compared to underwriting losses of$16.1 million for the same period in 2011. The$27.7 million increase in underwriting income is primarily attributable to more significant catastrophic events during 2011compared to 2012. In addition, as ofMarch 31, 2012 , we had liabilities associated with discontinued operations of$441.4 million . Although we account for the business comprising our formerLloyd's and Island Heritage reportable segments as discontinued operations, we owned the Island heritage business until completing its sale onApril 5, 2012 , and we will continue to own theLloyd's business and be subject to the risks associated with that business until theLloyd'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 March 31, 2012 2011 % Change Investment portfolio return 1.9 % 1.0 % 0.9 % 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 investments to investment income. The following table sets forth net investment income for the three months endedMarch 31, 2012 and 2011: For the three months ended March 31, 2012 2011 $ Change Cash and cash equivalents $ 270 $ 394 $ (124) Fixed maturity investments 5,767 9,808 (4,041) Short term investments 122 206 (84) Other investments (12) (59) 47 Investment expenses (1,080) (1,151) 71 Net investment income $ 5,067 $ 9,198 $ (4,131)
· The decrease in net investment income is primarily due to lower invested
assets and to lower interest rates during the period.
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, global bond, 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. 31
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The following table is a breakdown of the net realized and unrealized gains - investments for the three months ended
For the three months ended March 31, 2012 2011 $ Change Net realized gains on fixed maturity investments $ 8,597 $ 14,093 $ (5,496) Net unrealized gains on fixed maturity investments 15,930 19,142
(3,212)
Net unrealized losses on equity investments (3) (31)
28
Net realized and unrealized losses on derivatives instruments - investments (see table below) (12,305) (26,410)
14,105
Net realized and unrealized gains on other investments 5,884 3,977
1,907
Net realized and unrealized gains - investments $ 18,103 $ 10,771 $ 7,332 For the three months ended March 31, 2012 2011 $ Change Futures contracts $ 253 $ 7,568 $ (7,315) Foreign currency forward contracts (12,558) (33,976)
21,418
Mortgage-backed securities TBA - (2)
2
Net realized and unrealized losses on derivatives instruments - investments $ (12,305) $ (26,410) $ 14,105
· The change in net realized and unrealized gains on fixed maturity investments
is primarily due to a tightening of credit spreads and to a lower foreign
currency impact on the portfolio.
· The change in net realized and unrealized gains on other investments is
primarily due to the positive performance on investment funds.
· The change in net unrealized and unrealized gains on futures contracts is
primarily due to lower positive performance in the current period.
· The change in net realized and unrealized losses 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.
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The following table is the breakdown of net realized and unrealized gains (losses) - other for the three months ended
For the three months ended March 31, 2012 2011 $ Change Currency swaps $ 428 $ 1,080 $ (652) Foreign currency forward contracts 5,955 (2,011) 7,966 Reinsurance derivatives - 241 (241) Net realized and unrealized gains (losses) - other $ 6,383 $ (690) $ 7,073
· The net realized and unrealized gains associated with the currency swaps and
foreign currency forward contracts are due to currency fluctuations which are
partially offset by losses recorded through balance sheet currency revaluations and are attributable to operational hedges on reinsurance balances.
· There were no ILWs classified as derivatives written during 2011 and 2012.
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 for the three months endedMarch 31, 2012 , compared to$2.9 million for the three months endedMarch 31, 2011 . Foreign Exchange For the three months endedMarch 31, 2012 , we experienced net foreign exchange losses of$4.2 million compared to net foreign exchange losses of$9.6 million for the three months endedMarch 31, 2011 . This decrease is primarily due to the impact of the weakening 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$55.0 million and$51.6 million as hedging instruments, which had a fair value of$(0.2) million and$(0.5) million atMarch 31, 2012 andDecember 31, 2011 , respectively. During the three months endedMarch 31, 2012 and 2011, we recorded$2.2 million and$1.2 million , respectively, of realized and unrealized losses 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 areSouth Africa ,Canada ,India ,Switzerland ,United Kingdom , and the U.S. However, since the majority of our income to date has been earned inBermuda where we are exempt from income tax, the impact of income taxes to date has been minimal.
During the three months ended
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 March 31, 2012 2011 Income attributable to Mont Fort $ - $
556
Income attributable to Island Heritage 1,135
268
Income attributable to noncontrolling $ interest 1,135 $ 824 33
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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. EffectiveMarch 25, 2011 , upon the final redemption of Mont Fort preferred shares, there is no longer a noncontrolling interest in Mont Fort.
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 March 31, 2012 2011 Net income (loss) $ 40,320 $ (160,396) Change in currency translation adjustment 4,537
2,877
Change in defined benefit pension plan obligation (208) - Comprehensive income (loss) 44,649 (157,519) Less: Comprehensive income attributable to noncontrolling interest (1,135) (824) Comprehensive income (loss) $ attributable to Flagstone 43,514 $ (158,343) 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, atMarch 31, 2012 , comprised 95.1% 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 4.4% of our total investments and cash and cash equivalents atMarch 31, 2012 , do not trade in active markets and are subject to redemption provisions that prevent us from converting them into cash immediately. AtMarch 31, 2012 andDecember 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 AA+ and AA, respectively.
The average duration of our investment portfolio was 1.7 years at
Other investments as atMarch 31, 2012 , amounted to$131.5 million compared to$125.5 million atDecember 31, 2011 . AtMarch 31, 2012 , the other investments comprised$62.8 million in catastrophe bonds and$66.5 million in investment funds, which are recorded at fair value and our equity method investment of$2.2 million . The increase in other investments during the first three months of 2012 is principally related to positive performance and additional investments in investment funds partially offset by negative performance in the catastrophe bonds. As at March 31, 2012 December 31, 2011 Investment funds $ 66,507 $ 59,278 Catastrophe bonds 62,827 64,016 Equity method investment 2,175 2,158 Total $ 131,509 $ 125,452 34
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The net payable for investments purchased atMarch 31, 2012 , was$40.7million , compared to a net payable for investments purchased of$6.2million atDecember 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 three months endedMarch 31, 2012 used$37.3 million during the three months endedMarch 31, 2012 , as compared to providing$42.0 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, partially offset by higher net income in the current period. 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 three months endedMarch 31, 2012 , net cash of$4.1 million was used in financing activities, compared to$49.7 million for the same period in 2011. For the three months endedMarch 31, 2012 , the net cash used in financing activities related principally to the payment of distributions. For the three months endedMarch 31, 2011 , the net cash used in financing activities related principally to the redemption of preferred shares inMont 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. In addition, with reference to "Recent Developments" above, as of the date of this Quarterly Report, we do not anticipate the divestiture ofLloyd's and Island Heritage 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$217.1 million atMarch 31, 2012 . OnOctober 24, 2011 ,A.M. Best Co. commented that the Company's recent restructuring announcement (see "Recent Developments" above) has not changed the issuer credit ratings ("ICRs") of "a-" ofFlagstone Reassurance Suisse S.A. (Martigny, Switzerland ),Island Heritage Insurance Company Ltd. (Cayman Islands ) andFlagstone Alliance Insurance andReinsurance PLC (Limassol,Cyprus ) as well as the ICR of "bbb-" ofFlagstone 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 ofIsland Heritage Insurance Company Ltd. , remains negative. OnApril 4, 2012 , after the Company announced that it had entered into definitive agreements for the sale of itsLloyd's business and Island Heritage, A.M. Best Co. commented 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
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Index As at March 31, 2012 December 31, 2011 Long term debt $ 251,088 $ 250,575 Common shares 845 845 Common shares held in treasury (150,202)
(160,448)
Additional paid-in capital 859,327
872,819
Accumulated other comprehensive loss (8,255) (12,584) Retained earnings 127,601 88,416 Total capital $ 1,080,404 $ 1,039,623
The movement in both common shares held in treasury and additional paid-in capital during the three months ended
For the three months endedMarch 31, 2012 , accumulated other comprehensive loss arose from the changes in currency translation adjustment of$4.5 million and the defined benefit pension plan obligation of$(0.2) million .
Letter of credit facilities
OnAugust 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 ofMarch 31, 2012 ,$52.3 million had been drawn under the Barclays Facility, and the drawn amount was secured by$61.6 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 onMarch 5, 2009 . OnApril 28, 2010 , Flagstone Suisse and FCML entered into a secured$450.0 million standby letter of credit facility withCitibank 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 atLloyd's with a maximum tenor of 60 months. OnDecember 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$240.0 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$310.0 million facility for letters of credit drawn in respect of Funds atLloyd's with a maximum tenor of 60 months. As atMarch 31, 2012 ,$497.9 million had been drawn under the Citi Facility, and the drawn amount of the facility was secured by$586.6 million of fixed maturity investments from the Company's investment portfolio. The Citi Facility replaced a$450.0 million credit facility withCitibank Europe Plc which commenced onJanuary 22, 2009 . These facilities are used to provide security to reinsureds and for Funds atLloyd's , and they are fully collateralized by the Company, to the extent of the letters of credit outstanding at any given time. We do not anticipate any significant impact on our capital resources as a result of the divestitures discussed in "Recent Developments" above. However, this may result in a reduction in the utilization of our letter of credit facilities.
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. 36
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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 theLuxembourg 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.
Flagstone Suisse is licensed to operate as a reinsurer inSwitzerland and is also licensed inBermuda 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.
Flagstone Suisse is licensed as a Class 4 insurer inBermuda 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. The Company established a Luxembourg SICAF fund, FCML, onSeptember 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 aloneBermuda 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 theBermuda Monetary Authority (the "BMA") for FCML to qualify as a relevant asset for the purposes of meeting the 2011 liquidity ratio requirements and onMarch 13, 2012 the application was approved by the BMA. Flagstone Suisse is required to file statutory financial statements for the year endedDecember 31, 2011 with the BMA byApril 30, 2012 . 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. 37
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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 enableBermuda 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 FlagstoneAfrica is regulated by the Financial Services Board ("FSB") and is licensed to operate as a reinsurer inSouth 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 theFinancial Services Authority ("FSA") in theU.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 andLloyd's itself. The FSA andLloyd's have common objectives in ensuring thatLloyd's market is appropriately regulated and, to minimize duplication, the FSA has agreed arrangements withLloyd's for cooperation on supervision and enforcement. FSML's underwriting activities are therefore regulated by the FSA as well as being subject to theLloyd's "franchise". Both FSA andLloyd's have powers to remove their respective authorization to manageLloyd'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 atLloyd's ).Cayman Islands Our discontinued operation Island Heritage is domiciled in theCayman Islands and maintains a Class A Domestic Insurance License issued under the Insurance Law (as revised) of theCayman Islands . It is thereby subject to regulation by theCayman Islands Monetary Authority ("CIMA"), which enforces the applicable provisions of the Insurance Law and also the Monetary Authority Law. A Class "A" Insurer's license permits an insurer to carry on insurance business generally in or from within the islands. The Insurance Law mandates that changes to the information provided upon application for a license be approved or notified toCIMA , including director and ownership changes and the nature of the business. A relatively low capital requirement is currently prescribed in the Insurance Law, in order to accommodate the large captive insurance market in theCayman Islands , butCIMA is able to attach conditions to licenses and thereby prescribe an appropriate capital and solvency requirement. A new law was passed in 2010 and is due to come into effect in 2012 pending the finalization of subsidiary legislation and related regulations. It is expected that the 2010 Law together with certain related regulations will prescribe certain solvency requirements and a risk based capital requirement comprising a minimum and a prescribed amount, which failure to meet will lead to enforcement and remedial action respectively. 38
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Solvency II The European Parliament passed the Solvency II directive inApril 2009 , to establish a revised set ofEuropean Union (EU) wide capital requirements and risk management standards. All (re)insurers, includingLloyd's and its managing agents, within the EU need to be compliant with Solvency II byJanuary 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 forLloyd's . Flagstone is working closely withLloyd'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 theCayman 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 withMontana 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 withMontana Re , which incepted onJanuary 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
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 withMontana 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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