FLAGSTONE REINSURANCE HOLDINGS, S.A. – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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The following is a discussion and analysis of our financial condition as atSeptember 30, 2012 andDecember 31, 2011 , and our results of operations for the three and nine months endedSeptember 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 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 former Lloyd's and Island Heritage reportable segments. OnApril 5, 2012 , andAugust 20, 2012 , respectively, the Company completed the sales of the businesses comprising its former Island Heritage and Lloyd's reportable segments. The Company has classified the assets and liabilities associated with its former Island Heritage and Lloyd's 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 Island Heritage and Lloyd's discontinued operations have been presented as discontinued operations in the Company's consolidated statements of operations for all periods presented up to and includingMarch 31, 2012 andSeptember 30, 2012 , respectively. 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
OnAugust 30, 2012 , the Company and Validus Holdings, Ltd. ("Validus") jointly announced that the boards of directors of both Validus and Flagstone have approved a definitive merger agreement pursuant to which Validus will acquire all of the issued and outstanding shares of Flagstone. As of the announcement date, the transaction represented an aggregate equity value of$623.2 million and is currently expected to be completed in the fourth quarter of 2012, subject to customary closing conditions, including obtaining regulatory approvals and the approval of Flagstone's shareholders. See Note 12, "Pending Merger with Validus" in our unaudited condensed consolidated financial statements (Item 1 above) for more information. As previously announced onApril 2, 2012 , andApril 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 onApril 5, 2012 , and was recorded in the second quarter results, including a gain on disposal of$4.5 million . The Lloyd's transaction was completed onAugust 20, 2012 , and has been recorded in the third quarter results, including a gain on disposal of$5.7 million . 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. 24
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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 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 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 onDecember 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.
Recent Developments
OnOctober 23, 2012 , the Company announced that it has establishedNovember 28, 2012 as the date for an extraordinary general meeting of Flagstone shareholders. At the extraordinary general meeting, Flagstone shareholders will be asked to consider and vote upon a proposal to approve the previously announced Agreement and Plan of Merger. See Note 12, "Pending Merger with Validus" in our unaudited condensed consolidated financial statements (Item 1 above) for more information.
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 atSeptember 30, 2012 have not changed compared toDecember 31, 2011 . 25
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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 Nine 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 For the
nine months
ended
ended
U.S. dollar (weakened) strengthened against: September 30, 2012 September 30, 2012 Canadian dollar (3.6) % (3.6) % Swiss franc (0.9) % 0.1 % Euro (1.5) % 0.7 % British pound sterling (3.1) % (4.0) % Indian rupee (5.9) % (0.7) % South African rand 1.8 % 3.0 % Summary Overview The following table sets forth selected key financial information for the three months endingSeptember 30, 2012 and 2011: For the three months ended September 30, 2012 2011 $ Change % Change Underwriting loss $ (16,807) $ (52,866) $ 36,059 68.2 % Net investment income $ 6,130 $ 6,167 $ (37) (0.6) % Net realized and unrealized gains (losses) - investments $ 5,970 $ (19,592) $ 25,562 130.5 % Net realized and unrealized gains (losses) - other $ 5,589 $ (18,305)
Loss from continuing operations per common share - Basic $ (0.10) $ (0.76) $ 0.66 Loss from continuing operations per common share - Diluted(1) $ (0.10) $ (0.76) $ 0.66 Loss ratio 72.7 % 101.4 % Expense ratio 48.8 % 39.5 % Combined ratio 121.5 % 140.9 % 26
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The following table sets forth selected key financial information for the nine months endedSeptember 30, 2012 and 2011: For the nine months ended September 30, 2012 2011 $ Change % Change Underwriting loss $ (5,198) $ (231,182) $ 225,984 97.8 % Net investment income $ 15,063 $ 27,665 $ (12,602) (45.6) % Net realized and unrealized gains (losses) - investments $ 29,438 $ (16,726) $ 46,164 276.0 % Net realized and unrealized gains (losses) - other $ 6,982 $ (5,009) $ 11,991 239.4 % Income (loss) from continuing operations $ 33,098 $ (234,816) $ 267,914 114.1 % Income (loss) from continuing operations per common share - Basic $ 0.45 $ (3.38) $ 3.83 Income (loss) from continuing operations per common share - Diluted(1) $ 0.45 $ (3.38) $ 3.83 Loss ratio 60.9 % 118.2 % Expense ratio 42.1 % 33.6 % Combined ratio 103.0 % 151.8 % The following table sets forth selected key non-GAAP financial measures as atSeptember 30, 2012 andDecember 31, 2011 : As at September 30, December 31, 2012 2011 $ Change % Change Basic book value per common share $ 11.64 $ 11.21 $ 0.43 3.9 % Diluted book value per common share $ 11.45 $ 10.90 $ 0.55 5.1 % Diluted book value per common share plus accumulated distributions $ 12.29 $ 11.62 $ 0.67 5.8 %
(1)Income (loss) from continuing operations per common share - Diluted for the three and nine 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 987,950 and 1,762,442 PSU's expected to vest under the PSU plan as atSeptember 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 decrease in underwriting loss in the nine months endedSeptember 30, 2012 , is primarily due to fewer catastrophe losses (net of reinsurance and reinstatements) recorded in the period, which included the U.S. drought loss ($19.8 million ) compared to losses recorded in the same period last year, which included Australian floods ($35.0 million ), cyclone Yasi ($32.8 million ),New Zealand earthquake ofFebruary 2011 ($134.8 million ),Japan earthquake and tsunami ($102.8 million ), U.S. tornadoes ($28.6 million ),New Zealand earthquake inJune 2011 ($18.5 million ), hurricane Irene ($17.9 million ), Danish cloudburst ($8.4 million ) andMelbourne floods ($16.8 million ). The decrease in net investment income in the nine months endedSeptember 30, 2012 , is primarily due to lower investment assets, the change in asset allocation and interest rates during the period, which was partially offset by the positive performance of the investment funds. The increase in the net realized and unrealized gains and losses - investments, for the nine months endedSeptember 30, 2012 , is primarily due to the better performance of fixed maturity investments and investment funds, and the reduced exposure to futures contracts during 2012. The increase in the net realized and unrealized gains and losses - other, for the nine months endedSeptember 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 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.
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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 atSeptember 30, 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. 28
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Index As at September 30, 2012 December 31, 2011 Flagstone shareholders' equity $ 830,845 $ 789,048 Potential net proceeds from assumed: Exercise of PSU (1) - - Exercise of RSU (1) - - Conversion of warrant (2) - - Diluted Flagstone shareholders' equity $ 830,845 $
789,048
Cumulative distributions paid per outstanding common share $ 0.84 $
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 987,950 1,676,125 RSUs outstanding 214,350 290,470 Conversion of warrant (2) - - Common shares outstanding - diluted 72,554,787 72,367,446 Basic book value per common share $ 11.64 $ 11.21 Diluted book value per common share $ 11.45 $ 10.90 Basic book value per common share plus accumulated distributions $ 12.48 $
11.93
Diluted book value per common share plus accumulated distributions $ 12.29 $ 11.62 Distributions per common share paid during the period $ 0.12 $
0.16
(1)No proceeds due when exercised (2)Below strike price - not dilutive Outlook and Trends Following the announcement of the proposed transaction between Validus and Flagstone, all three of the rating agencies covering Flagstone announced positive ratings actions. OnAugust 31, 2012 ,Moody's Investor Services affirmed Flagstone Suisse's financial strength rating of A3, and revised the outlook from negative to stable. OnAugust 31, 2012 ,A.M. Best Co. placed Flagstone's financial strength rating of A- (Excellent) under review with developing implications. OnSeptember 4, 2012 , Fitch Ratings revised the Rating Watch on Flagstone's A- financial strength rating to Evolving from Negative. All three rating agencies indicated that a failure to complete the proposed transaction between Flagstone and Validus would have negative ratings implications. This information should be read in conjunction with the "Cautionary Statement Regarding Forward-Looking Statements" in this Quarterly Report and the other information in the 2011 Annual Report, including "Risk Factors-Risks Related to our Business". Market Outlook At theJuly 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. The next major North American renewal period is atJanuary 1, 2013 , and we would expect rates to be flat barring any significant loss activity occurring during this hurricane season. 29
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On average, clients have been seeking slightly more capacity this year although a continued increase in reinsurer capacity has met this demand. Rate levels continue to be adequate with pricing mostly meeting return hurdles. The third quarter is generally quiet for International market renewals with most underwriters preparing for the importantJanuary 1 renewal season by meeting inMonte Carlo andBaden Baden for market discussions. As a result of these meetings we expect that pricing for International programs atJanuary 1 will be relatively orderly with flat rate levels, barring any catastrophic events occurring. Regarding the specialty lines, rates in the marine business, aviation, and aerospace and satellite have been flat for approximately the last twelve months or so 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 due to a lack of loss activity and abundant capacity.
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 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. 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:
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Index For the three months ended September 30, 2012 2011 Gross premiums Percentage of Gross premiums Percentage of written total written total Line of business Property catastrophe $ 11,099 274.6 % $ 45,051 48.9 % Property (13,172) (325.9) % 19,898 21.6 % Short-tail specialty and casualty 6,115 151.3 % 27,213 29.5 % Total $ 4,042 100.0 % $ 92,162 100.0 % For the nine months ended September 30, 2012 2011 Gross premiums Percentage of Gross premiums Percentage of written total written total Line of business Property catastrophe $ 244,196 70.7 % $ 417,306 58.9 % Property 53,493 15.5 % 138,921 19.6 % Short-tail specialty and casualty 47,731 13.8 % 152,738 21.5 % Total $ 345,420 100.0 % $ 708,965 100.0 % For the three months ended September 30, 2012 2011 Gross premiums Percentage of Gross premiums Percentage of written total written total Geographic area of risk insured (1) Caribbean $ (9,829) (243.2) % $ 2,006 2.2 % Europe 17,796 440.3 % 16,220 17.6 % Japan and Australasia 4,806 118.9 % 18,134 19.7 % North America (17,252) (426.8) % 22,154 24.0 % Worldwide risks (2) 4,339 107.3 % 21,429 23.3 % Other 4,182 103.5 % 12,219 13.2 % Total $ 4,042 100.0 % $ 92,162 100.0 % For the nine months ended September 30, 2012 2011 Gross premiums Percentage of Gross premiums Percentage of written total written total Geographic area of risk insured (1) Caribbean $ (845) (0.2) % $ 5,422 0.8 % Europe 85,799 24.8 % 105,921 14.9 % Japan and Australasia 37,867 11.0 % 88,439 12.5 % North America 162,306 47.0 % 323,731 45.7 % Worldwide risks (2) 47,441 13.7 % 146,761 20.7 % Other 12,852 3.7 % 38,691 5.4 % Total $ 345,420 100.0 % $ 708,965 100.0 % (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.
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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 endedSeptember 30, 2012 and 2011: For the three months ended September 30, 2012 2011 $ Change % Change Property catastrophe reinsurance $ 11,099 $ 45,051 $ (33,952) (75.4) % Property reinsurance (13,172) 19,898 (33,070) (166.2) % Short tail specialty and casualty reinsurance 6,115 27,213 (21,098) (77.5) % Gross premiums written 4,042 92,162 (88,120) (95.6) % Premiums ceded 1,338 (30,577) 31,915 (104.4) % Net premiums written 5,380 61,585 (56,205) (91.3) % Net premiums earned 82,553 130,041 (47,488) (36.5) % Other related income 983 376 607 161.5 % Loss and loss adjustment expenses (60,051) (131,879) 71,828 (54.5) % Acquisition costs (21,104) (31,619) 10,515 (33.3) % General and administrative expenses (19,188) (19,785) 597 (3.0) % Underwriting loss $ (16,807) $ (52,866) $ 36,059 68.2 % Loss ratio 72.7 % 101.4 % Acquisition cost ratio 25.6 % 24.3 % General and administrative expense ratio 23.2 % 15.2 % Combined ratio 121.5 % 140.9 %
· The decrease in net underwriting loss is the result of fewer significant
losses recorded during the third quarter of 2012 (U.S. drought) compared to
losses recorded in the same period in 2011 (hurricane Irene, Danish
cloudburst, and
premiums written and net premiums earned, which is in line with our current
underwriting strategy.
· During the current quarter we recorded premium portfolio transfers in the
amount of
renewal of certain large proportional property treaties. The impact on net
premiums earned of such decrease in gross premiums written was offset by a
change in unearned premiums and therefore, net premiums earned for the current
quarter were not impacted by the reduced participation in or non renewals of
those large proportional treaties.
· Gross premiums written have decreased for all lines of business as 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 premiums ceded 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. Premiums ceded were positive during the current quarter
due to ceded premium portfolio transfers related to the non renewal of certain
large proportional property treaties.
† The decrease in the loss ratio in the three months ended
primarily the result of fewer significant losses recorded in the period, which
included the U.S. drought of
same period in 2011, which included hurricane Irene of
cloudburst of
developments on earlier 2011 known events of
retrocession but exclude reinstatement premiums. 32
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· Each quarter we revisit our loss estimates for previous catastrophe
events. During the quarter endedSeptember 30, 2012 , based on updated estimates provided by clients and brokers, we recorded net adverse developments of$4.3 million for prior accident years. During the third quarter of 2011, the net positive developments for prior accident year catastrophe events were$9.5 million .
· The general and administrative expenses are stable compared to the same period
last year. The expenses in the current period include one time items such as
an impairment charge on assets held for sale of approximately
well as severance costs of approximately
execution of our strategic realignment. These expenses are offset by expense
reduction initiatives in accordance with our overall decrease in underwriting
activities and 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 nine months endedSeptember 30, 2012 and 2011: For the nine months ended September 30, 2012 2011 $ Change % Change Property catastrophe reinsurance $ 244,196 $ 417,306 $ (173,110) (41.5) % Property reinsurance 53,493 138,921 (85,428) (61.5) % Short tail specialty and casualty reinsurance 47,731 152,738 (105,007) (68.7) % Gross premiums written 345,420 708,965 (363,545) (51.3) % Premiums ceded (89,846) (193,736) 103,890 (53.6) % Net premiums written 255,574 515,229 (259,655) (50.4) % Net premiums earned 298,797 449,714 (150,917) (33.6) % Other related income 3,728 1,379 2,349 170.4 % Loss and loss adjustment expenses (181,983) (531,368) 349,385 (65.8) % Acquisition costs (65,870) (95,303) 29,433 (30.9) % General and administrative expenses (59,870) (55,604) (4,266) 7.7 % Underwriting loss $ (5,198) $ (231,182) $ 225,984 97.8 % Loss ratio 60.9 % 118.2 % Acquisition cost ratio 22.1 % 21.2 % General and administrative expense ratio 20.0 % 12.4 % Combined ratio 103.0 % 151.8 %
· The decrease in net underwriting loss is the result of fewer significant loss
events in 2012 (U.S. drought) compared to the same period in 2011 (Australian
floods, cyclone Yasi,
cloudburst, and
premiums written and net premiums earned, which is in line with our current
underwriting strategy.
· During the current quarter we recorded premium portfolio transfers in the
amount of
renewal of certain large proportional property treaties. The impact on net
premiums earned of such decrease in gross premiums written was offset by a
change in unearned premiums and therefore, net premiums earned for the current
period were not impacted by the reduced participation in or non renewals of
those large proportional treaties.
· 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
nine months ended
reinstatement premiums compared to
in 2011. The decrease in reinstatements premiums was due to lower catastrophe
losses in the current period. 33
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Index
· The decrease in premiums ceded 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 is the result of reduced losses from fewer
significant loss events, which included U.S. drought losses of
compared to the same period in 2011, which included net incurred losses
related to the Australian floods (
million),
earthquake and tsunami (
(
million), Danish cloudburst (
million). Losses are net of retrocession but exclude reinstatement premiums.
· Each quarter we revisit our loss estimates for previous catastrophe events.
During the nine months ended
provided by clients and brokers, we recorded net adverse developments of
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
development.
· The increase in general and administrative expenses is primarily the result of
an impairment charge on assets held for sale of approximately
well as severance costs of approximately
execution of our strategic realignment and 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 includingMarch 31, 2012 ). Included in income from discontinued operations for the nine months endedSeptember 30, 2012 is underwriting income of$19.4 million , compared to underwriting losses of$4.0 million for the same period in 2011. The$23.4 million increase in underwriting income is primarily attributable to more significant catastrophic events during 2011 compared to 2012. There will be no future income from discontinued operations as the disposals of the Island Heritage and Lloyd's segments have both been completed. As ofSeptember 30, 2012 , we had no remaining assets or liabilities associated with discontinued operations. Although we account for the business comprising our former Lloyd's and Island Heritage reportable segments as discontinued operations, we ceased to own the Island Heritage business after completing its sale onApril 5, 2012 , and we ceased to own the Lloyd's business after completing its sale onAugust 20, 2012 .
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 comprises investment income and realized and unrealized gains and losses on investments.
For the three months endedSeptember 30 ,
For the nine months ended September 30,
2012 2011 % Change 2012 2011 % Change Investment portfolio return 0.9 % (1.1) % 2.0 % 3.4 % 0.2 % 3.2 % 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. 34
--------------------------------------------------------------------------------
Index
The following tables set forth net investment income for the three months endedSeptember 30, 2012 and 2011: For the three months ended September 30, 2012 2011 $ Change Cash and cash equivalents $ 221 $ 361 $ (140) Fixed maturity investments 1,393 6,806 (5,413) Short term investments 270 151 119 Other investments 4,990 (7) 4,997 Investment expenses (744) (1,144) 400 Net investment income $ 6,130 $ 6,167 $ (37)
· The decrease in net investment income from fixed maturity investments is
primarily due to lower invested assets and the change in asset allocation
during the period.
· The increase in investment income from other investments is primarily due to
the large income payments on one of our fixed maturity investment funds.
The following table sets forth net investment income for the nine months endedSeptember 30, 2012 and 2011: For the nine months ended September 30, 2012 2011 $ Change Cash and cash equivalents $ 705 $ 1,140 $ (435) Fixed maturity investments 9,337 29,475 (20,138) Short term investments 635 579 56 Other investments 7,138 (95) 7,233 Investment expenses (2,752) (3,434) 682 Net investment income $ 15,063 $ 27,665 $ (12,602)
· The decrease in net investment income from fixed maturity investments is
primarily due to lower invested assets and the change in asset allocation
during the period.
· The increase in investment income from other investments is primarily due to
the large income payments on one of our fixed maturity 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. 35
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Index
The following table is a breakdown of net realized and unrealized gains (losses) - investments for the three months ended
For the three months ended September 30, 2012 2011 $ Change Net realized (losses) gains on fixed maturity investments $ (2,104) $ 6,240 $ (8,344) Net unrealized gains (losses) on fixed maturity investments 9,666 (49,717) 59,383 Net unrealized losses on equity investments (16) (89) 73 Net realized and unrealized (losses) gains on derivative instruments - investments (see table below) (4,208) 26,297 (30,505) Net realized and unrealized gains (losses) on other investments 2,632 (2,323) 4,955 Net realized and unrealized gains (losses) - investments $ 5,970 $ (19,592) $ 25,562 For the three months ended September 30, 2012 2011 $ Change Futures contracts $ - $ (18,333) $ 18,333 Foreign currency forward contracts (4,208) 44,630
(48,838)
Net realized and unrealized (losses) gains on derivative instruments - investments $ (4,208) $ 26,297 $ (30,505)
· The change in net realized and unrealized on fixed maturity investments is
primarily due to the change in asset allocation and the 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 realized and unrealized on futures contracts is primarily
due to the elimination of all futures exposure during the period.
· 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 nine months ended
For the nine months ended September 30, 2012 2011 $ Change Net realized gains on fixed maturity investments $ 21,082 $ 42,948 $ (21,866) Net unrealized losses on fixed maturity investments (1,821) (27,247)
25,426
Net realized losses on equity investments - (845)
845
Net unrealized (losses) gains on equity investments (34) 661
(695)
Net realized and unrealized losses on derivatives instruments - investments (see table below) (1,003) (34,209)
33,206
Net realized and unrealized gains on other investments 11,214 1,966
9,248
Net realized and unrealized gains (losses) - investments $ 29,438 $ (16,726) $ 46,164 36
--------------------------------------------------------------------------------
Index For the nine months ended September 30, 2012 2011 $ Change Futures contracts $ 179 $ (27,319) $ 27,498 Foreign currency forward contracts (1,182) (6,888) 5,706 Mortgage-backed securities TBA - (2) 2
Net realized and unrealized losses on derivatives instruments - investments
· The change in net realized and unrealized on fixed maturity investments is
primarily due to the tightening of credit spreads, the change in asset allocation and the 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.
The following tables are a breakdown of net realized and unrealized (losses) gains - other for the three and nine months ended
For the three months ended September 30, 2012 2011 $ Change Currency swaps $ 215 $ (1,395) $ 1,610 Foreign currency forward contracts 5,374 (16,910)
22,284
Net realized and unrealized gains (losses) - other $ 5,589 $ (18,305) $ 23,894 For the nine months ended September 30, 2012 2011 $ Change Currency swaps $ (294) $ 152 $ (446) Foreign currency forward contracts 7,276 (5,402) 12,678 Reinsurance derivatives - 241
(241)
Net realized and unrealized gains (losses) - other $ 6,982 $ (5,009) $ 11,991
· 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 net losses recorded through balance sheet currency revaluations and are attributable to operational hedges on reinsurance balances. 37
--------------------------------------------------------------------------------
Index Interest Expense Interest expense consists of interest due on outstanding debt securities and the amortization of debt offering expenses. Interest expense was$2.8 million and$8.7 million , respectively, for the three and nine months endedSeptember 30, 2012 , compared to$3.1 million and$8.9 million , respectively, for the three and nine months endedSeptember 30, 2011 .
Foreign Exchange
For the three and nine months endedSeptember 30, 2012 , we experienced net foreign exchange losses of$5.9 million and$6.7 million , respectively, compared to net foreign exchange gains of$34.0 million and losses of$3.1 million , respectively, for the three and nine months endedSeptember 30, 2011 . This net change 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$51.9 million and$51.6 million as hedging instruments, which had a fair value of$0.3 million and$(0.5) million atSeptember 30, 2012 andDecember 31, 2011 , respectively. During the three and nine months endedSeptember 30, 2012 , we recorded $nil 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 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 and nine months endedSeptember 30, 2012 , income tax expense was$0.6 million and$0.9 million , respectively, compared to income tax provision of$0.7 million and recovery of$0.4 million , respectively, for the three and nine months endedSeptember 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 September For the nine months ended 30, September 30, 2012 2011 2012 2011 Income attributable to Island Heritage $ - $ 106 $ 1,135 $ 1,571 Income attributable to Mont Fort - - - 556 Income attributable to noncontrolling interest $ - $ 106 $ 1,135 $ 2,127 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. EffectiveApril 5, 2012 , upon final disposal of the former Island Heritage reportable segment, there is no longer a noncontrolling interest in Island Heritage.
Comprehensive (Loss) Income
The following table is the breakdown of comprehensive (loss) income in the unaudited condensed consolidated statements of operations into its various components:
38
--------------------------------------------------------------------------------
Index For the three months ended For the nine months ended September 30, September 30, 2012 2011 2012 2011 Net (loss) income $ (1,346) $ (59,439) $ 52,464 $ (238,848) Change in currency translation adjustment (2,803) (8,677) (2,935) (4,927) Change in defined benefit pension plan obligation 326 62 254 (96) Comprehensive (loss) income (3,823) (68,054) 49,783 (243,871) Less: Comprehensive loss attributable to noncontrolling interest - (106) (1,135) (2,127) Comprehensive (loss) income attributable to Flagstone $ (3,823) $ (68,160) $ 48,648 $ (245,998) 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, atSeptember 30, 2012 , comprised 97.3% 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 4.7% of our total investments and cash and cash equivalents atSeptember 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 second 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. During the current quarter, no significant change was made to our investment portfolio allocation. We continuously monitor the economic environment and global markets and will consider appropriate changes to the investment portfolio allocations if and when warranted. AtSeptember 30, 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 AAA and AA, respectively.
The average duration of our investment portfolio was 0.3 years at
Other investments as atSeptember 30, 2012 , amounted to$101.8 million compared to$125.5 million atDecember 31, 2011 . AtSeptember 30, 2012 , the other investments comprised$28.4 million in catastrophe bonds and$71.0 million in investment funds, which are recorded at fair value and our equity method investment of$2.4 million . The decrease in other investments during the first nine months of 2012 is principally related to the decrease in investments in catastrophe bonds, which was partially offset by the additional investments in investment funds along with an increase in the fair value of the catastrophe bond holdings. As at September 30, 2012 December 31, 2011 Investment funds $ 70,951 $ 59,278 Catastrophe bonds 28,354 64,016 Equity method investment 2,446 2,158 Total $ 101,751 $ 125,452 The net payable for investments purchased atSeptember 30, 2012 , was$3.2 million , compared to$6.2 million 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. 39
--------------------------------------------------------------------------------
Index
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 nine months endedSeptember 30, 2012 used$184.5 million , as compared to providing$98.3 million during the same period in 2011. This decrease in cash flows from operations was primarily related to lower loss and loss adjustment expense reserves resulting from the volume of claims paid on the 2011 loss events, partially offset by net income in the current period due to fewer significant loss events during the nine months endedSeptember 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 nine months endedSeptember 30, 2012 , net cash of$9.8 million was used in financing activities, compared to$54.5 million for the same period in 2011. For the nine months endedSeptember 30, 2012 , the net cash used in financing activities related principally to the payment of distributions. For the nine months endedSeptember 30, 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.
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 divestitures of Island Heritage and Lloyd's did not 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$307.5 million atSeptember 30, 2012 . OnOctober 24, 2011 ,A.M. Best Co. commented that the Company's recent restructuring announcement 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 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. OnMay 18, 2012 ,A.M. Best Co. again commented that these ICRs remain unchanged and that the outlook for all ratings remains negative. OnAugust 31, 2012 ,A.M. Best Co. placed the Company's ICRs under review with developing implications. These actions followed the recent announcement that the Company and Validus had entered into a definitive merger agreement in which Validus will acquire all of the issued and outstanding shares of Flagstone, representing an aggregate equity value (as of the announcement date) of$623.2 million . The under review with developing implications reflects the uncertainty around the future plans Validus may have for Flagstone, the possibility of the deal not closing due to risks beyond the parties control and this occurring during the peak of wind season. 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 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
40
--------------------------------------------------------------------------------
Index As at September 30, 2012 December 31, 2011 Long term debt $ 250,456 $ 250,575 Common shares 845 845 Common shares held in treasury (150,202)
(160,448)
Additional paid-in capital 855,722
872,819
Accumulated other comprehensive loss (15,265) (12,584) Retained earnings 139,745 88,416 Total capital $ 1,081,301 $ 1,039,623
The movement in both common shares held in treasury and additional paid-in capital during the nine months ended
For the nine months endedSeptember 30, 2012 , accumulated other comprehensive loss arose from the changes in currency translation adjustment of$(2.9) million and the defined benefit pension plan obligation of$0.3 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 ofSeptember 30, 2012 ,$5.1 million had been drawn under the Barclays Facility, and the drawn amount was secured by$5.4 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 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 at Lloyd'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$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 atSeptember 30, 2012 ,$371.7 million had been drawn under the Citi Facility, and the drawn amount of the facility was secured by$406.2 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 they are fully collateralized by the Company, to the extent of the letters of credit outstanding at any given time.
The divestitures of Island Heritage and Lloyd's did not have a significant impact on our capital resources. However, the Lloyd's divestiture did 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 in reserve in accordance with the Luxembourg Law or in accordance with the Articles. 41
--------------------------------------------------------------------------------
Index
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 and sums to be placed in 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 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, followed by the receipt of official documentation onMay 1, 2012 . Flagstone Suisse is required to file statutory financial statements annually with the BMA byApril 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. 42
--------------------------------------------------------------------------------
Index
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.
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. The Company purchased$28.0 million units of Montana Re Catastrophe bonds to decrease the amount of reinsurance protection the Company held, and these bonds had a fair value of$28.4 million as ofSeptember 30, 2012 . As both the ceding reinsurer and as a holder of the Montana Re Catastrophe bonds, the Company pays premiums and receives interest income related to these bonds. An amount of$0.8 million was eliminated from premiums ceded and net investment income during the three months endedSeptember 30, 2012 , which had no impact on net income for the period.
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".
43
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Index
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VALIDUS HOLDINGS LTD FILES (8-K) Disclosing Other Events
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