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

The following is a discussion and analysis of our financial condition as at September 30, 2008 and December 31, 2007 and our results of operations for the three and nine months ended September 30, 2008 and 2007. This discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included in Part 1, Item 1 of this Form 10-Q and with "Management's Discussion and Analysis of Financial Condition and Results of Operations", and the audited consolidated financial statements and notes thereto, presented under Item 7 and Item 8, respectively, of the Company's Annual Report on Form 10-K for the year ended December 31, 2007. Some of the information contained in this discussion and analysis is included elsewhere in this document, including information with respect to our plans and strategy for our business, and includes forward-looking statements that involve risks and uncertainties. Please see the "Cautionary Statement Regarding Forward-Looking Statements" for more information. You should review Item 1A, "Risk Factors" contained in our Form 10-K, filed with the SEC on March 19, 2008, for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements.

References in this Quarterly Report on Form 10-Q to the "Company", "we", "us", and "our" refer to Flagstone Reinsurance Holdings Limited and/or its subsidiaries, including Flagstone Réassurance Suisse SA, its wholly-owned Switzerland reinsurance company, Island Heritage Holdings Limited, its Cayman-based insurance company and any other direct or indirect subsidiary, unless the context suggests otherwise. References to "Flagstone Suisse" refer to Flagstone Réassurance Suisse SA and its wholly-owned subsidiaries, including its Bermuda branch, and references to "Island Heritage" refer to Island Heritage Holdings Limited and its subsidiaries. References in this Form 10-Q to "dollars" or "$" are to the lawful currency of the United States of America, unless the context otherwise requires. All amounts in the following tables are expressed in thousands of U.S. dollars, except share amounts, per share amounts and percentages.

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

Executive Overview

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

Because we have a limited operating history, period to period comparisons of our results of operations are limited and may not be meaningful in the near future. Our financial statements are prepared in accordance with U.S. GAAP and our fiscal year ends on December 31. Since a substantial portion of the reinsurance we write provides protection from damages relating to natural and man-made catastrophes, our results depend to a large extent on the frequency and severity of such catastrophic events, and the specific insurance coverages we offer to clients affected by these events. This may result in volatility in our results of operations and financial condition. In addition, the amount of premiums written with respect to any particular line of business may vary from quarter to quarter and year to year as a result of changes in market conditions.

We measure our financial success through long term growth in diluted book value per share plus accumulated dividends measured over intervals of three years, which we believe is the most appropriate measure of the performance of the Company, a measure that focuses on the return provided to the Company's common shareholders. Diluted book value per share is obtained by dividing shareholders' equity by the number of common shares and common share equivalents outstanding.

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

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Our expenses consist primarily of the following types: loss and loss adjustment expenses incurred on the policies of reinsurance and insurance 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 PSU and RSU Plans, and other general operating expenses; interest expenses related to our debt obligations; and minority interest, which represents the interest of external parties with respect to the net income of Mont Fort Re Ltd. ("Mont Fort"), Island Heritage, and Flagstone Africa. 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. As a result of the merger between Flagstone Reinsurance Limited and Flagstone Suisse, we expect our tax expense to increase to approximate our effective Swiss Federal tax rate of approximately 8% on the portion of underwriting profits, if any, generated by Flagstone Suisse, excluding the underwriting profits generated in Bermuda through the Flagstone Suisse branch office.

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

Those segments are more fully described as follows:

Reinsurance

Our Reinsurance segment has three main units:

(1) Property Catastrophe Reinsurance. Property catastrophe reinsurance contracts are typically "all risk" in nature, meaning that they protect against losses from earthquakes and hurricanes, as well as other natural and man-made catastrophes such as tornados, wind, fires, winter storms, and floods (where the contract specifically provides for coverage). Losses on these contracts typically stem from direct property damage and business interruption. To date, property catastrophe reinsurance has been our most important product. We write property catastrophe reinsurance primarily on an excess of loss basis. In the event of a loss, most contracts of this type require us to cover a subsequent event and generally provide for a premium to reinstate the coverage under the contract, which is referred to as a "reinstatement premium". These contracts typically cover only specific regions or geographical areas, but may be on a worldwide basis.

(2) Property Reinsurance. We also provide reinsurance on a pro rata share basis and per risk excess of loss basis. Per risk reinsurance protects insurance companies on their primary insurance risks on a single risk basis, for example, covering a single large building. All property per risk and pro rata business is written with loss limitation provisions, such as per occurrence or per event caps, which serve to limit exposure to catastrophic events.

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

Insurance

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

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Critical Accounting Policies

Critical accounting policies at September 30, 2008 have not changed compared to December 31, 2007. The Company's critical accounting policies are discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 of the Company's Annual Report on Form 10-K for the year ended December 31, 2007.

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 management to make assumptions and best estimates to determine the reported values. If events or other factors, including those described in Item 1A, "Risk Factors," of our Form 10-K, 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.

New Accounting Pronouncements

The Company maintains the Plan, which covers certain employees at Flagstone Suisse. The Company accounts for this pension plan using the accrual method, consistent with the requirements of FASB Statement No. 158, "Employers' Accounting for Defined Benefit Pension and Other Post-retirement Plans, an amendment of FASB Statement No. 87, 88, 106 and 132" ("SFAS 158"), which was adopted by the Company on January 1, 2008. SFAS 158 requires an employer to recognize the over-funded or under-funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in funded status through comprehensive income in the year in which the changes occur. An unfunded transitional liability of $0.6 million was recorded in accumulated other comprehensive income at January 1, 2008 and is being amortized over the estimated average remaining service life of 12.2 years. The net periodic pension expense for 2008 is expected to be approximately $1.2 million, of which $0.3 million and $0.8 million have been recorded as a pension expense in the three and nine months ended September 30, 2008. A pension asset of $0.7 million and a pension liability of $1.3 million were recognized in the September 30, 2008 unaudited condensed consolidated balance sheet. The Company funds the Plan at the amount required by local legal requirements.

In March 2008, the FASB released Statement No. 161, "Disclosures About Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133" ("SFAS 161"), which expands the disclosure requirements in SFAS 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") about an entity's derivative instruments and hedging activities. SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk related contingent features in derivative agreements. This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early adoption encouraged. The adoption of SFAS 161 will have no impact on the Company's results of operations or consolidated financial condition but it is expected to change the Company's current disclosures regarding its derivative instruments.

In May 2008, the FASB issued SFAS 162, "The Hierarchy of Generally Accepted Accounting Principles" which identifies the sources of generally accepted accounting principles and provides a framework, or hierarchy, for selecting the principles to be used in preparing U.S. GAAP financial statements for nongovernmental entities. This Statement makes the GAAP hierarchy explicitly and directly applicable to preparers of financial statements, a step that recognizes preparers' responsibilities for selecting the accounting principles for their financial statements. The hierarchy of authoritative accounting guidance is not expected to change current practice but is expected to facilitate the FASB's plan to designate as authoritative its forthcoming codification of accounting standards. This Statement is effective 60 days following the SEC's approval of the PCAOB's related amendments to AU Section 411, "The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles", to remove the GAAP hierarchy from its auditing standards.

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

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On October 10, 2008, the FASB issued a FASB staff position, SFAS 157-3, to clarify the application of SFAS 157, in a market that is not active. SFAS 157-3 provides that determination of fair value in a dislocated market depends on facts and circumstances and may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales. The use of a reporting entity's own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available. Regardless of the valuation technique used, an entity must include appropriate risk adjustments that market participants would make for nonperformance and liquidity risks. SFAS 157-3 is effective immediately, including prior periods for which financial statements have not been issued. The Company has considered the provisions of SFAS 157-3 on the current quarter and determined that the application of SFAS 157-3 does not have an effect on the Company's current financial position. To further clarify, the Company has reviewed its Level 3 investments, and the valuation methods applied to those investments are as follows. Catastrophe bonds are stated at fair value as determined by reference to broker indications. Those indications are based on current market conditions, including liquidity and transactional history, recent issue price of similar catastrophe bonds and seasonality of the underlying risks. The private equity investments are valued by the investment fund managers using the valuations and financial statements provided by the general partners of the funds on a quarterly basis. These valuations are then adjusted by the investment fund managers for cash flows since the most recent valuation. The valuation methodology used for investment funds is consistent with the methodology that is generally employed in the investment industry.

Recent Developments

Alliance Re

On April 28, 2008, the Company announced its intent to acquire up to 30.0% of Alliance Re from current shareholders. The Company completed its acquisition on August 12, 2008, through the purchase of 10,498,164 shares (representing 15.4% of its common shares) for $6.8 million. The acquisition was partially completed in the second quarter of 2008 through the purchase of 9,977,664 shares (representing 14.6% of its common shares) for $6.8 million. Alliance Re, domiciled in the Republic of Cyprus and publicly traded on the Cyprus Stock Exchange (ALL), is a specialist property and casualty reinsurer writing multiple lines of business in Europe, Asia, and the Middle East & North Africa regions.

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

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

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Marlborough Underwriting Agency Limited ("Marlborough")

On October 17, 2008, the Company announced that it has entered into an agreement to acquire Marlborough, the managing agency for Lloyd's Syndicate 1861 - a Lloyd's syndicate underwriting a specialist portfolio of short-tail insurance and reinsurance, from the Berkshire Hathaway Group. The acquisition does not include the existing corporate Lloyd's member or any liability for business written during or prior to 2008. The Company is in the process of licensing its own corporate capital vehicle which is expected to be the capital provider for Lloyd's Syndicate 1861 for fiscal year 2009 onwards. The transaction is subject to Lloyd's and UK Financial Services Authority approval. Total consideration for the acquisition of the shares of Marlborough is £32.0 million. The acquisition is expected to close in the fourth quarter of 2008. It provides the Company with a Lloyd's platform with access to both London business and that sourced globally from our network of offices. This allows the Company to complete our mission of being a multiline reinsurer and an insurer in selected markets.

Emergency Economic Stabilization Act of 2008

In response to the financial crises affecting the banking system and financial markets, on October 3, 2008, President George W. Bush signed into law the Emergency Economic Stabilization Act of 2008 ("the Act"). One of the objectives of the Act is to restore liquidity and stability to the financial system in the United States. Pursuant to the Act, the U.S. Treasury will have the authority to, among other things, purchase up to $700 billion of mortgages, mortgage backed securities and certain other financial instruments from financial institutions. It is not clear at this time what impact the Act will have on the financial markets generally, or the Company specifically. However the Company does not anticipate that the Act will have a material impact on its future financial position, results of operations, cash flows or liquidity.

Investments

Review of asset allocation

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

Fair value disclosure

The valuation technique used to fair value the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets. The following is a summary of valuation methodologies we used to measure our financial instruments. Investments are recorded on a trade date basis and realized gains and losses on sales of investments are determined on a first-in, first-out basis.

Fixed maturities and short term investments

The Company's U.S. government securities are stated at fair value as determined by the quoted market price of these securities as provided by exchange market prices, which represented 51.3% of our total fixed maturities portfolio. These securities are classified within Level 1.

The fair value of the corporate bonds, mortgage-backed securities, and asset-backed securities are provided by independent pricing services or by broker quotes based on inputs that are observable for the asset, either directly or indirectly. These securities are classified within Level 2 and the specific details of the sources are described below.

Pricing Services

At September 30, 2008, pricing for approximately 48.0% of our total fixed maturities was based on prices provided by nationally recognized independent pricing services. Generally, pricing services provide pricing for less-complex, liquid securities based on market quotations in active markets. For fixed maturities that do not trade on a listed exchange, these pricing services may use a matrix pricing consisting of observable market inputs to estimate the fair value of a security. These observable market inputs include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-side markets, benchmark securities, bids, offers, reference data, and industry and economic factors. Additionally, pricing services may use a valuation model such as an option adjusted spread model commonly used for estimating fair values of mortgage-backed and asset-backed securities. At September 30, 2008, we have not adjusted any pricing provided by independent pricing services.

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Broker-Dealers

In some cases, we obtain quotes directly from broker-dealers who are active in the corresponding markets when prices are unavailable from independent pricing services. This may also be the case if the pricing from these pricing services is not reflective of current market levels. At September 30, 2008, approximately 0.7% of our fixed maturities were priced by broker-dealers. Generally, broker-dealers value securities through their trading desks based on observable market inputs. Their pricing methodologies include mapping securities based on trade data, bids or offers, observed spreads and performance on newly issued securities. They may also establish pricing through observing secondary trading of similar securities. Given the severe credit market dislocation experienced in September 2008, it has been more challenging for broker-dealers to observe actual trades due to the lack of liquid and active secondary markets. The market illiquidity has been evidenced by a significant decrease in the volume of trades relative to historical levels and the significant widening of the bid-ask spread in the brokered markets, in particular for our Alt-A securities, which represents less than 0.6% of our total fixed maturity portfolio. To price these securities, although thinly traded, the broker-dealers may consider both pricing from recent limited trades (market approach) and discounted cash flows (income approach) using significant observable market inputs. The evaluation of whether or not actual transactions in the current financial markets represent distressed sales requires significant management judgment. We do not believe quotes received from broker-dealers reflect distressed transactions that would warrant an adjustment to fair value based on obtaining sufficient relevant observable market data to corroborate these quotes. At September 30, 2008, we have not adjusted any pricing provided by broker-dealers.

Equities

The Company's listed equity securities are stated at fair value as determined by the quoted market price of these securities. These investments are classified in Level 1.

The Company's equity exchange traded funds are stated at fair value as determined by the quoted market price of these securities as provided either by independent pricing services or exchange market prices. Due to the reduced trading activity for these securities around September 30, 2008, these investments are classified in Level 2.

Other investments

The Company's fixed income funds are stated at fair value as determined by the quoted market price of these securities. These securities are classified within Level 1.

Investment funds and REIT funds are stated at fair value as determined by the most recently published net asset value, being the fund's holdings in quoted securities adjusted for administration expenses. These investments are classified within Level 2.

Catastrophe bonds are stated at fair value as determined by reference to broker indications. Those indications are based on current market conditions, including liquidity and transactional history, recent issue price of similar catastrophe bonds and seasonality of the underlying risks and accordingly we have classified within Level 3.

The private equity investments are valued by the investment fund managers using the valuations and financial statements provided by the general partners on a . . .