Taken directly from the Pirates! ReadMe html:
Pirates! supports `user-created` flags and sail emblems. To add your own flags and emblems to the game, follow these steps:
1. Flags and sail emblems must be saved in DirectDraw Surface (DDS) or Targa (TGA) format. You may need special programs or plugins to create DDS files. The following links may be useful:
* NVidia Texture Tools page
<a href="http://developer.nvidia.com/object/nv_texture_tools.html" target="_blank">http://developer.nvidia.com/object/nv_text...ture_tools.html</a>
* Any Image (Batch Image Converter)
<a href="http://www.fmjsoft.com/aiframe.html" target="_blank">http://www.fmjsoft.com/aiframe.html</a>
* DDS Converter (Image conversion utility)
<a href="http://www.modsonline.com/`Downloads-full`-1962.html" target="_blank">http://www.modsonline.com/`Downloads-full`-1962.html</a>
2. Flags must be named starting with the prefix "flag_". Sail emblems must be named starting with the prefix "ship_sail_emblem_lrg_". Filenames for both flags and sail emblems may not contain any underscores than those in these prefixes.
3. Custom flags and sail emblems must be placed in a special "Custom" directory before they will show up in the game. To find the Custom directory, navigate to "My Documents", "My Games", "Sid Meier's Pirates!". If the Custom folder does not exist, you may need to create it. Once you see the Custom folder, place all `properly-named` and saved custom flags and emblems inside it.
4. Start the game and access the options screen. Click "Modify your ship's sails and flags".
5. You should now be able to select any of the sails or flags you've created as they would appear on your ship. Click the dagger to save your changes or the X to cancel and return to the previous screen.
<img src="http://www.piratesahoy.com/forum/style_emoticons/<#EMO_DIR#>/onya.gif" style="vertical-align:middle" emoid="

" border="0" alt="onya.gif" />
(as a side note... on my system the custom folder is located in the main Pirates! directiry as opposed to the one mentioned in the text body.)