Yea it took me a while too, what you do is you have to make sure it's a certain size, I wanna say 32 by 32, then go into the psobb folder and find team flag.bmp I believe, copy your flag from paint ( that's how I did mine) paste and I think your good to go.
"Update" right click the Ultima psobb launcher, it says open file location that's how you get there. Under a folder entitled team flag
Hope this helps