Incremental rate increases and a modestly improving economy offset catastrophe losses and weak investment returns as most of the largest U.S. commercial property/casualty insurers posted profits for 2012.

The 2012 results were a marked contrast to the 2011 results, which were ravaged by a string of catastrophe losses and years of declining rates.

Despite the continued modest rise in rates this year, however, the fragile economy, low bond yields and dwindling reserve redundancies may be a drag on insurer earnings in 2013, analysts say.

“The year was a story of building momentum,” said Mark Dwelle, an insurance analyst at RBC Capital Markets, a unit of RBC Securities Inc. in Richmond, Va. “We saw improvement, both from a top line standpoint with rate increases and stronger premium flows and also from a bottom line perspective, as by the third and fourth quarters we saw that rate improvements were leading margin improvements and positively affecting earnings.”

Mr. Dwelle said the rate increases were of the “Goldilocks” variety: high enough to improve margins but not so high to cause frenzied competition where insurers undercut each other to gain market share.

Jim Auden, managing director of insurance for Fitch Ratings Inc. in Chicago, said the gradual rate increases in selected commercial lines and increased demand resulting from modest economic improvement were key factors in the industry's performance.

“Core underwriting results showed some improvement in 2012,” Mr. Auden said. “The accumulation of improved pricing over time has led to some loss ratio improvement.”

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The industry's underwriting numbers for the year were also strong — that is until Superstorm Sandy hit the East Coast.

“It was a relatively benign year for three quarters, and then Sandy hit,” Mr. Auden said. Commercial lines insurers absorbed a larger-than-usual percentage of the losses from Sandy given the degree of flooding witnessed in the business districts of Manhattan.

While the extent of the natural catastrophe losses the industry will endure in 2013 remains to be seen, slack demand from businesses affected by the still-weak economy likely will keep a lid on premium growth, said John Ward, CEO of Cincinnatus Partners L.L.C., a Cincinnati-based private equity firm focused on the insurance industry.

“The challenge on premium growth is that the exposure portion of the equation, insurable risk, is very soft due to the soft economy,” Mr. Ward said.

Observers differed, however, on whether the outlook for growth will lead to more mergers and acquisitions in the insurance sector (see related story).

Ongoing low interest rates will continue to hurt insurers' investment income, said Mr. Ward, noting that industrywide investment yields in 2012 were about 10% less than 2011. “Investment returns still look quite soft. When you look at the yield of new money coming in, it is earning about 150 basis points less than the overall portfolio yield. This new money dynamic will likely continue declining through 2013,” Mr. Ward said.

What's more, the traditionally bond-heavy asset portfolios of insurers leave the industry ill-suited to capitalize on the recent surge in equity prices.

“Investment income is the black spot on the banana,” RBC Capital Markets' Mr. Dwelle said. “It's bad and it is only getting worse.”

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Meyer Shields, Baltimore-based managing director-equity re-search, property/casualty insurance for Keefe, Bruyette & Woods Inc., said lagging investment income makes insurers depend more on prudent underwriting.

“This is a big deal because investment income has been historically less volatile,” Mr. Shields said. “Having that greater riskiness in your earnings stream is one quibble I would have with the characterization that insurers had a strong year.”

Another ongoing industry trend — tapping prior-year reserves to boost current-year results — looks to continue this year, Mr. Auden said.

“We, like a number of folks, thought that reserves have been weakening for some time, but it's not really showing through in what companies are reporting,” Mr. Auden said.

“We're predicting that it will slow down, but we've been saying that for a while,” he said.

While reserve releases in 2012 actually were slightly higher than 2011, Mr. Auden said, “Most companies do try to leave a little margin for safety in those numbers. The surest way to be punished (by investors) is to have a reserve charge.”

Similarly, he said he expects the industry to chart a cautious course when it comes to capital management. While some commercial insurers in recent years took advantage of their flagging stock prices to mount share buybacks, the trend may wane as the industry shares gain value.

“Companies that have been buying back stock have continued to do so, even though their stock prices continue to move up from where they were,” Mr. Auden said. “But at some point it becomes less economic to continue buybacks because you eventually hit a point where there are better uses for that capital.”