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Reserve Study is a Risk Management Tool

By Mike Price CMCA, AMS, RS with input from Ron Tsukamaki CPCU, ARM, FPE

The primary duty of the Board of Directors is to protect and maintain the association's common areas. Risk management is a method to protect and preserve association components. Risk management involves identifying potential losses, managing the loss event and controlling (reducing) loss impact. Most people identify risk management with the association's insurance coverage. However, when a common area major component like the roof, elevator or central hot water boiler fails from causes such as wear and tear, or age decay, it is also a loss, but not an insured event.

 The financial risk of fire, flooding or hurricane damage is transferred to insurance policy coverage. Fire, flooding and hurricanes are unpredictable events. By paying a third party insurance company premiums, losses from insured perils to insured property are compensated for and damage replaced under the limits of the insurance coverage. Periodically the Board needs to evaluate the association's coverage to make sure coverage limits are adequate to replace damaged property at today's cost. The Board also reduces potential damage with protective measures. For example, fire extinguishers, alarm systems, fire escapes and fire sprinkler systems reduce potential losses to the building and owners.

The risk of major common area component (roof, central hot water, asphalt) loss is controlled by maintaining an adequate reserve fund to replace components in a timely manner when needed. Component repair and replacement is mostly a predictable event. Annual or monthly reserve fund contributions are needed to maintain an adequate reserve fund in order to replace components as projected. Items such as pavement, sidewalks, and retaining walls are usually not items that are even covered by insurance under most property insurance policies. Repairs or replacement would need to be funded by the reserve fund. Insurance coverage premiums and the reserve fund contributions make up a significant portion of the annual budget.

Insurance coverage and limits of coverage are mandated by the association documents. Reserve funding is required by most association documents and State law. The amount of money maintained in the reserve fund is left to the discretion of the Board. Scheduling major replacements like elevator modernizations is also decided by the Board.

The Board must decide how much risk the association can bear to avoid surprise unexpected special assessments or loans to make up for inadequate reserve funds. Generally minimal reserve funding plans bear a higher risk of future cash flow problems than stronger funded plans. Also deferring needed maintenance replacements due to inadequate reserve funds compounds the financial risk to the association.

Waiting until failure of critical components like central hot water boilers and elevators creates a catastrophic loss. A planned elevator modernization replacement takes approximately 2-3 months after delivery of parts. An unscheduled replacement failure increases time of replacement along with additional shipping and labor costs. Consequences of neglecting replacement prior to failure expose the association to high risk of property damage, personal injury, interruption of services, legal claims, increased insurance claims, and possibly higher insurance premiums.

Some Boards decide to under fund the reserve fund to maintain low maintenance fees. They defer component replacement into the future beyond what is normal useful life. This is a poor risk management approach that can lead to a major loss. An example is a neglected leaking roof that damages carpeting, concrete structure, wood structure, and drywall. Besides the leaking roof, these damaged components now need replacement as well. Again the association is exposed to high risk of property damage, personal injury, interruption of services, legal claims, and increased insurance claims. Also, a leaking roof itself might not be covered by insurance since this could be an example of "wear and tear" and not an occurrence that is sudden and accidental.

Adequate reserve funding is just as important as having adequate insurance coverage to reduce risk of loss. Updating the reserve study plan has the same importance as reviewing insurance coverages. A strong insurance program and a strong reserve fund reduce the risk of losses to the association.

Summary: The Board of Directors' fiduciary duty to the owners is to review the reserve study funding plan and the insurance coverage annually and make adjustments for changes to the property and current replacement costs. The Board can perform this task or use professional recommendations to update the reserve study and insurance coverage program. The insurance program and the reserve study are important risk management tools. Adjusting these plans for current conditions and current replacement costs avoids having cash problems and consequential damages in the future.

 About the Authors: Mike Price - CAI Reserve Specialist #164 and former President of Association Reserves Hawaii LLC, provides independent third party comprehensive reserve studies for all Islands. Mr. Price has a bachelor degree from Eastern Washington University and over 30 years' experience in construction and project management. Mr. Price can be contacted at mprice@akamaireserves.com or (808) 936-4789. Ron Tsukamaki - Insurance Agent Senior Consultant at Atlas Insurance Agency, a local agency specializing in community association insurance coverage for clients on all islands. Mr. Tsukamaki can be contacted at rtsukamaki@atlasinsurance.com or 808 533-8705.