The Reserve Funding Analysis is one of the most important documents that an insurance provider can have for a property it covers.
A Reserve Funding Analysis is a formal evaluation of the physical condition of a property and the expected future expenses that will be needed to keep the property in a viable state of repair. Having this funding statement out in the open on Day One discloses to the owner, the insurance company, financial institution and all other stakeholders the real cost of preserving the asset that everyone is vested in.
For the insurance carrier, the analysis establishes the baseline property condition, helps ensure responsible operation of the property and provides the actual numbers that support appropriate pooling of the risks and accurate pricing of the insurance product.
This is not trivial. Where there is an absence of knowledge and inadequate reserve funding, there is little incentive for the operators to mitigate major system exposures. Many times, market conditions such as “curb appeal,” trend-setting landscaping, new exterior paint or other highly visible amenity may receive disproportionately higher funding priority than the hidden major building system peril such as a potable water system rupture, building envelope failure, venting or water drainage intrusion.
This situation represents a severe moral hazard. The insurer becomes the de facto major system reserve fund. This is especially the case when the owner can claim no knowledge of imminent failure or will attribute the failure to one or more lesser contributing factors.
While this is not quite as scandalous as TV crime dramas where the crook sets a building ablaze to collect the insurance money, owners are still making insurers unfairly responsible for more subtle perils such as catastrophic water system failures and building envelope failures such as roofs, water rot and foundation decay.
These conditions are often difficult to see until there is a major failure. Or, they may be exacerbated, but not caused, by a storm, earthquake or natural risk. Piping systems corrode from the inside, becoming weaker while showing little or no indication of a problem until water is cascading down 12 floors of luxury condominiums. Building envelope water intrusions can go unnoticed until toxic mold appears in the venting or a deck collapses. Certain concrete cracks can allow water to enter invisible places, undermining the purpose of the foundation.
Many of these perils are easily avoided with routine maintenance, assuming the owner is aware of and has budgeted for them.
The most typical Reserve Study available on the market is a common tool for condominiums. The purpose is to protect mortgage holders and shared asset community members and to help set homeowners association (HOA) dues fairly and comparably (vs. alternate properties) while avoiding the need for imposing special assessments on the owners.
Think about it. These are exactly the same business functions as the insurance carrier! Therefore, a specialized Reserve Study that meets the needs of the insurance carrier should be considered essential in any significant building, facility or property.
The Building Condition Assessment
The first step is to perform a comprehensive Property Condition Assessment by a registered professional engineer knowledgeable in the ASTM E2018-08 standard. No law exists that requires a professional engineer or architect to perform the inspection, but one is highly recommended by most attorneys in the event that the findings are legally challenged. The ASTM E2018-08 standard will provide visibility to major systems and components that are due to be replaced, that are failing or that are operationally sub-standard or outdated.
The Condition Assessment can also reveal how a building is “aging.” For example, a 10-year-old building can reveal what the next 40 years will be like much better than a new building can. A quarter inch of settling after 10 years can be re-measured after 20 years. Corrosion or rot on the north side, but not on the south side, can tell an important story for the future. A good engineer can see these trends and predict future conditions with surprising clarity.
Hiring a Consultant
It is imperative that a licensed, professional, civil or mechanical engineer perform the assessment and reserves estimate. Many engineers closely align themselves with architects and other engineers, so it is important to inquire about their professional network. There are many Certified Inspection Professionals who are qualified to perform inspections, but the science of engineering can quickly become an integral part of the process. Water chemistry, corrosion science, water vapor diffusion and hydrocarbon compatibility, electronic logic controllers, etc., are the domain of engineering. Further, only the engineer would be qualified to allocate other engineers where needed — the lineage should remain intact wherever possible because only engineers can come up with the numbers that fit the actuarial tables and can be upheld in court.
Initial Project Review
Once the responsible engineer has been retained, he will require a set of initial information about the build, property or facility. This will include:
- As-built drawings and architectural specifications
- The declaration and description
- Reciprocal cost-sharing agreements
- Previous reserve fund studies
- The most recent audited financial statements
- What the current annual contribution to the reserve fund is
- Inspection of the current maintenance and repair record
- A summary of (end-user) problems and concerns
- The engineer is provided the above information. The as-built drawings and specifications are prior to visiting the site in order for the engineer to become familiar with the overall design and construction schemes. If they are absent or deficient, this is a red flag.
- Site inspection is performed. Problem areas are reviewed and documented.
- The report is prepared. The drawings are used to “take-off” quantities such as roofing, exterior wall cladding, asphalt, hallway finishes, etc. that will assist in preparing the replacement/repair cost budgets.
- The engineer presents a draft report to the insurer prior to its being finalized.
- Upon receiving direction from the investors, the Reserve Fund Study is finalized and submitted.
The Report Format
Every engineer may have a slightly different format, but, in general, the Reserve Funding Analysis has two main components: physical analysis and financial analysis. The analysis includes:
- Inspection Report. Based on the results of the site inspection, the report will provide an itemized overview of the major common elements. This will include general condition, the need and timing for remedial work or replacement and any other information that the stakeholders should be aware of.
- Information Tables. There is typically a table that summarizes the common elements in terms of current age, life expectancy, remaining service life and current and future cost budgets.
- Expenditure Tables. The data from the information tables is summarized to show when the itemized common element repair/replacements are estimated to take place. For each year, these expenditures are summed. The annual projections must be a minimum of 30 years commencing in the year the study (and updates) is prepared.
- Cash Flow Tables. Based on the estimated expenditures, different contribution plans can be provided. Often, one plan includes the contribution level currently being used as a form of comparison with other scenarios.
The Funding Plan
As part of the Financial Analysis, the study must have a recommended funding plan projected over 30 years from the date of the study. The plan must show:
- The estimated cost of major repairs and replacements based on current costs.
- The same costs adjusted to account for an assumed inflation rate. The inflation rate must be stated in the study.
- The opening balance of the reserve fund.
- The recommended amount of contributions to the reserve fund determined on a cash flow basis that are required to offset adequately the expected cost in the year of the expected major repair or replacement common elements and assets.
- An estimate of the interest earned on the reserve fund contributions based on an assumed interest. The study should state the assumed interest rate.
- The percentage increase in annual contributions to the reserve fund for each year of the 30-year study.
- The estimated closing balance of the reserve fund for each year.
It may be surprising to know that much of this due diligence is already being performed by the owners, management firm, bank, attorneys, accountants, real estate brokers, etc. However, it is the insurance carrier that must have the clearest probabilistic view of the property. The insurance carrier must be assured that due diligence has been performed by the right professionals, at the right time, and articulated in the right numerical form that serves the calculations of insurer, not just the calculations of the insured.