When PMI terminates at 78%, the mthly PMI pmt is substracted from the mthly escrow pmt to get the new escrow pmt. Doesn't the servicer have to also refund the 2 month PMI cushion? Or is it ok to leave in the escrow bal until the next annual analysis?

That depends how you disclosed how the payments would be treated in your legal agreement.

Are the reserved payments used to pay the last two payments of the premium or do you collect the premium through the termination point? If you collect through the termination point then the reserve payments are unearned premiums and must be refunded.

You should review the Commentary to Reg. Z 226.18(g).

Thanks, I needed reassurance that I was correct.