what is the proper protocol

I have to agree with Ditto - the shipping company will typically start a "search" that can take weeks or months to resolve. I had a lost package with Fedex, 2 months later they found it in the search phase (they said that paint had spilled on it and destroyed the outer label). If the package is delivered late the shipping company will deny the claim, and at that point the seller can only hope the buyer will either pay or return the package.

If I trusted the buyer I would go ahead and refund the money now, but I think it is reasonable to ask the buyer to wait until the search is resolved. The seller takes a big risk if the seller refunds the money while the package is still en route to the buyer.

"as soon as it was reasonably determined the item was lost"

I'd agree with that too - it should take no more than a week or so to file a claim and have the shipping company admit that it is lost and start a search. In the case I described, I was able to have fedex redirect the package to a new address after it was found (over a month and many phone later) so the ability to redirect the lost package (at least at fedex) should provide protection for the seller and allow for a much quicker refund to the buyer.