In Nipponkoa Ins. Co., Ltd. v. NDK Crystal, Inc., 3:11-cv-50205 (N.D. Ill. Dec. 29, 2011), the court held that a first party property policy covered the insureds’ losses arising from an explosion, concluding that because the insurer had equal knowledge of the potential liability, the known loss doctrine did not apply. Further, the court held that the ensuing loss exception to several policy exclusions clearly provided that the insurer was liable for loss or damage caused by an explosion.

The insureds operate a facility in Belvidere, Illinois to grow synthetic quartz crystals in eight pressurized vessels called “autoclaves.” (The crystals are for use in crystal frequency control devices and optical applications). In early 2007, after one of the autoclaves began leaking a pressurized caustic solution, an inspection revealed a large crack in five of the autoclave lids and that the other three autoclave lids had indications of potential cracks. A joint investigation revealed that all of the autoclaves were at risk of catastrophic failure and that the cracking was due to stress corrosion caused by design and material defects. While the investigation was pending the insureds elected to resume operations with the three of the autoclaves whose lids did not yet have confirmed cracks, despite warnings from both the insurer’s metallurgist and he design firm that there was a risk of serious injury or death should one of the autoclaves fail. The insurer warned that it would provide no coverage in the event of a loss or damage sustained as a result of returning the autoclaves to service in their current condition. Meanwhile, the insureds had already filed a lawsuit against the design firm. In July 2008 the insureds amended their complaint against the design firm to allege that the heat treatment and fabrication of the autoclaves were negligently performed, failed to comply with the implied warranties of merchantability or fitness for a particular purpose, and that the autoclave bodies and covers would require replacement. The insureds did not, however, replace the autoclaves.

The Policy went into effect on August 1, 2009, and on December 7, 2009, one of the autoclaves failed and exploded, causing significant damage to the facility and one fatality. The insurer filed a declaratory judgment action seeking a declaration that the Policy did not cover the insureds’ losses because the explosion was not the result of a fortuitous event (Count I). The insurer alternatively sought a declaration that, among other things, there was no coverage for the cost associated with replacing the components involved in the explosion because the explosion was caused by perils specifically excluded from coverage (Count II).

The insurer argued that the known loss doctrine precluded coverage because the insureds continued operations when they knew or should have known prior to the inception of the Policy period that the facilities were defective and susceptible to catastrophic failure. Granting the insureds’ motion to dismiss Count I, the court rejected the argument and noted that while the known loss doctrine excludes from coverage losses that ”exist or are so probable or imminent at the time the parties enter the insurance agreement that their occurrence is foreseeable to the parties,” (citing Zaragon Holdings, Inc. v. Indian Harbor Ins. Co., No. 08 C 111, 2011 WL 1374980, at *4 (N.D. Ill. Apr. 12, 2011)), the insurer’s knowledge also is relevant to the application of the doctrine. As the court explained, if an insurer is equally aware of the potential liability from conduct alleged to be a known loss, it must expressly exclude that risk from coverage. (quoting Mo. Pac. R.R. Co. v. AM. Home Assurance Co., 286 Ill. App. 3d 305, 315-16 (1997).) The court agreed with the insureds, reasoning that the insurer was aware of the risk of an autoclave failing or exploding, went so far as to warn its insureds of that risk in the years prior to issuing the Policy, and contemplated a reservation of rights with respect to loss from any explosion, yet failed to include in the Policy any reservation or exclusion relating to the potential risk.

The court also rejected the insurer’s argument that the Policy excluded from coverage loss resulting from the explosion. Among other things, the insurer sought a declaration that the Policy’s exclusions for “cracking” and “corrosion” and/or “design,” “workmanship” and “material defects” applied, thereby excluding coverage. The insureds argued that the ensuing loss exception applied, under which, if an enumerated excluded loss (e.g., the cracking, corrosion, design, workmanship, material defects exclusions on which the insurer relied) “results in a ‘specified causes of loss’ [sic] … [the insurer] will pay for the loss or damage caused by that ‘specified causes [sic] of loss.’” The Policy defined “specified cause of loss” to include explosions. Characterizing the ensuing loss provision as an “an exception to the exceptions,” the court rejected the insurer’s argument that its holding “interpret[ed] an ensuing loss provision to create coverage where none exists.” Accordingly, the court granted the insureds’ motion for partial judgment on the pleadings.