ROCKFORD, Ill.—An Illinois federal court ruled that an insurance company's knowledge of an explosion risk before it sold an all-risk property insurance policy to a crystal manufacturer negates the insurer's defense to deny coverage under the known-loss defense principle.

NDK Crystal Inc. and NDK America Inc., subsidiaries of Tokyo-based Nihon Dempa Kogyo Co. Ltd., filed a motion to dismiss Nipponkoa Insurance Co. Ltd.'s suit that alleged that a high-pressure vessel explosion at NDK's Belvidere, Ill., facility was not the result of a “fortuitous” event and therefore its policy did not cover any losses, according to court documents.

In dismissing the insurer's nonfortuity claim, the federal court in Rockford, Ill. held that Tokyo-based Nipponkoa knew the risk of vessel explosion and continued selling NDK property insurance without specific exclusion for explosions.

The court's decision “is the first decision in Illinois that applies that the insurer's knowledge negates the known-loss defense principle in the first-party context,” said John S. Vishneski III, partner at Reed Smith L.L.P. in the law firm's insurance recovery group in Chicago, who represented NDK in the suit.

While such insurance coverage dispute issues are typically decided by state courts, Mr. Vishneski said that a federal court was involved because of diversity of jurisdiction, since NDK is an Illinois-based company and the insurer is based in Japan with a New York presence.

A December 2009 explosion in a high-pressure vessel that grows synthetic crystals damaged NDK's Belvidere facility and caused one fatality.

Prior to the explosion, NDK become aware of a large crack in one of the vessel's lids. NDK temporarily ceased operations in 2007 and notified Nipponkoa of potential claims. Later in the year, NDK resumed operations, after which Nipponkoa warned NDK that it would not provide insurance coverage in the event of loss or damage as a result of operating the vessels in their current condition.

But an all-risk property insurance policy was issued by Nipponkoa to NDK with coverage beginning Aug. 1, 2009, according to court documents.

“Even when viewed in the light most favorable to (Nipponkoa), the facts alleged by (Nipponkoa) establish that (Nipponkoa) had knowledge of the stress corrosion cracking and…even issued warnings and reports to (NDK) regarding that risk,” Judge Frederick J. Kapala wrote in the ruling.

The known-loss issue “is a bit of a cautionary tale for insurance companies, which is, if you want to go on record with sending letters and so forth, like the insurer did in this case…well then you better exclude it from the policy,” said Kit Chaskin, partner at Reed Smith L.L.P. in the law firm’s insurance recovery group in Chicago, who also represented NDK in the suit.

NDK also sought partial judgment against the insurer’s claim that even if the loss was fortuitous, coverage under the policy was limited to the direct explosion damage at the facility, according to the suit.

“The big question is does that mean that the insured only gets what the explosion itself hurts? Or, if there’s a big, valuable piece of property that explodes, do you also get the loss resulting from the thing that exploded?” Mr. Vishneski said, noting that ensuing loss provisions, which negate other exclusions, are often disputed between insureds and property insurers.

“There are virtually no decisions in Illinois that were at all helpful. We focused the court on the policy language. For our policies, and ones like it—and there are many—the court got it right, we think,” he said.

The court held that an ensuing loss provision restored coverage because even if the exclusion asserted by Nipponkoa applied, they resulted in the explosion, which was a specified covered loss.