A recent Fifth Circuit case highlights the potential risks of purchasing a defense-within-limits policy: If an insurer is obligated to hire independent counsel due to a conflict of interest, that counsel’s fees may erode your policy limits.

When an insurer accepts coverage of a liability claim, the insurer typically has the right to choose counsel to defend the policyholder as well as to control the defense. When an insurer defends under a reservation of rights, however, a conflict of interest arises between insurer and policyholder. Many states obligate the insurer in this situation to pay for independent defense counsel selected by the policyholder to obviate the conflict. For example, in Mississippi, a policyholder’s right to independent counsel paid by the insurer is known as the “Moeller” rule.

The Fifth Circuit recently decided just how far the rule extends. In Federal Insurance Co. v. Singing River Health Systems, the insurer agreed to defend a public hospital system, Singing River Health System (SRHS), and various officers, under a reservation of rights in multiple lawsuits stemming from alleged underfunding of a pension plan. The policy and policy application clearly stated that defense costs would erode the limits of liability. SRHS nevertheless argued that defense costs paid under Moeller should not erode the policy limits.

The policy defined covered “loss” to include defense costs that SRHS was “legally obligated to pay.” Because the insurer, not SHRS, is “legally obligated to pay” for Moeller counsel, SRHS reasoned that such costs should fall outside the limits. The federal district court agreed, holding that at a minimum, the phrase “legally obligated to pay” was ambiguous and should be construed in favor of SRHS.

During oral argument before the Fifth Circuit, the insurer reported that it had expended over $3 million in defense costs on a policy with $1 million limits.

The panel held that the district court’s ruling pushed the Moeller rule too far. The court cited a more recent Mississippi Supreme Court decision holding that the policyholder must meet the policy’s deductible requirement before the insurer’s Moeller obligation is triggered. The Fifth Circuit held that the insurer’s duty to pay for independent defense counsel is similarly subject to the terms of the policy, including the policy limits. The court also rejected SRHS’s public policy arguments against enforcement of the defense‑within-limits provision.

At oral argument, one of the judges quipped that perhaps SRHS underfunded its insurance coverage. While not apropos from a legal perspective, as a practical matter it is a valid point. SRHS had the option to purchase a separate limit of liability for defense costs and chose not to do so. However, even if there had been a separate limit, defense costs were triple the policy limit with the underlying litigation still ongoing. Failure to realistically assess risks and secure sufficient insurance coverage for those risks can be the ultimate peril.