Mr Justice Burton said that doing so would "fetter" an insured's freedom to choose its own lawyer.
In his ruling (17-page / 100KB PDF), the judge said that the amount of legal costs an insured could recover "falls to be assessed... not as restricted to [the limit] but taking it into account".
Litigation expert Damian Crosse of Pinsent Masons, the law firm behind Out-Law.com said that the decision provided clarity to insured parties particularly in specialist or sensitive cases.
"However, in reality if insurers are going to be hit in the pocket then they are likely to increase premiums or possibly change policy wording so that the insured's choice is more clearly restricted," he said.
The test case involved three clients of London employment law firm Webster Dixon, who held before the event (BTE) legal expenses insurance with Equity Red Star.
BTE insurance is taken out by people wishing to protect themselves against potential litigation costs should they be subject to future legal action. BTE insurers usually retain a 'panel' of solicitors, with whom they have already negotiated fees, to represent their clients if that happens.
Mr Justice Burton said that this practice had led to concern that insured parties were being forced to "instruct a panel solicitor, often in a different part of the country, or are referred direct [there] by their insurer".
However the Insurance Companies (Legal Expenses Insurance) Regulations gives an insured party the express right to choose a lawyer "whenever a conflict of interest" arises with an insurer.
One of the insured parties in the test case had used Webster Dixon since the start of her case while the other two had been with lawyers on Equity's panel who had later joined the firm and taken their cases with them.
The insurance policies taken out with Equity Red Star stated that the insured would take "reasonable steps" to keep any amount the insurer had to pay as low as possible. Equity said that this allowed them to refuse to allow an insured to use a solicitor who did not agree to charge no more than their prescribed fixed hourly rate for 'non-panel solicitors'.
Equity also claimed that any costs which were not given in accordance with their rates could not be "reasonably incurred" under Part 48 of the Civil Procedure Rules (CPR).
The judge said that where the insured party selected a different solicitor at the start of the case, that solicitor's rates would not of themselves be "exceptional circumstances" that could permit an insurer to refuse the appointment according to the wording of the policy.
He added that fees would then be assessed under the CPR Part 48 in accordance with the terms of the policy, not restricted by the stipulated rates but taking those rates into account.
"It seems to me both inevitable and right that there should be consideration of the reasonableness of the fees charged by the lawyer selected by the insured by reference to the existence of the panel of solicitors prepared to act at panel rates... [or that] there are or were suitable solicitors who would have been prepared to act on that basis. This however will be part of a comparative exercise which can be carried out as part of the CPR 48 assessment," he said.
He added that the Regulations did not mean that an insured's freedom of choice was limited to one selection at the beginning of a case. Where the insured's solicitor was moving to a non-panel firm and retaining the case, it was not reasonable for an insurer to refuse to consent to the change.
"I see no basis upon which [the Regulations] can be interpreted to arrive at a conclusion that the freedom of choice of the client is limited to one selection or 'election' at the outset. There may be all kinds of scenarios in which it is appropriate and reasonable," he said.
Damian Crosse of Pinsent Masons said it was very important that an insured's freedom to choose legal representation should take priority.
"It's very important both in terms of an insured knowing it has specialist lawyers on board who it can trust, and also in avoiding any potential conflict of interest between the insured's interests and the insurers' interests," he said.
"Although this would normally need to be in line with other insurer panel law firms or by reference to the CPR, it's likely much will depend on the facts of an individual case. The more difficult or specialist the area of law, the greater the likelihood of higher rates being recovered from the insurer."