Optimal cap on claim settlements based on social benefit maximization

Caps on damages constitute one of the proposed reforms of the tort system, especially in the U.S. In this paper, we establish models to capture both the claimant's and the insurer's behaviors under a system whereby damages are capped. We also establish an objective function of maximizing the social benefit, expressed as the sum of claimant and insurer benefits. We examine the optimal upper limit that balances both claimant and insurer benefits. Our model implies that the optimal value of the upper limit should be the expected value of the random claim payment independent of the type of probability distribution the claim payment follows. Finally, we apply empirical data to our theory and arrive at an estimate of the optimal damage cap.