Punitive damages in the legal system can lead to unpredictable and unfair outcomes due to high severity awards. The current approach fails to address this variance issue. By analyzing the relationship between variance, litigation valuation, and deterrence, it is found that punitive damages create risk arbitrage opportunities, leading to inefficient pricing in the legal system. Caps on punitive damages can either underdeter or overdeter defendants, depending on the case's severity. A risk-based theory is needed to set legal limitations on punitive damages to ensure fair outcomes.