When Indemnity Insurance Fails: Parametric Coverage under Binding Budget and Risk Constraints

Abstract

In high-risk environments, traditional indemnity insurance is often unaffordable or ineffective, despite its well-known optimality under expected utility. We compare excess-of-loss indemnity insurance with parametric insurance within a common mean-variance framework, allowing for fixed costs, heterogeneous premium loadings, and binding budget constraints. Motivated by the disaster insurance and risk-sharing literature, we show that, once these realistic frictions are introduced, parametric insurance can yield higher welfare for risk-averse individuals, even under the same utility objective and without relying on behavioral assumptions. The welfare advantage arises precisely when indemnity insurance becomes impractical (particularly when households face binding premium budgets), and disappears once both contracts are unconstrained. Our results help reconcile classical insurance theory with the growing use of parametric risk transfer in high-risk settings, and rationalize the interest in hybrid designs that combine both indemnity and parametric elements.