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

TL;DR

This paper demonstrates that in high-risk environments with budget and risk constraints, parametric insurance can outperform traditional indemnity insurance in terms of welfare for risk-averse individuals.

Contribution

It introduces a mean-variance framework incorporating real-world frictions, showing the conditions under which parametric insurance is more beneficial than indemnity insurance.

Findings

Parametric insurance can lead to higher welfare under realistic constraints.

Indemnity insurance's advantages diminish when contracts are unconstrained.

Parametric risk transfer aligns with classical insurance theory in high-risk settings.

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, 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.