I successfully Followed Gadgetgrrrl's process above.
I have Parallels Desktop Pro 17.1 - current at 7 Nov. 2021
I had created a High Sierra VM already, so used that to Create an "Install Mac OS X Lion.app" by running the InstallMacOSX.pkg package from the Installer application.
Note this does not fail in a VM as it does when tried on the host machine (because the host is too new for the old OS).
Then copy the .app file back to your host machine and follow the Parallels install process for a new VM using this file. - Step 4 above.
The problem appears to be Parallels wants to use the install.app file, where older OS versions are contained in .dmg files.
Fortunately High Sierra is available as a .app file from Apple.
Say hello again to your favourite old 32 bit applications !