Asymmetric information:

In certain cases there is asymmetric information available to the contracting parties. For example, purchase of a second hand car or purchase of life insurance policies. While purchasing a second hand car, obviously the owner/seller have better access to information about the car than the buyer. Similarly, while purchasing life insurance policy the insured knows better about his/her health than the insurance company.

Adverse selection:

Asymmetric information may give rise to 'adverse selection'. It it refers to a market process in which bad results occur due to information asymmetries between buyers and sellers. Let us explain it by an example from insurance. As a result of private information, the insured are more likely to suffer a loss than the uninsured. For example, suppose that there are two groups among the population, smokers and non-smokers. As the insurer selling life policies cannot distinguish between the two, the beneficiaries pay the same premium. Non-smokers are likely to die older than average, while smokers are likely to die younger than average. So the life policy is a better buy for the smokers.

The insurance company anticipates or learns that the mortality rate of the combined policy holders exceeds that of the general population, and sets the premiums accordingly. The outcome is that the non-smokers are at disadvantage as they have to pay relatively higher premium. They 'may go uninsured though if they could buy a policy on terms that are actually fair given their characteristics, they would do so. So market failure is involved.