Adverse Selection:

Adverse selection is a problem that arises when an insurer cannot differentiate between two groups of  people with different risks  (say, high and  low  risks) and has to charge the same premium from both. The problem arises because an average premium charged from the two different risk groups, which might result to be too high  for the lower-risk group. Due  to such an approach, some members of the lower-risk group go uninsured.

Example

Suppose an  insurance company in a competitive market cannot ascertain the difference between smokers  and  non-smokers. Smokers have a 20% probability of getting  lung  cancer, whereas non-smokers  have  only 10%. Assume that smokers constitute one-half of the population. As a result, from the viewpoint  of  insurance company, a person randomly chosen from the population as a whole has a 15% chance of getting cancer.