Adverse selection is a phenomenon wherein the insurer is confronted with the probability of loss due to risk not factored in at the time of sale.

I studied George Akerloff’s paper on “The Market for Lemons”, which serves as an example for Adverse Selection arising due to asymmetric information prevailing between the buyer and the seller.  

Following is a brief summary of the paper-Suppose buyers can't distinguish between a high-quality car (a "peach") and a defected car (a "lemon"). Then they are only willing to pay a fixed price for a car that averages the value of a "peach" and "lemon" together (pavg). But sellers know whether they hold a peach or a lemon. Given the fixed price at which buyers will buy, sellers will sell only when they hold "lemons" (since plemon < pavg) and they will leave the market when they hold "peaches" (since ppeach > pavg).

Thus the uninformed buyer's price creates an adverse selection problem that drives the high-quality cars from the market. Adverse selection is the market mechanism that leads to a market collapse.

To counter this problem the American government issued the Lemon Laws, which protects the consumers purchasing the vehicle and prevents the market moving towards market failiure.

Lemon laws are American state laws that provide a remedy for purchasers of cars and other consumer goods in order to compensate for products that repeatedly fail to meet standards of quality and performance. Although there may be defective products of all sorts ranging from small electrical appliances to huge pieces of machinery, the term "lemon" is generally thought of as applying to defective vehicles such as automobiles, trucks, SUVs, and motorcycles.

There are two types of warranties. Express warranties are usually statements in writing such as those provided by the manufacturers in owner's manuals and other written sales or advertising materials, or by a sample or model. Implied warranties are broader in scope and assure consumers that the retail product would meet certain minimum standards of quality whereby the product is fit for use for the purpose intended. In each type the manufacturer assumes the liability and responsibility to correct the defect or to repurchase or replace the product. Typically, the existence, scope and consequence of express and implied warranties is a matter of state law, usually covered by Article II of the Uniform Commercial Code.

Bibliography

"George A. Akerlof." : The Concise Encyclopedia of Economics. N.p., n.d. Web. 10 Jan. 2016

"Lemons Problem Definition | Investopedia." Investopedia. N.p., 16 Apr. 2011. Web. 10 Jan. 2016.