Adverse selection refers to a market situation where traders involved have levels of information regarding the quality of the product in question. It follows, naturally, that the more knowledgeable participant will take advantage of the trade to benefit most. This concern often occurs in insurance where people engaging in high risk jobs purchase covers like health and life insurance.

Moral hazard occurs when one entity to a contract takes unnecessary risks to earn a profit since it will not incur any costs in case of loss. Moral hazard also occurs when one entity has not entered into an agreement in good faith.

Adverse selection occurs in real life when people seeking insurance cover do not provide truthful information regarding their risk profile. Smokers, for example, tend to hide this behavior when looking for health insurance. The providers, therefore, offer cheaper premiums unbeknownst to them that they should charge even more given a smoker's high risk profile.

One way through which insurance companies can reduce the problem of adverse selection is by requiring the injured parties to share a part of the costs incurred. In the smoker's case highlighted above, the injured party must first cover a fraction of his medical bills before the insurance company pays its bit. This practice is known as using deductibles.