Final answer:
Adverse selection in the insurance market occurs when the insurance company cannot differentiate between high, medium, and low-risk drivers, resulting in low and medium-risk drivers choosing not to buy insurance.
Step-by-step explanation:
To understand adverse selection in the insurance market, let's consider the example of 100 drivers purchasing automobile insurance. Out of these drivers, 60 have low damages of $100 each, 30 have medium-sized accidents costing $1,000 each, and 10 have large accidents costing $15,000 each. The insurance company, unaware of the risk groups, sets the premium at $1,860 per year to cover the average loss. As a result, drivers with low and medium risks may opt not to buy insurance, leading to the insurance company mainly selling insurance to high-risk drivers who will average $15,000 in claims each.