No, does not include shields. Likely just Armor and Natural Armor, with the two being made to explicitly not stack for the temp HP.
An encounter model does make sense, but then the values need to be much higher even than my initial proposal to make it worth it. I say this from experience with video games that have armor increase max HP... armor typically just gets ignored entirely in these games. Take it if it comes free, but typically look for other stuff to get instead. Having it refresh each round makes the mechanic more meaningful.
As an aside, the more I sit on it, the more I like Pechavery's take on it. I might reduce armor values by 1 or 2 for some armors, so you still have the trade off between AC and temp HP, but the tradeoff would be 1-2 points of AC, as opposed to 6-7, since the temp HP is lower. That change may even be reflected via special materials, maybe something like adamantine increases effective armor for temp hp by 2, while mithril increases max dex by 2. Also since it is a lower amount of temp HP, then the degradation mechanic is wholly unnecessary unless you want a gritty feeling game.