Last week, at a White House forum on reforming health care, President Obama issued a challenge to advocates of less government control of the medical marketplace.

"If there is a way of getting this done [i.e., reforming health care] where we're driving down costs and people are getting health insurance at an affordable rate and have choice of doctor, have flexibility in terms of their plans, and we could do that entirely through the market, I'd be happy to do it that way."

More to the point, Obama added that he'd be just as happy to pursue an approach that involved more government control as well, and that seems to be the tack he's taking. During the 2008 presidential campaign, Obama promised a sweeping overhaul of the health care system that would leave the system of employer-provided group insurance intact while creating a new National Health Insurance Exchange that would offer the benefits of group insurance to those who don't have access to it. The Exchange would give people access to a choice between various private plans and a new public insurance plan modeled on Medicare, and insurers would be forbidden from charging on the basis of pre-existing conditions of health status.

Congressional Republicans have criticized Obama's approach, and they've been particularly hostile to the idea of a new public insurance plan. They argue that Obama's reforms will eventually lead to a nationalized health care system. But as of yet they've failed to offer an alternative that meets Obama's criteria for a successful health care reform.

Enter John Cochrane, an economist at the University of Chicago Booth School of Business. Professor Cochrane has long advocated a proposal he calls "health-status insurance," an approach that could guarantee long-term health security while also freeing medical insurers to compete for customers. To most health care reformers, this sounds like a contradiction in terms. Our health care system has a strong built-in bias towards employer-provided group insurance. The appeal of group insurance is that it allows healthy customers to cross-subsidize unhealthy customers.

The great fear that has motivated reformers for decades is that insurers will compete for healthy customers by offering them inexpensive plans, in the process unraveling the delicate web of cross-subsidies and leaving unhealthy customers to pay ever-higher premiums. This is called "adverse selection." And so most reform proposals promise to further restrict competition between medical insurers by, for example, mandating that all insurance plans charge the same rates to all subscribers. This approach, called community rating, has an intuitive appeal. Why should a family be punished because it has a child with leukemia? Why should a small business face punishing health care costs because one of its employees suffers from diabetes?

It is easy to see why businesses large and small are increasingly agitating for a health care reform that will ease these burdens. Obama's call for a National Health Insurance Exchange is rooted in these concerns. By gathering everyone up in ever-larger pools, you preserve the web of cross-subsidies and insulate the unhealthy and the unfortunate.

As Professor Cochrane argues, however, this "forced-pooling" has a serious downside. As in any industry, reduced competition leads to higher costs, lower-quality service and less innovation. To "solve" these problems, we instinctively impose more regulations--yet these regulations further reduce competition, and the cycle begins anew. The inevitable end result, as Obama's critics suggest, is a single government-run insurance pool covered by a single government-run insurer, or perhaps a public plan plus a handful of private plans that essentially behave like regulated utilities.

So how does Cochrane reconcile robust competition with health security? In addition to medical insurance, he proposes that individuals and families purchase health-status insurance. In the event that one develops a chronic illness, the health-status insurance policy would pay for the lifetime increase in medical insurance costs. Medical insurers would be free to adjust premiums upwards, but the consumer would be insulated from the economic shock. For those who already suffer from chronic conditions or other expensive ailments, the government could step in and deposit money in a health-status insurance account to cover the higher costs.

The Cochrane plan doesn't solve all of America's health care maladies by any means, but it does create a competitive insurance marketplace while protecting people from the economic effects of unanticipated health problems. Tackling the problem of the uninsured actually becomes much easier in a world with health-status insurance, as it will make medical insurance more affordable for everyone.