While I can't speak for SBS, I imagine they've taken this into account and believe that retaining the current system of character death is the best route.

Off the top of my head, my guess is that reducing something like player capabilities might be an even worse consequence than spirit loss. If I keep getting killed in a short period of time, my capabilities will likely decrease to the point where, even if I had a good connection, I would never be able to get out of the situation anyway. Furthermore, if food was all it took to restore my capabilities, then the consequences of death will probably not be as severe as SBS would like.

Of course, I could imagine a system where your PC has to rest for a long time: a sort of "resurrection sickness." But even then that wouldn't stay true to what Chronicles of Elyria is: a game of risk. The point of adventuring in Chronicles of Elyria is that it is risky, and that you have to weigh the value of playing like that against other play styles you might enjoy. So, if you have a tendency to lag out constantly, then maybe playing like that isn't for you.

Of course, you can also adjust your play style to accommodate. For instance, when I first started gaming on the PC, I had a terrible internet connection that would often go out; so, I played a sneakier character so that, if I lagged or saw signs that my connection was faltering, I could take appropriate measures. Sometimes this didn't work, and I was a fish out of water, but that's just the nature of online gaming.

Bearing in mind that this game is pretty ground breaking in terms of offline players following AI scripts, I would imagine (hope) that going offline will engage your script. If you're mid combat, the AI should attempt to continue combat. If you're near a tavern or your home and your character is tired or hungry, it should rest. Other actions should be prioritized according to what's enabled.

My biggest concern is that "time should continue" and there should be no allowance for lag-exploits or teleporting characters and combat cheats.

The devs have stated that just normal monsters/animals right now should only knock you unconcious (no spirit loss). It's only when you get into PVP and uncommon/rare/epic monster fights that their is the immediate risk of spirit loss. For the normal monsters, if you get knocked out, then wake up and start fighting again, getting knocked unconcious again might kill you (spirit loss)