There's a lot going on in this thread, so I'll see if I can help...
Firstly, even though increasing in rank has minimal game impact (except for magickers, I guess), advancement in Dragon Warriors is so slow that even a small step backwards might demotivate a player. Have you considered introducing protégés into your game? Basically, an NPC to which a character can donate up to 10% of their wealth and XP (within the narrative of the game, obviously) and could take over playing from the GM should the PC die. Such a protégé might be a knight's squire, a sorcerer's apprentice, a family member back home the PC sponsors, etc. Not only do these NPCs create attachments for the PC to roleplay but they can also generate whole new storylines and plot hooks.
Secondly, allow a character that has fallen behind in experience additional opportunity to earn more. In my game, any PC at least two ranks behind the party average earns an additional experience point per adventure, simply from being around more experienced adventures - something rubs off. If the player wants to write an adventure log, create a family tree, or otherwise contribute to your game world with some simple trivia, background, or colour, that should be worth something, too - remember that XP is as much a reward for the player as it is for the character. You might find that even those players that haven't fallen behind might start to contribute ideas and context to your game world too.
Lastly, if you're interested in introducing lasting injuries as alternatives to death, I have a little system I use in my games you're welcome to adapt:
http://cobwebbedforest.co.uk/library/Do ... Wounds.pdfAnd it sounds like a great background to adventure - a cursed island in which demonic powers seep through the living fabric of the land, twisting the living and the dead alike into grotesque parodies of immortality. If you get around to writing up the adventure, I'd encourage you to share!