So I've read that the 3 factions exist more as a grudging necessity, I'm wondering if there will be any game mechanics that would reward a certain level of xenophobia built into the game? With the way the factions are explained it would make sense for them to be suspicious of each other and only work together when necessary. I don't know if this would be an element the devs would want to encourage, or how it might be implemented. I think it'd help create a more appropriately tense atmosphere though if they played into this. I'm worried that the factions might otherwise seem like a convenient way to justify the equal distributions of races per faction.

Well they are clearly considering the lore in the game.

For example, House Telvanni will not be taking part in the Ebonheart Pact and they are estranged from the rest of Morrowind.

No doubt the factions began as a gameplay device, but they definitely were careful not to make them seem forced.