Couldn't you kill anyone in Daggerfall? Haven't played that since Windows 98!
Guild members, tavern goers, temple occupants, merchants, and courtiers simply ignored attacks. Only the people shuffling around outside the towns could be attacked.
I wouldn't mind this approach in newer TES games. If you attack someone essential, the attack simply does no damage, they don't turn hostile, it isn't reported as a crime (since a bounty can't be removed if you can't kill the victim). The part of essential NPC's in this game that bothers me is the whole 'fall to one knee, then get back up and proceed to chase and fight the player.' It is incredibly stupid. If the idea is to disallow the player from killing these NPC's, simply have them ignore attacks completely.
Turning off essential NPC's is, unfortunately, a slippery slope. Killing an NPC that isn't supposed to be killed can have consequences you may not foresee. This includes the simple immersion-breaking of other NPC's not acknowledging the victim NPC's death. Obviously Bethesda would not have written and voiced dialogue acknowledging the death of an NPC that they flagged as unkillable.
Another potential solution is making the cities larger and populating them with generic unnamed NPC's (much like the farmers and mercenaries wandering the roads). It would be a chore to implement and might cause FPS problems on certain rigs, but it would provide murderous types with plenty of clear safe targets.