I like the idea of applying the penalties only if the person is wielding his/her weapon at the time, but:
1) What about pickaxes etc? Tools
and weapons - do they count? Probably shouldn't - who'd fight with a pickaxe anyway?
2) I don't think that losing the weapon is the way to go, since people put so much effort into improving them. But there should definitely be some penalty. Perhaps one based around time? The player needs to recover their corpse to get their items back (they could still be in the inventory, but flagged as hidden until the corpse has been recovered or a certain period of time has passed - that way they don't lose their stuff if the corpse NPC dies).
3) Perhaps instead of making sheathing/unsheathing take large amounts of time, it could work like this: The player can draw their weapon instantly, as is currently the case. However, he/she can only sheathe it if they have not used it in the last twenty seconds. This way they can't quickly opt out of fights (they must run and not fight for at least twenty seconds), but it doesn't inconvenience those who aren't engaging in PvP fighting.