How would you do it then?!
First i have to say i'm not a huge fan of the expansions. Not that i think they're bad, but i feel they take away more from TES than they add.
I came to TES through MW, so all i have to go on is what i saw and read in that game. I'm trying to get daggerfall to work pretty much so i can learn more about TES (I like reading books in an in-game environment as opposed to over the net).
I think my attraction to lore is that they said enough to keep me interested, but they were ambiguous enough to keep me even more interested. The daedric princes and realms of oblivion were a mystery to me because some sources were suggesting that the daedra were ancestors, other sources saying they were not (more to it obviously but just an example).
The idea of a realm of madness is almost by definition a psychologically disturbing place, whether it be the source of madness, an afterlife for the mad or a library for insane thoughts and fantasies. So to answer the original question, i would've broken from the open world style and gone for something that better allows an exploration of the concept of madness, whatever that might be.
I was annoyed with shivering isles for a few reasons. First they broke with ambiguity and set in stone what a daedric realm was. Secondly, this is NOT my idea of a realm of madness, SI is a very sane world inhabited by mentally ill people.
P.S Did they add a new god just for an ending to AN EXPANSION?