Per item 2: Have you heard of Dwarf Fortress? That’s the kind of game that actually might benefit from an LLM generating dialogue on the fly over anything pre-written. The game is already a mad-lib of tons of randomized little parts. You kinda have to use your imagination to truly understand the dialogue when talking to another character in Adventure mode or the log in Fortress mode because it’s NOT written in advance, but still conveys everything you need to understand what is going on.

It would be nice if that already randomly generated dialogue based on actual in-game information that is also randomly generated had a bit more flavor to it and came along more naturally.

It would not be good for every game, and telling an actual story would still work better the traditional way. But for games like Dwarf Fortress or Rogue or anything like that, where nothing is written by a human except for the individual pieces that the game eventually stitches together itself, it would be pretty cool.