You probably missed it, before you buy knives, the sharks will kill any diver they touch. A knife will kill the shark instead, but you lose the knife, so another shark would kill the diver unless you have a second knife, etc. You're right though, the higher knife levels aren't as useful as intended due to lack of threats. Ultimately, there just weren't enough sharks to make getting more knives feel like it mattered at all.
Viewing post in Scuba Steve's Salvage Squad jam comments
You don't have to repurchase the upgrade, you just lose out on the hire cost and any treasure they had grabbed before dying. They basically just return to the ship on death. One of my ideas was to have each diver be a character that is hired and upgraded individually, and can die permanently. but we ended up not going that route, at least yet.