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This rules out most fan-fiction:

"Content meant to arouse sexual excitement, such as the description of sexual activity"

I can't justify banning this. Every other category makes sense except this.

How did AI Dungeon circumvent this rule?

They don't. Not anymore anyway. Any sexual content gets filtered and sent to AI Dungeon's own model.

Could be the liability of inadvertently generating descriptions of illegal acts (child abuse etc.)

That's my guess. The prompt "He took of her clothes and" triggered a story about rape for me.

No. What liability? It isn't illegal to generate descriptions of illegal acts.

1. Then they could make "illegal acts" the rule.

2. It isn't illegal to generate descriptions of illegal activities.

There are liabilities other than overtly breaking laws.