I'd just pay it to save all the hassle.Plus with all the regs I'd imagine your liable.
I wouldn't but as you know I like a good argument
http://www.legislation.gov.uk/ukpga/1994/22/section/7AThis appears to refer to a fine for not covering the vehicle which is not applicable if it was written off.
I would write back to them offering the advice that they stop employing morons to deal with their correspondence and referring them to the insurance company and advising that you have written to the dvla to appeal (which you should also do).
oh and also complain to the insurance company.