Your car catching fire because the car next to yours that failed to respond to the recall.
In order for the above statment to be held valid, there would have to be documented occurances of where the recall created the danger of spontaneous combustion.
If the recall and or the validity of of a possible fire could result from failing to respond to a recalls adverse conditions then it would be warrantied that the basis for the recalls notice could be held as fact.
Had there been other instances where cars that did not abide by the terms of said recall suffer the same fate or was the resulting fire an isolated instance ?
As to your insurance repairing the car, it appears from your letter that the vehicles interior suffered damage from the encroachment of the fire.
You will need to examine your insurance policy for a vehicle repair / customer acceptance clause.
Also you should check for a buyout clause.
I am not sure how you determined that the leather interior has toxic fumes,,does it smell different ?
You should not accept a repaired vehicle until the repairs are done to your satisfaction.
If the insurance company tries to feed you some kind of baloney like,,"thats the best that can be done " or " thats all we will do " ,,then at that point you should seek legal counsel.