Remember insurance companies arent charities.
they are a business.
also, if your mods arent approved by your local state/territory then it is illegal full stop. its the law. why should a company pay you out for something illegal?
if the mods contributed to the accident and were not approved - of course they have every right not to pay.
however if you have mods that arent approved, and someone runs up the back of you, the mods did not cause the accident so if an insurer then says we arent paying, that is wrong.
stig mick has it right - re:agreed value.
I have done the right thig and I got my car engineered. its covered with shannons.
but also, you pay for what you get - if shannons have agreed to cover you - regardless of cost, I know what Id be doing.