Because they were under no obligation to do so. The fact that they didn't pay for his lawyers doesn't prove he was not operating under the color of law. It proves that insurance companies don't give money away for free.
If the police department had negotiated a policy that said their insurance would apply to retired cops performing law enforcement duties, then the insurance company would have paid for his lawyers.
The insurer didn’t even defend under a reservation of rights, which would be the right thing to do if there was even the remotest chance the guy was acting under color of law.
I don't see insurance companies as being motivated primarily by a desire to see justice done. I see them as being motivated by a need to provide a service for a profit.
Sorry, you just have no clue.
If there was even the remotest chance he was acting under color of law, both the department and its insurer had an OBLIGATION to defend him. If they had such an obligation, and they refused to defend him, he’d end up owning a nice chunk of the insurer, at least.