The only place the code requires the 1.25" setback is next to framing members.
I don't like it, or even agree but that is the way it reads and the way it gets enforced here.
A agree with your concern on service entrance conductors. I would probably go after that with 250.30(A)(1)
<service disconnect shall be>... "nearest the point of entrance of the service conductors." and tell them the "up" has to happen outside the building with the penetration right behind the service disconnect.