Tami,

This is a tough question and it is often confusing to students.  A deductible is always applied to the loss and not the policy limit.  Although you also have to remember that the insurance company will never pay you more than the policy limit.

In this case the insured lost $125,000 so the deducitble is subtracted from $125,000. This means the insured should receive $125,000 - $5,000, but they only have $100,000 in coverage available so the insurance company will pay them $100,000 instead of the $120,000 they would have received if they were properly insured.

You correctly added the debris removal cost of $7000 which makes the correct answer $107,000.

I hope this helps.  Please let me know if you have other questions.

Jan