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Think about the story: Starfish (plural) have a certain ability: if they lose an arm, another one grows in its place. In fact, sometimes the animal overcompensates for the loss by growing extra arms. Note that the last idea (the animal overcompensates) is not an explanation of how the arm is replaced, but rather a side note about what sometimes happens along with the replacement of the arm.

Now that we have a clear idea of the intended meaning, let's go through the choices.

A) "it replaces it" is not right since starfish is used in the plural here (we know because of the plural verb "have" earlier). In addition, it's not ideal to link the two ideas with "by" as though the animal replaces the arm by overcompensating. As noted above, the overcompensation is a possible side effect rather than how the arm is replaced.

B) Passive voice ("one arm is lost" and "one arm is replaced" are both passive). This doesn't automatically make a sentence wrong, but raises a flag. Otherwise, I don't have any problem with B

C) Like A, this answer links the ideas with "by" as though the starfish replaces its arm by overcompensating. This doesn't fit the intended story.

D)"they are quickly replaced" is incorrect since "they" cannot refer to the singular arm that was lost.

E) See Additional notes below.

Additional notes:
(1) In addition, unlike A and B, which tell us "with/by the animal overcompensating and growing extra arms", C through E tell us "with/by the animal overcompensating, growing extra arms". The linkage in A and B is more appropriate since these actions occur in sequence. The animal indeed overcompensates and grows extra arms. This can be used to eliminate C, D and E

(2) A, D and E break the flow of the sentence by having a mismatch of active and passive voice in the condition and consequence. A is passive->active (if one arm is lost it replaces it) while D and E are active->passive (if they lose one arm it is quickly replaced). Ideally, both clauses would be active ("if they lose one arm they quickly replace it" as in C). The next best option is to have two passive options ("if one arm is lost it is quickly replaced"). This can be used to eliminate A, D, and E

B is correct.

-Patrick