1) Am I spending too much time in Urubamba and the whole Cusco area?
Urubamba is a dump (relatively speaking); Cusco has a lot more to do and you just might need more time to acclimatize than you thought.
2) Suggestions are welcome for a place to stay at Lake Titicaca.
We did a family stay at Amantani, which although sparse by US standards, was quite nice and an authentic experience. Because our arrival didn't mesh with the normal folks who'd arrive in the morning for the group tour of titicaca, we ended up hiring a boat all to ourselves. It was a bit extravagant but nice and quiet. We booked through
http://www.titicacaperu.com/
4) For Arequipa, we want to stay in a (nice - US 3.5-4 star level) hotel that is within walking distance of all the historical sites in the center of the city.
We spent a night at los tambos, which was quite nice despite the day we arrived it started to pour. It's a 3.5 star hotel and if I remember correctly, definitely within walking distance to all the good sites.
Hope this helps!