That option is not automatically turned on for you.  To turn this on, navigate to your settings and click on the Labs tab.  Scroll through the list until you see one that says “Insert Image”

Click on Enable to turn it on.  Scroll down to the bottom of the page and click on Save.  This will activate the image feature on your email account.

Now when you compose a message and want to insert an image click on the following icon:

Then you can insert an image by selecting it.  Once this feature is active you can also copy and paste to insert an image.