How to: Insert an image link
You can insert a text link by clicking Insert Link to Web Page 
. If you highlighted any text that text will become the link.
If however you highlight an image you get an error: Windows Live Writer tells you to select or enter some text first. An "empty" link is not allowed.
So, back to manually crafting a link?
No.
It is possible to add a link to an image in the same "easy does it" fashion Windows Live Writer so quickly has made us grown accustomed to.
If your image is already present, select it by clicking on it. Otherwise proceed to insert an image.
In the sidebar we now see the Image Properties side panel. Click on the second tab marked Image. A bit down the bar is a section marked Link to. Select the source from the dropdown.
Once you select Webpage URL a window pops up to enter the URL. It has a checkbox to open to URL in a new window if you like:
If a link is already present you have to click the Options button next to the link source dropdown in order to get the window above.
Finally, here is a quick video overview of the steps involved.
With thanks to Joe Cheng for his explanation.
