This is most likely because the image is copied from File Explorer. It will then be added as an attachment instead of embedded in the text.
To verify that your Outlook is working as intended try using the PrtScrn button and then Ctrl + V in Outlook. If the file is added directly then everything is working as intended. There is no way to copy a picture directly from File Explorer and have it embedded.
If you want to embed a picture you have already saved in File Explorer, open it in Paint > Copy the picture > paste into Outlook.
To insert a picture from a file:
- In an open message, on the Insert tab, click Picture.
- Browse to locate the picture that you want to insert.
- Click the picture you want, and click Insert.
NOTE: Microsoft Outlook automatically embeds pictures in a message. You can reduce the size of your email by linking to the picture. In the Insert Picture dialog box, click the arrow next to Insert, and click Link to File.