Drag an image from your computer onto a message you are writing in Mail, and it goes into the message where you drop it. Insert images, beside the paperclip, puts in images from Your images, or uploads them there, at the cursor. Images you add are saved in Your images too.
While you write, a large image is shown smaller, so it does not push the writing out of view. The email is sent with each image at its full size, where you put it. To take an image out, select it and delete it. Other files dropped on the message are attached, as the paperclip attaches them. Images and attachments can be up to 10 MB in total.