After some digging http://drupal.org/node/320979 I discovered permissions were not set for utilizing the Drupal blogapi_module under:
Home > Administer > User management > Access control (see image below).
I also manually applied the patch outlined here http://drupal.org/node/224006 but it did not work. I am leaving in unless it becomes a problem.
However I discovered one can no longer just insert the image into WLW as before. Now you must configure FTP upload. I used public_html/files with the URL www.bluealien.org/files as my dumping ground. Though I may have had that setup before and forgot about it being needed.
Fix #2 – It wasn’t just images I was encountering problems with but also embedded videos (from GameTrailers) which I had done numerous times without issue. The second fix comes from http://techgurls.blorc.com/2006/10/11/windows-live-writer-xmlrpcphp-cannot-found-error-for-wordpress-blogs/ and by adding a section to the .htaccess file.