AO3 doesn't have an image system.
When that will change, who knows…
You have to upload your images on a separate site, then add the URL of your image location into your story.
Popular options include:
- Imgur,
- Tumblr,
- Livejournal
When you click the 'insert image' button in Rich Text view, you'll notice that there's no 'browse' option for uploading pics, but rather, there's a place ('Source') where you'll paste the URL of where your image is hosted, all you need to do is paste the url of the actual image location. Then you can do fancy things if you switch over to HTML view, like centering the image.
I created an Imgur account purely so I can add pics to my AO3 stories.
The downside is that if you mess with the externally hosted image, you'll break the link of the image in your fic, so whenever you make updates on the externally hosted page, you have to update the URL link in your AO3 fic.