kaneohe, that is an odd message about the incoming mail server.
Are you doing this?:
-In iPhoto, select the image
-Choose "email" under the "Share" menu at the top of the screen
-You should see a dialog where you can choose a size plus some minor options
-When you are done there, click "Compose"
-iPhoto will automatically generate a mail using the mail app you choose in iPhoto preferences (with whatever your primary account is there, I assume).
If you can't send outgoing mail from hotmail using the mail program(s) on your computer then, yeah, you should sign up for another account as CFB describes .. or use an outgoing address that comes directly from your Internet Service Provider.
Alternately, if you really need/want to use hotmail then, in iPhoto, choose "Share"/"Export" and save as a .jpg that you can attach somehow in hotmail (I have no experience w/hotmail but I assume you can do this).
P.S. Double-check size limits for hotmail attachments to make sure it has a likelihood of going through.