Admin CP > Avatars > User Picture Storage Type That will tell you the storage type at the top. If you want to switch the storage type, click the Help question mark there and it will tell you what you need to do. If you don't understand something in there, just post back here.
Well, you need to have the folder chmodded to 777 so you can read and write to it. You can use htaccess on the folder though if you want to prevent hotlinking, but that isn't necessary.