Even if they had seen the insulation "hit" the instant it happened (and it happened so fast it was only visible on the slow-motion "instant replay" later -- someone watching that camera's monitor would have missed it "live"), there's another issue.
It just didn't look that bad at the time. It certainly wouldn't have been the sort of issue that screamed "MUST ABORT!". In fact, even the next day, after they had a discussion about the video, based on all they could see and all they knew from previous flights, they concluded that it didn't look all that serious. It's only in retrospect that it's suddenly looking Really Serious. (And even now it may possibly turn out to be a red herring that had nothing to do with the failure.)
And they *can't* and *shouldn't* abort any time something looks "odd" or a "possible" problem. The abort sequence itself is untested, risky, and may result in the loss of the craft. One thread quoted one of the astronauts saying that in the simulator they managed to land safely in less than half of the abort simulations -- the rest of the time they crashed for being unable to make it back to an appropriate runway.
Aborting is NOT something they should do lightly, or "just in case" something appears out of the ordinary. It should be saved for *undeniable* emergencies during launch, when the danger of proceeding truly outweighs the danger of aborting.
It's like leaping out of a commercial airliner with a parachute. It's not something you do except in the gravest of circumstances -- hearing or seeing "something funny" is not a good enough reason.
Not a lot of people realize this. The mindset seems to be, abort the launch and you'll be okay. That is far from true. It takes guts to call an abort because of the inherent risks associated with that. Controllers in fact are reluctant to call for it precisely because it places the systems in a state where there is little experience and even less margin for error.
There have been previous cases where abort is the seemingly obvious call yet isn't made, going back to the very early days of spaceflight. Some of you may be old enough to recall the aborted launch of Gemini 6. The Titan II engines quit after being ignited and the crew had a couple of seconds to decide whether to pull the ejection handle or not. They knew that blasting themselves out of that capsule while it was still on the ground was not exactly without risk, so they sat tight, and saved their ship and themselves.
The other was on the launch of Apollo 12 when the spacecraft lost electrical power as a result of a lightning strike during ascent. The flight director there was very close to calling a launch abort and getting that crew out of there, but the Saturn V was controlling normally even though the command module (separate systems) had lost power. He knew it was safer to get them up into a stable orbit and figure things out than to try an untested abort procedure and risk the loss of the crew during powered flight.