You can insulate it, but not with a flammable insulation. Fiberglass or rock wool wrapped in high-temp foil tape would be fine, closed cell foam as depicted not so much.
The gases in the vent stack under normal operation are well above the service temp of any closed cell pipe insulation, and under some conditions will exceed it's melting or kindling temperature (varies by polymer type.) The gases coming out of the water heater itself are even hotter, but diluted by the room air by the time it's in the vent piping, making the stack temp somewhat cooler. If the stack is blocked or backdrafting, you get the full blast of less-diluted exhaust pouring across the top of the tank.
It's quite possible that it's venting properly when the water heater is firing, with the spillage onto the water heater occurring primarily when the other bigger-burner appliance is running. It's also possible that your house is tight enough that any time the clothes dryer and kitchen exhaust fans are running at the same time it back-drafts. Any time there is any suspicious symptom like what you see in the pictures it's worth testing it under different modes, but get it looking sorta-code-legal first: Replace the tee with a wye into the common flue, seal all seams & joints, peel back the insulation so that even if it backdrafts the hot gases won't be blowing directly onto the insulation.
Last edited by Dana; 10-24-2013 at 08:50 AM.