Although you can create ripples in a clip in Premiere Elements, you can't map an image to a moving texture in Premiere Elements 8. Sorry.
You can easily do this for a static flag, but when it's in motion, things become a lot more difficult.
This would be an ideal Project for Adobe AfterEffects, their great image animation and compositing program.
About the closest that I can think of in PrE would be to do a Track Matte approximately the size/shape of the flag footage, and then apply it to your image, which would then have its fixed Effect>Opacity lowered to reveal the flag. It will not be exact to the shape of the flag, which will change over time, and is probably not the effect that you are looking for. AE, on the other hand, can do what I think you are looking for, but not without some work.
It could also be done in Photoshop, with Rotoscoping, but this will be a Frame-by-Frame image editing project, using the Warp, or Liquify Filter, and probably Displacement Filter. For a very long Duration, this will be tedious, at best.