A novel on-line technique for monitoring the insulation condition of AC machine stator windings is proposed in this paper. The concept is to measure the differential leakage currents of each phase winding from the terminal box in a non-invasive manner to assess the insulation condition during motor operation. The conventional differential CTs used for phase fault protection can be replaced with high performance current sensors to measure the leakage current with higher accuracy. Indicators for insulation condition such as the capacitance and dissipation factor are calculated based on the measurements to provide a low cost solution for on-line insulation condition assessment. A simplified on-line insulation system model is derived for analysis and interpretation of the measured data. Experimental results on a 15 hp induction motor under simulated insulation degradation conditions show that the proposed technique is a very sensitive method capable of detecting incipient signs of insulation degradation.