When you link an image file of a Word document, MS Word creates a virtual connection with that image without actually fit into the document. This is very similar to images embedded in a HTML web page. So if you edit the linked file, the change is reflected immediately throughout the document in Word using that image.
The problem with the "Link to file" approach is that if you upload a document on the web or share via email, the recipient would not see any images as the links are broken. That is where the "Insert Link" command comes in handy. It is like saying - link to the image selected in the Word document, but to be on the safe side, also integrate a copy of the image so that if the original source file could not be found or accessed, the recipients would see the image in the document despite of the fact that image file was not able to be located.
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