Color Management Policies
The Color Management Policies section of the Color Settings dialog box allows you to instruct Photoshop how to deal with particular situations related to profiles embedded (or not embedded) in existing images. The options you set will define the default action Photoshop will take when an embedded profile in an image doesn't match the working space you have defined, or when there isn't a profile embedded at all. Individual options are available to set the policy for RGB, CMYK, and grayscale colour models. The options for Colour Management Policies are Off, Preserve Embedded Profiles, and Convert To Working. It is important to understand that the setting you use here is the default option, and there are ways to override the default value as explained in the following text.
Off
This setting, as you might expect, simply turns off colour management. Since you're reading this, you probably want to take full advantage of the benefits of colour management, and so this option is not one you would choose. It most certainly isn't an option I recommend. With this setting, the colour numbers in the image are preserved, but the meaning of those numbers will be interpreted based on the current working space. If the embedded profile in an image matches the working space, then the colours will appear correctly. If the image is not tagged with a profile, or if it is tagged with a profile other than the current working space, the colour numbers will still be interpreted with the working space and, therefore, probably will not be displayed accurately. I can't think of a single good reason to use this setting when working with photographic images, so I avoid it.
Preserve Embedded Profiles
This option will preserve the embedded profile in an image if it is tagged with a profile. This allows you to see what the image looks like with the embedded profile without converting to the working space. Although such a conversion is intended to maintain the appearance of colours in the image, a significant difference in the colour gamut of the source versus destination profiles can still result in a loss of information. This setting is most useful if you frequently open images that have already been tagged with a profile other than your normal working space. For example, if you have images scanned by a lab that assigns a custom profile to the images, you would want to see what the image looks like before the conversion to your working space. For most photographers, this type of situation doesn't come up very often, so it usually isn't the best choice. Particularly for photographers using a digital camera, I prefer to convert the image to the working space rather than keep it in the colour space defined by the camera. However, if you work with a large number of images that have a custom profile assigned to them, such as drum scans provided by many labs, this may be a good choice.
Although the Preserve Embedded Profiles option isn't the best option for most photographers, it is the right option if you use custom profiles. When using a custom profile for film scans or digital captures, you don't want to convert the image to the working space before assigning the custom profile, and so the Preserve Embedded Profiles option makes most sense.
There are situations where different profiles are used for particular images. For example, images that will be presented on the Web, via e-mail, or with a digital projector will likely benefit from being converted to the sRGB colour space; you would not want to convert to your working space of Adobe RGB (1998), for example, only to convert them again to sRGB after adjusting them. For those images, you want to preserve the embedded profile rather than converting to your working space. If this is a significant portion of the images you work with, you may want to select Preserve Embedded Profiles as your default Colour Management Policy. However, for most photographers this won't represent the majority of images.
For images that do not have an embedded profile, when you have this option selected the image will be interpreted based on the current working space, and when you save the image it will still not have a profile embedded.
Convert to Working
The working space you select as your default should be chosen because it represents the
best balance between the colour gamut of your monitor and that of the intended output method you will use to reproduce your images, both now and in the future. Therefore, it makes sense to convert your images to that working space unless you have a very good reason for doing otherwise (such as when you are using custom profiles, as mentioned in the previous section).
Besides the fact that your selected working space is well-suited for the output methods you will use for your images, it also provides the benefit of consistency for your images. While this isn't a significant benefit, it does mean that all of your images will have the same colour palette available to them, which provides some consistency for them.
If your scanner software provides the option to tag the scanned images with your working space as a profile, I recommend taking advantage of that option. Otherwise, convert those images as well. Likewise, if your digital camera offers the option to tag your images with your preferred working space at the time of capture, I recommend using this option, in which case you won't need to convert your images to the working space after the fact. If this option isn't available with your digital camera, then convert the images to your working space when you open them.
If you open an image that is already tagged with your working space as the profile, then no conversion is necessary, and you won't receive a warning message when you open the image.
Profile Mismatches
The Profile Mismatches checkboxes allow you to specify whether the option you set under the Colour Management Policies should be performed automatically to your image or whether you want to be asked if a different action should be taken instead.
With the Ask When Opening checkbox checked, the Colour Management Policy you selected will be the default action, but you will be asked for confirmation with the opportunity to change the action to be taken if you open an image tagged with a profile that differs from your current working space. If the box is not checked, the Colour Management Policy selected will determine the action taken, and it will be done without offering you the option to change the action to be taken.
The Ask When Pasting option has the same behaviour, except that it affects the copying of pixels from one document to another. If this checkbox is checked and you copy and paste pixels from a source document with a different profile than your destination document, you will be asked what action should be taken. The Colour Management Policy will determine which action is the default. If the box is not checked, then the Colour Management Policy selected will determine the action taken, and it will be done without offering you the option to change the action to be taken.
If you always use the same Colour Management Policy for every image in every situation, then it is convenient to leave these checkboxes unchecked, so that you don't need to be bothered with an extra dialog box asking you a question that you answer the same way every time. However, if you turn off the checkboxes, you'll never receive a warning, which means that when you do have an exception you may not remember to change your colour settings first, causing the image to be handled inappropriately. For example, if you have images you have optimized for the Web and converted to the sRGB colour space, you won't want to convert them to a working space of Adobe RGB (1998) when you open them.
My preference is to keep the boxes checked at all times. It means I am asked what action I want to perform for every single image, but I prefer this for two reasons. First, I always know what is being done to my images. Second, I always have the option of changing the default behaviour, so when I'm working with an image that is an exception to my normal workflow, I will get a reminder to change the setting as needed.
Missing Profiles
The Missing Profiles option provides the same Ask When Opening checkbox available for Profile Mismatches. The only difference is that this option deals with images that are untagged, meaning that no profile is assigned to them. I always leave this option turned on, so that if I open an image that doesn't have an embedded profile, I'll want to select a specific profile to assign to the image to provide the most accurate interpretation of the colours in the image.
Default Doesn't Mean Always
It is important to remember that the right setting is defined by your specific needs for the image, the source of those images, and the specific method to be used to produce the final output. While I've offered recommendations based on what settings will work best for most photographers in most situations, that doesn't mean the settings presented will always be the best choices for all of your images. By understanding what each setting means, and what determines the optimal choice for each setting, you'll be able to make an informed decision about what settings to use under particular situations.
This also reinforces the reasons I recommend keeping the Profile Mismatch checkbox and the Missing Profile checkbox selected so you will be notified when such a situation exists and can determine the best course of action for the particular image with which you are working.