It is indeed condition 2.
Your master password is used to derive a master key, using the specified number of KDF iterations. This master key is then used to decrypt an encryption key, which is used to encrypt/decrypt everything in your vault.
There are several reasons why this wrapping method is preferred, the biggest one for Bitwarden right now is the fact that you can change your password without needing to update everything in your vault.
If you a looking to update the encryption of everything in your vault, for some reason, that can by done by selecting “Also rotate my account’s encryption key” on the change password screen. You should note that this might take a while and is a somewhat more dangerous operation due to potentially causing your vault items to be locked forever if something goes wrong during your key rotation (see the help docs)