Yes, it's made from bugs
Shellac is cleaned and dried lac, which is a natural resin that is exuded by smallish sap-sucking insects (especially L. lacca). It has been known and used in India and China for about 4,000 years, but came to Europe only about 300 years ago.
More than a varnish
Shellac is most familiar to most people as a liquid that is applied as a wood finish, but wood finishing ranks only eighth among the uses for shellac, the top four being in pharmaceuticals, food, hats and electrical products. Shellac is non-toxic and FDA approved for use in food and drugs. For foods, it is used to coat and glaze candies so they "melt in your mouth, not in your hands" or to give a shiny appearance (Reese's Pieces, for example, and previously M&M's). It is also used to coat apples and other fruit. On pills, a shellac coating provides a time-release function, ensuring that the medication passes through the stomach for later absorption in the intestines. Shellac is also used as sealing wax and to glue glass light bulbs to their metal bases. It was once used as an insulator for wires, in hairspray, and to make early 78 rpm phonograph records.
Shellac was apparently first used as a protective and beautifying finish for wood in India, where most lac is produced. Wood turners applied wax-like shellac to the turning wood, which melted it. They then rubbed it in with brushes. That technique is still in use today. Europe didn't use shellac as a finish until the early 1800's, when shellac began to replace oils and waxes in finishing wood. It was appealing because of its high polish and mirror-like surface.
Today, shellac is seldom used to finish new funiture or cabinetry. Since WWII, it has been replaced by acrylics and polyurethane varnishes, which have superior qualities in durability and application. Shellac absorbs water, is easily redissolved by alcohols and reacts chemically with alkalies, so it is easily marred by beverages and household cleaners. It is also easily scratched and can crack. Some of these drawbacks can be prevented by using high-quality de-waxed shellac and using freshly-dissolved flake shellac rather than the canned liquid form. In ordinary woodworking, shellac finds use as an excellent wood sealer. It is unrivaled in preparing wood for staining and other finishes.
Shellac remains the finish of choice for restoring fine antique furniture, however. Some fine funiture makers still favor shellac, though, because the beauty and feel of its finish cannot be matched by modern synthetic finishes, particularly when applied by the French Polish technique. Shellac is also by far the most environment-friendly of all wood finishes.
How it's made
The raw material and main constituent of shellac is lac, a waxy resin that female insects of the subfamily Lacciferinae secrete to attach themselves and their eggs to the small branches of certain tropical trees. The lac crust also protects the parasitic larvae of the bug. Twigs heavily encrusted with the lac exuded by millions of the tiny insects are harvested from the trees in a form called sticklac.
The sticklac is crushed and the wood is picked out. It is then washed to remove the natural coloring (lac dye), a useful by-product which may make up about 10% of the sticklac. The lac is then powdered and is either dissolved in alcohol or melted and then filtered to remove insect bits, wood, sand and other gunk. The result is seedlac. The filtered lac is dried or cooled into thin sheets from which the shellac flakes are obtained. The Indian shellacs are made by melting the dried lac. They come in different color grades and all contain wax. Commercial-grade shellacs have been further refined to remove wax and color.