The Sea of the Damned is the threshold on which piratical souls end up, and quite possibly the raw stuff from which the Sea of Thieves was formed as a dimension. It is from there that they are chosen and uplifted by the Pirate Lord and set on the doorstep of the Sea of Thieves, the isle we play the tutorial at. The pirates of the Sea don't seem to truly die, with player pirates merely discorporating and outright returning from the Sea of the Damned immediately and others either becoming ghosts and skeletons (possibly with the ability to regain their fleshy forms held back only by their corruption) or reincarnating the same way they first came in, or like the players; only those who completely move on leave this cycle. The two Seas exist in a dualistic state and can interact with one another, and the lost souls of the Sea of the Damned envy and covet the Sea of Thieves's paradisaical conditions; the Skeleton Lords are powerful souls corrupted by potent vices to the point of demonhood, which seek to subvert, damage or take over that paradise. Chosen pirates can still be corrupted back into phantoms and skeletons, as Briggsy shows. As chosen souls, pirates of the Sea are superhumanly hardy and capable of absurd feats beyond normal humanity; their original state as ghosts is hinted at by the login screen which has the player pirate form out of the same green soulstuff as all phantoms.
Thus, the Sea of Thieves is a sort of heaven of pirates where they get to engage in all things pirates love (or are popularly thought to love) to do, from adventure and looting and fighting each other to drinking and doing crazy dumb things for fun, presided over by the Pirate Lord as a kind of benevolent god of piracy. Meanwhile, the Sea of the Damned is held in check by his friend the Ferryman, and functions as an underworld for the baser souls deemed unfit for the paradise Sea; the Ferryman and the Pirate Lord both ensure that the chosen always return to the Sea of Thieves as per their cosmological order. Together, they preside over all aspects of afterlife for pirates.