Captain Blood didn't always have a hook for a hand. He used to have two perfect hands. However, that was before he challenged El Toro to a duel above Gold Creek. In the ensuing duel, Captain Blood lost his hand "and it fell, along with his sword, into the creek below" (as stated by the second El Toro, Don Rodrigo).
Eventually, Blood achieved undeath; this spread to his removed hand. However, given that it was in water, it deteriorated much faster than the rest of Captain Blood. In fact, by the time the player learns of its location and comes to get it, the hand is little more than bones (which have been warped into a claw-like vice because of the loophole with Death).
The hand comes to be quite useful, as it is the only thing that can stop Blood's immortality. Though the game cannot end unless Blood plays the cards "by his own hand", it just means that his hand alone can play the cards and the game will end. With help from the local Card Dealer in Miranda, the player tracks down every last card- two aces, two eights and a two -and plays the cards at the table, where Death's hand still waits. Understandably, Blood loses the game.
Presumably, Blood's loose hand turns to dust along with him after he is killed.