Life insurance is meant to protect people who would lose something when the insured dies. STOLI turns it into a bet on a stranger's death, which is why California prohibits it.
Definition (§10113.1(w)): stranger-originated life insurance is an act, practice or arrangement to start a life insurance policy for the benefit of a third-party investor who, when the policy is issued, has no insurable interest in the insured. Typical signs: the premiums are funded by someone who could not lawfully buy the policy, and from day one there is an agreement to transfer the policy or its benefits to that third party. Trusts created just to look like they have insurable interest violate the law too. Entering into STOLI is listed as a fraudulent life settlement act.
The test is timing: insurable interest must exist when the policy is issued.
A person has unlimited insurable interest in his or her own life and may name any beneficiary.
Others have insurable interest through love and affection (close relatives by blood or law) or a reasonable expectation of financial loss from the death: for example an employer in its officers and key employees, a business partner under a buy-sell arrangement, or a creditor.
Legitimate life settlement: the owner bought the policy with genuine insurable interest, and later circumstances changed (health, finances, no more need). Selling it to a licensed provider for more than the cash surrender value is legal. A viatical settlement is the same idea for a chronically or terminally ill insured. A life agent who represents an owner in a settlement acts as a life settlement broker; an agent licensed for at least one year qualifies by notifying the Commissioner within 10 days and paying $85, with no separate broker license (§10113.2(b)(1)(D)).