Substitution of collateral in basic terms means that in a total loss situation you are able to substitute the car that was the collateral for the loan with a different car. So instead of the lien holder getting the actual cash value for the vehicle and you needing to pay off the balance of the loan and find another car instead you use the ACV settlement check to get another vehicle and your existing loan and terms remain the same. Some lenders allow this while others do not.
Sometimes this procedure is called a title swap. The process may differ in other ways too such as the insurance company may pay for a car of similar value to yours and exchanges titles with your finance company or bank.
So if your car was in an accident and declared a total loss then instead of being compensated by receiving the actual cash value for the vehicle, which may or may not be enough to pay off what you owe to your lending institution, you can suggest or request a substitution of collateral. This means simply that you use the insurance settlement money for the vehicle to replace your totaled vehicle with one similar in value and ask your lien holder to accept an exchange of title of the totaled original car for the title of the new one that you are replacing it with.
If the lending institution agrees then a lien similar to the original auto is placed on your new car. The title of the totaled vehicle is given to the insurance company for them to sell for salvage, etc. To be able to get a substitution in collateral all parties must agree to the substitution of the new vehicle for the old wrecked one. So the insurance company, the lien holder (bank or lending agency), the dealer selling you the new replacement car and you agree to this new situation.
If your vehicle has been found to be a total loss you may speak with the insurance adjuster dealing with your claim and the lien holder of your vehicle to see if a substitution of collateral is an option that they both would agree to.