I think it's important you let your brother and sister in-law know. Just tell them straight out what actually happened and that it made you feel concerned, chances are because you are family, they're most likely going to take it better that if it were a freind for example. I know this is going to sound like the usual type of advice but the only thing you can do at this stage is you and your brother sit down with him and explain that the behaviour wasn't acceptable, also that "mum and dad don't expose themselves to other people etc". additionally, when they are together, make sure they are strictly supervised, and tell your daughter she is to come straight to mummy if it happens again. all the best :)
You tell the parents exactly what happened, they speak to him and get some counseling for him, do not allow your daughter to be alone with him and infact he should not be in your home.at all.