While it sounds like you have some less desirable options, which would be worse... going to a loving sister with a small house and being raised a little differently (but well loved) or your children divided up and shipped around to different foster homes where they may end up being one of several foster kids crowded into an even smaller house and not loved?
I am personally of the opinion that the KNOWN UNDESIRABLES are better than the UNKNOWN UNDESIRABLES. What I mean is that you can make some provisions in your will that will combat against what you already know. As a pp mentioned, you can get life insurance policies that are put in a living revocable trust for your children. You want to make sure you designate a trustee of the estate and NOT leave anything directly to minor children. By establishing something like this, your sister, although she may not raise your child as you would exactly, would have a greater bond with your kids than any stranger juggling multiple foster children. As long as you are not sending them into an abusive family, not designating a guardian would add so much more pain to your children than any damage familiar family could cause.
We have a will and while our designated trustee and guardian will not raise dd as *I* would, she'd love and protect her. Nothing would ease the pain of losing both parents if sent into the system. The best you can hope for is a loving, safe environment. Anything beyond that is pure luck.