I noticed that my kid and her cousin play some doctor game where she had raised her t-shirt. As soon as entered they got scared and tried to cover up all. What does all this mean and how to deal with the situation? They both are 5 and 7 respectively.

They are still kids who don't really know about the "sexual" aspect of anything. They are innocent yet they know that something is just not right in what they are doing else they wouldn't cover up or get scared when they see you or anyone else. The situation needs to be dealt calmly. Talk to both and just explain that they shouldn't remove their clothes in front of anyone other than parents or allow anyone to touch them in their privates. Kids need to made confident and aware so that they don't get scared or feel guilty.